I met a friend at Ole’s (Waffle Shop) yesterday. The restaurant has been in Alameda since 1927. My friend was greeted by name, by most of the staff.
It was 11:45am and we both ordered breakfast. I’m a fan of their waffles.
It is the way the property is used that determines the type of property it is, not what it looks like. Based on the intent of the owner, the property could be a principal residence, income property, investment property or dealer property.
A principal residence is a home that a person lives in. There can be only one declared principal residence. It is afforded certain benefits like deducting the interest and property taxes on a taxpayers’ itemized deductions, up to limits. Up to $250,000 of gain for a single taxpayer and up to $500,000 for a married couple filing jointly can be excluded from income if the property is owned and used as a principal residence for two out of the previous five years.
An income property is an improved property that is rented for more than 12 months. The improvements can be depreciated based on a 27.5-year life for residential property or 39-years for commercial property. This is a non-cash deduction that shelters income. When the property is sold, the cost recovery is recaptured at a 25% tax rate.
An investment property could be an improved property or vacant land that does not produce income and is not eligible for depreciation or cost recovery. The gain on both income and investment properties are taxed at a lower, long-term capital gain rate and are eligible for a tax deferred exchange.
Second homes are properties that a taxpayer primarily uses for personal enjoyment but is not their principal residence. For IRS purposes, it is treated as an investment property in that the gain is taxed at preferential long-term rates if it is held for more than 12 months. However, it is not eligible for exchanges because personal use properties are excluded from that benefit.
Properties that are built or bought to make a profit are considered inventory and are labeled dealer properties. The gain is taxed at ordinary income rates and they are not eligible for section 1031 deferred exchanges.
The financing available differs considerably based on the intent of the owner which determines the type of property. Owner-occupied homes, used as a principal residence, are eligible for low down payment mortgages like VA, FHA, USDA and conventional ranging from nothing down to 20%.
A second home, in most cases, requires a minimum of 10% down payment. Investment and Income properties, generally, require 20% or more in down payment with some possible exceptions. There is not any long-term financing available for dealer property.
The least amount in a down payment is an attractive option when people are thinking of buying a home. A common reason is to have cash available for furnishing the new home and possible unexpected expenses.
Some people don’t have any options because they only have enough for a minimum down payment and the closing costs. For those fortunate buyers who do have extra money available, let’s look at why you’d want to do such a thing.
Most loans in excess of 80% loan to value require mortgage insurance to protect the lenders for the upper portion of the loan if the home were to go into foreclosure. FHA requires an up-front premium of 1.75% of the amount borrowed plus a monthly amount of .85% on the balance. FHA mortgage insurance premium must be paid for the life of the loan.
Mortgage insurance on conventional loans varies depending on the borrowers’ credit and the amount of down payment being made. Unlike FHA, when the unpaid balance reaches 78% of the original amount borrowed, the mortgage insurance is no longer needed. If the home enjoys rapid appreciation, after a period, the lender may allow the borrower to get an appraisal to show that the unpaid balance is now less that 78% of the current appraised value.
The premium for mortgage insurance on conventional loans can be paid as a single premium upfront in cash or financed into the mortgage. A second option would be monthly mortgage insurance included in the payment until it is no longer needed. A third option could be lender-paid MI where the cost is included in the mortgage interest rate for the life of the loan.
VA loans do not require mortgage insurance but there is a one-time funding fee of 2.3% that can be paid in cash at closing or added to the amount borrowed. Disabled veterans and Purple Heart recipients are not required to pay the funding fee.
Putting at least 20% down payment on a home not only will avoid the mortgage insurance, it could also help you to get a little lower interest rate. Since the loan to value is lower, there is less risk for the lender.
A $350,000 with a 10% down payment at 4% interest could have a monthly mortgage insurance cost between $70 to $130. A trusted mortgage professional can help you assess the options you have available. It is always better to make some of these decisions before you start shopping for a home.
This is another reason it is good to start by getting pre-approved with a trusted mortgage professional. If you need a recommendation, call me at (510) 908-9021.
Home improvement loans provide a source of funds for owners to finance the improvements they want to make. These are usually, personal installment loans that are not collateralized by the home itself. Since there is more risk for the lender with this type of loan, the interest rate is higher than a normal mortgage loan.
In today’s market, the rates on home improvement loans could vary between 6% and 36%. A borrower’s credit score will determine the interest rate; the lower the score, the higher the rate and the higher the score, the lower the rate.
Smaller loan amounts are under $40,000 with larger loan amounts over $40,000 based on the extent of the improvements to be made. With all things being equal, a larger loan may have a lower interest rate.
Besides the interest rate being higher than a regular mortgage, the term is shorter. Similar to a car loan, the term can be between five and seven years. A $50,000 home improvement loan for a borrower, with good but not great credit, could have a 12% interest rate for seven years. That would make the monthly payment $882.64.
An alternative way to fund the improvements would be to do a cash out refinance. These types of loans are collateralized by the home. The current mortgage would be paid off with the new mortgage plus the amount for the improvements. Lenders will usually require that the owner maintain a minimum of 20% equity in the home.
Assuming a homeowner owed $230,000 on the existing mortgage and wanted $50,000 for improvements. The new loan amount would be $280,000 and the home would have to appraise for at least $350,000 for the homeowner to have a 20% equity remaining.
Another thing that occurs on a refinance is that the standard term for mortgages is 30 years which means the owner would be financing the improvements for 30 years instead of a shorter term. The advantage would be a smaller payment.
Let’s say in this example, the owner originally borrowed $250,000 at 4.5% for 30 years with a payment of $1,266.71. After 54 payments, the unpaid balance is $230,335. If they did a cash out refinance at 4.5% for 30 years for the additional $50,000 and financed the estimated closing costs of $8,700, the new payment would be $1,464.50.
Using the home improvement loan, the combined payments would be $2,149.35 which would be $684.85 higher. While the cash out refinance produces a lower payment, it adds $8,700 to the amount owed and stretches it out over a longer period. Home improvement loans have lower closing costs than regular mortgage loans.
Another alternative loan is a HELOC or Home Equity Line of Credit which can be explored and compared to the two options mentioned above. If a homeowner is going to finance improvements, a comparison of different types of loans and payments can be helpful in the decision-making process.
A trusted mortgage professional is a valuable resource to assist you with current and accurate information. If you need a recommendation, please call me at (510) 908-9021.
House-hacking refers to buying a multifamily property on an owner-occupied mortgage, living in one unit and renting the others. If you’re thinking about becoming a rental mogul, starting early is an advantage. Not only will you have longer to accumulate a larger portfolio, you can increase the leverage on the first acquisitions if they are owner-occupied.
Leverage is the use of other people’s money to finance an investment. The higher the loan-to-value, the greater the leverage which can increase the yield.
A $200,000 rental property with an 80% LTV at 4.5% for 30 years producing a 16.88% before-tax rate of return would increase to a 23% return on investment by increasing the mortgage to 90%. A typical down payment on an investor property in today’s market is 20-25% but, in some cases, a higher loan-to-value is possible.
Owner-occupied, multi-unit properties, two to four units, allow a borrower to occupy one of the units and rent the others out. The cash flows from the rental units subsidize the cost of housing for the unit occupied by the owner. VA will guarantee 100% of the mortgage for eligible veterans, while FHA will loan up to 96.5% for qualifying borrowers.
Consider a four-unit property was purchased as owner-occupied and the other three units were rented for $800 each. If an FHA loan was obtained, the owner could live for roughly $355 a month after collecting the rent and paying the expenses. Assume the owner lived in it for two years and then, rented out the fourth unit for the same $800 per month. The cash flow would rise to $4,800 a year with a before-tax rate of return of 30% based on a 2% appreciation.
|Occupy 1 unit||Rent all 4 units|
|Gross Scheduled Income @ $800 monthly each||$2,400||$3,200|
|Cash Flow Before Tax||$4,59||$4,861|
|Before Tax Rate of Return||20.77%||30.56%|
Rental properties offer the investor to borrow large loan-to-value mortgages at fixed interest rates for up to 30 years on appreciating assets with tax advantages and reasonable control that many other investments don’t enjoy.
Some people consider rental properties the IDEAL investment with each letter in the acronym standing for a benefit it provides. It provides income from the rent which many investments do not have. Depreciation is a non-cash deduction from income that increases cash flow. Equity buildup occurs as each payment is made by reducing the principal owed. Appreciation happens over time as the value of the property increases. L stands for leverage that was explained earlier in this article.
You may be able to buy another four unit as an owner-occupant before you need to start using a normal investor’s down payment. In the meantime, you could have eight units that are increasing in value while the mortgage balance is decreasing with every payment made. If there is sufficient equity in the properties by the time, you’re ready to buy more, you may be able to take cash out of the existing ones to use for the down payments.
This can be a great way to turbocharge your net worth by becoming an owner and a real estate investor at the same time. To learn more about rental properties, download the Rental Income Properties guide and/or contact me at (510) 908-9021 to schedule an appointment to meet to discuss the possibilities.
What do you think the motivating reason would be for the 5% of all homebuyers who chose not to work with an agent but instead conducted their own home search, contacted the seller, negotiated the contract, located their financing, arranged their inspections and all of the other services provided by REALTORS®? Most people would probably guess the buyers were wanting to do the work themselves and earn the commission in the form a lower purchase price.
Looking at it from the seller’s perspective, what would be the reason for the 8% of all home sellers who chose not to work with an agent but instead did their own research to determine the value of their home, coordinated all of the marketing efforts necessary to have sufficient exposure to the market, negotiate directly with the buyer, and investigate all of the other steps necessary to close the sale? Is it possible and even probable, that they too were trying to earn the commission and net more proceeds from the sale?
If the home sold for fair market value, it would be reasonable to assume that the seller won out over the buyer. If it sold for less than market value, it seems that the seller didn’t realize his full equity in the home. In either case, both buyer and seller engaged in activities that they were less experienced and capable than the real estate professional.
The Profile of Home Buyers and Sellers (Exhibit 8-1) reports that 14% of sales were For-Sale-by-Owners in 2004 compared to just 8% in 2019. The trend shows that agent-assisted sales rose to 89% in 2019 from 82% in 2004.
The three most difficult tasks identified by for-sale-by-owners is getting the price right, preparing or fixing up the home for sale, and selling within the length of time planned.
The time on the market for sale by owners experienced was less than that of agent assisted homes; two weeks compared to three weeks. This could indicate that the home didn’t maximize its potential sales price. According to the previous mentioned survey, for sale by owners typically sell for less than the selling price of other homes.
The reality is that both parties cannot earn the commission. It is earned by providing specific services that are essential to the transaction. The capital asset of a home represents the largest investment most people make. An investment of that importance certainly deserves the consideration of a professional trained and experienced to handle the complexities involved. There is value to having a third-party advocate helping each party to the transaction.
The tasks involved in buying and selling a home exist and must be done. Since nine out of ten transactions involve an agent and therefore, a commission. It comes down to deciding which is more important: time or money. If a buyer or seller values their time more than the commission, they’ll usually work with an agent. If money is more valuable to a buyer or seller, they may try purchasing or selling without an agent. One thing is for sure: there are two parties to the transaction and only one commission.