When it comes to mortgage debt, I’m a man of contradictions.
I’m a big fan of having the option of tapping your home equity to meet short-term cashflow needs, as I explained over a year ago in “Springy Debt instead of a Cash Cushion“.
On the other hand, I’m also a fan of paying off your full mortgage balance in the case of early retirement, since it provides a stable return equal to the interest rate of the mortgage you’re paying off, reducing the risk of trouble during economic storms of the future. A mortgage-free primary residence is the biggest factor that keeps the MMM family’s living expenses so low these days (around $2000 per month).
But mathematically, if you don’t mind higher risk, the odds are still in your favor if you leave your house leveraged and invest in higher-yielding assets. As noted in “Pay Down the Mortgage or Invest More?“. In that article, we learned that today’s cheap mortgage debt is a very useful tool in the hands of a skilled real estate investor.
In the area of rental houses, I have also taken the most wimpy and conservative path: I have one rental with no mortgage at all. Even though the case for keeping a mortgage on your rental property is actually much stronger than that for your primary house. The reason is taxes:
You’ll often hear people repeat the slogan “In the US, mortgage interest on your primary house is tax deductible”. But it’s actually not true for many of us, because of a concept known as “the standard deduction. Here’s a quick example to illustrate:
Imagine a couple, filing under the “married filing jointly” tax category with $100,000 in combined income and no mortgage debt. They got to claim a “standard deduction” of $11,600 on the 2011 taxes that they just filed earlier this month.
Now imagine an almost-identical couple with a $200,000/4% mortgage on their house. Their mortgage interest was about $8000 for the year, and property taxes were $1500. Both those items are tax deductible in US tax law, so they type them into Turbo Tax.. and… the program informs them that they’ll still pay less taxes by taking the Standard Deduction of $11,600.
So in fact, you could say that mortgage interest for couples is only tax-deductible on the balance of your mortgage between about $250,000 and $1 million, the upper limit for the mortgage deduction. Most people, especially those hoping to amass great wealth, try to avoid mortgages in those higher ranges. (For single tax filers the standard deduction is halved to $5800, but the impact is still significant).
But the situation is different, and better, when you start talking about investment properties. On the rental, every dollar of mortgage interest is 100% deductible off of your taxable income for the property. And you still get to keep the full standard deduction on your personal return. This is a significant benefit, especially for people in higher tax brackets.
So now we’re about to get to the point. I’ve been doing some investment property shopping in my neighborhood in recent weeks, and I think I’d like to pick up a second rental sometime soon.
In fact, I might even buy the house next door to me. It’s currently tenant-occupied, as the original owner moved away several years ago. The owner is an older lady who is clearly frustrated with the experience of being a landlord. She also lives in another city, forcing considerable commuting time onto her when she needs to tend to the house. With a shortage of cash and no carpentry skills, she keeps the place in less-than-beautiful condition, which reduces her rent income, and provides a daily eyesore for me. If I could buy it and make it beautiful, I could rent it out for $1600 per month, providing a great return on my investment. It would also increase the eventual resale value of my own house and the entire street, so any upgrades I complete will generate payback in multiple ways.
Don’t tell her I’m thinking of this, however, or she’ll raise the price on me.
My choices to pay for it would be:
1) Pay cash for the new investment property.
PROS: The ultimate in convenience and fun.
CONS: Ties up a lot of cash, and I don’t even have enough cash to do it right now.
2) Get a conventional mortgage to buy the new place.
PROS: fairly simple
CONS: slows down the home-buying process, locks you out of the best fixer-upper deals, since they are typically in a condition that will not qualify for a mortgage, and increases your costs since you need to pay lender and appraiser fees.
3) Use my existing home equity line of credit.
PROS: Same convenience as cash, since you’re just writing a check. But keeps cash free for other investments. Ultra-low 3.25% interest rate.
CONS: Interest is not tax-deductible as noted above. Decreases or eliminates my cash cushion, which is a safety margin I’d like to keep. Line of credit is not currently large enough to buy a typical investment house around here, although I could expand it, for a fee. Would need to pay back balance in full if I decide to move.
4) Get a line of credit on the existing rental house, and use it to buy a second house in “cash”.
PROS: Same convenience as cash, tax-deductible, keeps all other funds available for use. Automatically gets paid back if I ever sell the existing rental house.
CONS: Slightly higher interest rate due to it not being a primary residence. May need to pay fees to set up this line of credit.
So I’m leaning towards #4. And I want to do it pretty soon, because Mrs. Money Mustache is about to quit her cushy part-time job to pursue new adventures. If I apply for the line of credit while our family income is still higher, we’ll qualify for better loan terms.
Now I’d like to turn it over to you. Who among the Wise Mustachian readers has extracted value from a rental house in the past? Where would you recommend that I look to get the best experience and a great deal? Or do you think I should go for the standard style of mortgage if the house next door qualifies?
A few ideas I’ve had so far:
- My business bank, US bank, has a whiteboard out front advertising 3.25 or less% home equity lines of credit with no closing costs.
- I’ve heard that lendingtree.com might get reasonable results. But I’ve never used it. Has anyone had positive or negative experiences in that area?
- I know a wheeler-dealer independent mortgage broker who is very honest, competent and operates on commission. He dishes out loans from a variety of financial companies, and he’s always up-front about total costs. It probably wouldn’t hurt to give him a chance at earning the business as well.
The ideal situation would be that I go through the paperwork and end up with a nice fat $200,000 line of credit on my existing rental house, with a low interest rate and minimal closing costs. Then I will be armed and ready for business, and you’ll get to read about the total gutting and remodeling of the house next door sometime this fall!
What do you think?
Another idea that may fit into the brainstorming above is using the private banking arm of a bank. If the higher rate that they would likely lend you money at cancels out “standard closing fees” associated with a primary mortgage or a HELOC type loan, it may be beneficial.
I did this when I bought my farm as a short term bridge between sale and intra-family financing.
It seemed private banking at this institution had the ability to do basically anything they wanted.