Ep.65- Are You Ready to Buy An Investment Property? Find Out With This Checklist
Read Time: 5 Minutes.
In the past couple of years, my friends and I explored the topic of investing in rental properties in Los Angeles. Time after time, we pondered on the question, how do we know if we are financially ready.
After having gone through the process of buying two properties myself, I gained some insights in retrospect. In my opinion, if one can check the the following 5 boxes, he/she is ready.
1. AN INVESTMENT PROPERTY SHOULD COME AFTER A PRIMARY HOME
This seems like a no brainer. You should buy a primary home first, before buying an investment property, because a primary home comes with better tax advantages, lowered borrowing costs, and a lower down payment. In layman's terms, it is more expensive to buy an investment property.
For residential properties, there are typically 3 types based on occupancy: a primary home, a vacation home, and an investment property. In other words, when you go to a bank trying to get a mortgage, you will be asked the occupancy of the property. Make sure your first property is a primary home, not an investment property.
- Tax Advantage: Upon the sales of your primary home, if you can make any money, your proceeds are tax free for up to $250k (single)/$500k (married). If you bought it as an investment property, you will have to pay long-term capital gain taxes at the federal and state level, depending on your annual income. For example, for a family that pulls in $100k/yr in California, the combined tax is 24.3% (15% federal + 9.3% CA) on an investment property.
- A Lower Interest Rate: On a primary home, a typical mortgage rate on a 30-year fixed mortgage can be found on Wells Fargo's website, as they update it daily. Today's rate (August 2018) is 4.75%. However, if you were to purchase an investment property, the rate is at least 1 percentage point higher, meaning 5.75% or more.
- A Lower Down Payment: On a primary home, you have the option of an FHA loan with just 3.5% down payment, or 5% down on a conventional loan. On an investment property, you will need at least 20% down, or sometimes even 25% down.
If you already own a primary home, move on to item #2.
2. SO YOU ARE BUYING A SECOND PROPERTY. CAN YOU HOLD ON TO IT FOR AT LEAST 2 YEARS?
If you don't plan on holding on to the investment property for at least 2 years, don't buy it. Why? There are a lot of transaction costs involved with buying and selling, so you need to hold on to it for at least 2 years to make it worth it.
There are 4 main transaction costs. Let's use the scenario of buying a $500,000 home with $100,000 down ($400,000 in mortgage) in Los Angeles. Let's suppose it is worth $550,000 after 1 year. Let's say you want to sell it then, thinking you will have $150k ($550k of sales price - $400k of mortgage). Just think again after all the transaction costs.
- Closing Costs at Purchase: Typically 2-3% of home purchase price. Let's use 3%, so it's $15k with a home of $500,000.
- Down Payment: Typically 20% of home purchase price. It's $100k in our example.
- Closing Costs at Sale: Typically 6-7% of home sale price. Let's use 6%, so it's $33k, on a home sale price of $550,000.
- Long Term Capital Gain: Likely 24.3% on sales proceeds. It's $28k in our example.
All the transaction costs add up to $176k, more than the hypothetical $150k profit. In other words, it will be a loss if you were to sell in 1 year. It will probably break even after at least 2 years.
3. SO YOU WILL KEEP IT FOR A WHILE. DO YOU HAVE ENOUGH INCOME?
Typically, the aggregated total of all your monthly debt payments have to be smaller than 38% of your pre-tax income.
Let's break it down. If you and your partner together make $120,000/yr pre-tax, meaning $10k/month. All your debt together, including the investment property you want to buy, need to be less than $3,800/month.
- If you have a car payment of $400k/month, then your budget for the investment property is down to $3200.
- If you have student loan payments of $200/month, then you budget is now $3000.
- If you already have a mortgage payment...
- If you have credit card debt payment...
In a previous blog post on home affordability rule of thumb , I broke down the $600 = $100k mortgage rule. We can apply that here, the $3000/month budget can roughly translate into a home mortgage of $500,000.
4. SO YOU HAVE A GREAT INCOME. DO YOU ALSO HAVE GOOD CREDIT?
You will need to have good credit in order to buy a second home. A good credit score means 720 and above. Anything lower than 720 will hurt you a bit by increasing the interest rate you have to pay. In layman's terms, you have to pay more. If you have anything less than 640, you are unlike to quality for a second home.
5. SO YOU HAVE GOOD CREDIT. DO YOU HAVE ENOUGH DOWN PAYMENT.
I mentioned it earlier. You will need to cough up at least 20% for a down payment. There are no ifs and buts here.
How do you know if you are ready to buy an investment property? You need to be able to say yes to the following 5 questions.
- Do you have a primary home already?
- Do you plan on holding on to the property for at least 2 years?
- Will your total debt payment be smaller than 38% of your monthly pre-tax income?
- Do you have a good credit score?
- Do you have 20% down payment saved?
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