As a general rule, diversification means carrying sufficient amounts in cash equivalents, stocks, bonds, and real estate.
An emergency fund should have six months income (conservative) or expenses (less conservative) in some kind of cash equivalent (like a savings account). As you approach retirement, that number should increase. At retirement, it should be something like five years of expenses. At that time, it is no longer an emergency fund, it's your everyday expenses. You can use a pension or social security to offset your effective monthly expenses for the purpose of that fund. You should five years net expenses after income in cash equivalents after retirement.
The normal diversification ratio for stocks, bonds, and real estate is something like 60% stocks, 20% bonds, and 20% real estate. You can count the equity in your house as part of the real estate share. For most people, the house will be sufficient diversification into real estate.
That said, you should not buy a second home as an investment. Buy the second home if you can afford it and if it makes you happy. Then consider if you want to keep your first home as an investment or just sell it now.
Look at your overall ownership to determine if you are overweighted into real estate. Your primary house is not an investment, but it is an ownership. If 90% of your net worth is real estate, then you are probably underinvested in securities like stocks and bonds. 50% should probably be an upper bound, and 20% real estate would be more diversified.
If your 401k has an employer match, you should almost certainly put enough in it to get the full match.
I prefer a ratio of 70-75% stocks to 25-30% bonds at all ages. This matches the overall market diversification. Rebalance to stay in that range regularly, possibly by investing in the underweight security. Adding real estate to that, my preference would be for real estate to be roughly a quarter of the value of securities. So around 60% stocks, 20% bonds, and 20% real estate. A 50% share for real estate is more aggressive but can work.
Along with a house or rental properties, another option for increasing the real estate share is a Real Estate Investment Trust (REIT). These are essentially a mutual fund for real estate. This takes you out of the business of actively managing properties.
If you really want to manage rentals, make sure that you list all the expenses. These include:
- The mortgage payment.
- Property taxes (which may increase in the future).
- Time to find new tenants. In some cases, this can be as high as 25% of the rent, so be careful. A 10% vacancy rate is more manageable and may be achievable depending on the type of renter. Tends to be high for college kids and lower for families with kids and/or pets.
- Clean up. You usually have to spend extra to clean between tenants. Check local laws carefully before assuming that you can get this out of the damage deposit. High for college kids and families with children or pets.
- Maintenance. You are responsible for keeping the rental in good repair. If you rent out an oven and refrigerator, they have to work. When they fail, you have to fix or replace them. You are responsible for keeping the roof from leaking, the furnace running, etc.
- Wear and tear. Over time, carpets will wear out and need replaced. Hardwood floors need refinished. Walls need repainted.
- Damages. Yes, you can sue the residents if they damage things. However, some of that may be counted as wear and tear. Also, for large damages, you may not be able to collect from your tenants. They may not have enough money.
Also be careful that you are able to handle it if things change. Perhaps today there is a tremendous shortage of rental properties and the vacancy rate is close to zero. What happens in a few years when new construction provides more slack?
Some kinds of maintenance can't be done with tenants. Also, some kinds of maintenance will scare away new tenants. So just as you are paying out a large amount of money, you also aren't getting rent. You need to be able to handle the loss of income and the large expense at the same time.
Don't forget the sales value of your current house. Perhaps you bought when houses were cheaper. Maybe you'd be better off taking the current equity that you have in that house and putting it into your new house's mortgage. Yes, the old mortgage payment may be lower than the rent you could get, but the rent over the next thirty years might be less than what you could get for the house if you sold it. Are you better off with minimal equity in two houses or good equity with one house?
I would feel better about this purchase if you were saying that you were doing this in addition to your 401k. Doing this instead of your 401k seems sketchy to me. What will you do if there is another housing crash? With a little bad luck, you could end up underwater on two mortgages and unable to make payments. Or perhaps not underwater on the current house, but not getting much back on a sale either.
All that said, maybe it's a good deal. You have more information about it than we do. Just...be careful.