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I have recently purchased a home which will presumably be my long-term residence. I have not yet sold my original home, and I am trying to decide whether I should rent it out, or sell it.

The 1st home has a mortgage remaining of $175,000, with a 5/5 ARM at 2.5% The next adjustment is in 4 years, and the maximum it could go up to is 4.5% This home was purchased 10 years ago for $203,000 - just before the real estate bubble burst.

The home I just purchased has a 1st mortgage of $608,000 @ 4.25% for 30 years fixed. It also has a second mortgage of $76,000 @ 5.5% for 15 years.

I think I can rent out the 1st house for $1500, and after property management fees, take home about $435 per month. That is not including any additional taxes on that income, or deductions based on repair work, etc.

I think I could sell the first house for about $227,000 which after fees and loan payoff nets me $35000

If I sold the house, I could use my existing cash reserve and the net proceeds to pay off the 2nd mortgage. I could also pay off some, or none of the 2nd mortgage, and try to beat that 5.5% by investing the $35000

If I do not sell the house, I could use the $434 to almost pay off the 2nd mortgage per month/invest the $434 into an IRA or something, and try to beat the 5.5% over time.

http://www.bankrate.com/calculators/savings/compound-savings-calculator-tool.aspx

According to this website, the S&P500 has gained 6.6% over the last 10 years, or 10.3% since 1970. At 6.6%, over 7 years, I would have $46,000 dollars in the account, which would be enough to make up the $35000 sale proceeds, and additionally cover any upcoming repairs to that house.

Should I sell the house now, or hold onto it and rent it out?

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    You are going to get varied opinion-based answers (and there are several near duplicates) - do you have a plan that you are just wanting a sanity check on or are you really on the fence? – D Stanley May 15 '17 at 13:44
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    How many months could you go without rental income before you'd be in a bind paying off three mortgages? – D Stanley May 15 '17 at 13:52
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    Yes, I guess I was just looking for opinions. My plan right now is to rent it out. My thought process being that, say over 7 years, I will have broken "even" on the net proceeds, but hopefully the property value will have gone up, and I will have a principal remaining of about 148,000, so i could sell then with a net proceed of perhaps 75k+ – Derek May 15 '17 at 13:57
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    We have an emergency fund which we didnt want to touch (which is why we did the 2nd mortgage to supplement the downpayment). I think we could go at least 24 months with no rental income – Derek May 15 '17 at 13:59
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    What was the S&P 500 like from 2000 to 2010? (Hint: not pretty!) After 8 years of steep climb... a serious correction wouldn't be out of the question. – RonJohn May 15 '17 at 14:02

10 Answers 10

27

So here are some of the risks of renting a property:

  • The renters damage the home or leave it in disrepair
  • You can't find a good renter and the house goes unrented for several months
  • The housing market falls again and you are underwater on your second mortgage and can't sell the house

Plus the "normal" risk of losing your job, health, etc., but those are going to be bad whether you had the rental or not, so those aren't really a factor.

Can you beat the average gain of the S&P 500 over 10 years? Probably, but there's significant risk that something bad will happen that could cause the whole thing to come crashing down. How many months can you go without the rental income before you can't pay all three mortgages? Is that a risk you're willing to take for $5,000 per year or less?

If the second home was paid for with cash, AND you could pay the first mortgage with your income, then you'd be in a much better situation to have a rental property. The fact that the property is significantly leveraged means that any unfortunate event could put you in a serious financial bind, and makes me say that you should sell the rental, get your first mortgage paid down as soon as possible, and start saving cash to buy rental property if that's what you want to invest in.

I think we could go at least 24 months with no rental income

Well that means that you have about $36k in an emergency fund, which makes me a little more comfortable with a rental, but that's still a LOT of debt spread across two houses.

Another way to think about it: If you just had your main house with a $600k mortgage (and no HELOC), would you take out a $76k HELOC and buy the second house with a $200k mortgage?

  • Just to be clear, the ARM is on the 175k loan, which is for the property that could be sold. – Derek May 15 '17 at 14:03
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    +1 for last paragraph. Reversing the decision in your mind can help determine the best course of action - turn 'should I sell house' to 'should I buy house'. – Jeutnarg May 15 '17 at 16:20
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If it was me, I would sell the house and use the proceeds to work on/pay off the second.

You don't speak to your income, but it must be pretty darn healthy to convince someone to lend you ~$809K on two homes. Given this situation, I am not sure what income I would have to have to feel comfortable. I am thinking around 500K/year would start to make me feel okay, but I would probably want it higher than that.

think I can rent out the 1st house for $1500, and after property management fees, take home about $435 per month. That is not including any additional taxes on that income, or deductions based on repair work, etc.

So this is why. Given that your income is probably pretty high, would something less than $435 really move your net worth needle? No. It is worth the reduction in risk to give up that amount of "passive" income. Keeping the home opens you up to all kinds of risk. Your $435 per month could easily evaporate into something negative given taxes, likely rise in insurance rates and repairs.

You have a great shovel to build wealth there is no reason to assume this kind of exposure. You will become wealthy if you invest and work to reduce your debt.

  • Regarding the taxes, I would assume a rather high tax bracket given the ability to pay the two mortgages, while the proceeds on the sale would probably not even be subject to capital gains tax. I agree here; sell the house, pay off the second mortgage, then invest. – chepner May 15 '17 at 13:58
  • As far as moving the needle on net worth, I agree that the $435 per month doesnt really do it. I was more thinking about the net proceeds of selling the house in 7 - 10 years, given appreciation in the area of 2%/year, and of course paying the loan down over that time period. I think this would net me $75k+ if I sold in say 7 years. – Derek May 15 '17 at 14:05
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    When i bought the first home, I was a single person. I have just bought the 2nd home with my soon to be wife. Our combined income is about $240,000. We basically have no debt other than housing debt. – Derek May 15 '17 at 14:17
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    To be fair, he should be making more than the 435 because money is going into a mortgage. So in the long term there is more than just the 435 a month being gained. – corsiKa May 15 '17 at 15:51
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    @Derek yousa, that is cutting it close. Sell that house! Think of it as diversification without risk to the money invested. – Pete B. May 15 '17 at 17:43
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I kind of hate piling on with another opinion, but this is too long for a comment. I did what you are thinking of doing, I would at least try renting it for a couple years so long as:

  1. You can cover all mortgages comfortably for a period of time if it goes unrented or rent goes unpaid.
  2. The rental market is strong in your area.

The primary risks of renting are mostly related to unexpected costs and bad tenants, you've got a very healthy income, so as long as you maintain a nice emergency fund it doesn't sound like keeping this property as a rental will be too much risk. If the rental market is strong where your house is, then you have a better chance of avoiding bad tenants. I like to keep my rent a little lower than the max I think it could go for, to attract more applications and hopefully find someone who will be a good longer term tenant.

Tax-free gains
So long as you lived in your house 2 of the last 5 years, you can sell without paying capital gains tax on your profit, so you could try renting it for 2 years and then sell. That was a key for me when I converted my first house to a rental. I liked that flexibility, there's still the typical renting risks associated, but it's not a lifelong commitment. You can get 2 years of increased equity/appreciation tax-free, or you could find you enjoy it and keep it for the long haul.

  • I really love the tax free gains. The tax rule behind it may be rooted in, "it's good for the country (vaguely)", and although the benefit is not received by all citizens equally, it IS available and is a very tangible benefit for those who make use of it. I even considered making a living building homes, living in them for 2 or 3 years and selling. That strategy has no SS or Medicare (wage taxes). – donjuedo May 15 '17 at 16:53
  • Thanks for pointing this out. This is exactly why I posted this - I hadn't thought of that time-based rentout strategy. – Derek May 15 '17 at 17:02
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    FWIW, we prefer to ask for a little higher than we think we can get because people who can afford it tend to be far less riskier. Yes, fewer applicants, but higher quality. We learned the hard way, as we asked for less than market when first starting out because we weren't sure we could even rent the property. Despite background checks and all of that we ran into a string of people who had trouble paying. We decided to up our rental price just for purposes of accounting for "non/late payments" and were surprised that we got people more financially secure and reliable. That is now how we roll. – Dunk May 15 '17 at 18:55
  • @Dunk, thanks, I'll keep a mental note of that for the future. – grfrazee May 15 '17 at 19:00
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    To keep good long-term tenants, start with close to the max and then if your tenant is good, don't raise the rent until you're close to your min (you'll probably have to raise at some point because of inflation driving up maintenance cost etc). – Sumyrda - Reinstate Monica May 16 '17 at 8:56
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It sounds like you plan to sell sooner or later. If your opinion is that there is still room for the housing market to grow, make your bet and sell later. The real estate market is much less liquid than other markets you might be invested in, so if you do end up seeing trouble (another housing crash) you may be stuck with your investment for longer than you hoped.

I see more risk renting the house out, but I don't see significantly more reward. If you are comfortable with the risk, by all means proceed with your plan to rent.

My opinion is contrary to many others here who think real estate investments are more desirable because the returns are less abstract (you can collect the rent directly from your tenants) but all investments are fraught with their own risks. If you like putting in a little sweat equity (doing your own repairs when things break at your rental) renting may be a good match for you. I prefer investments that don't require as much attention, and index funds certainly fit that bill for me.

4

One piece of information you didn't mention is how much you paid for the original home. If you hold onto that home for too long you will have to pay capital gains on the difference between sale price and original price. This can be a TON of money, thousands of dollars easily.

The rule is: If you lived in a home for 2 out of the past 5 years, you don't have to pay the capital gains tax. So if you just moved, you have 3 years to sell. Perhaps as a compromise you can try renting it for 3 years and then selling it a few months before the deadline.

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Option A - you sell the house and then use the money to pay off a portion of your second mortgage. The return on that investment is 5.5% a year, or $1925 net.

Option B - you rent it out, that will bring you $5220 (435 x 12), more than 2.5 times option A. That's not counting any money going towards the principal of the loan. Given that you'll be using a property management company, you can be fairly certain that there won't be any unexpected expenses (credit check, security deposit should take care of that)

Option C - you invest the money somewhere else. You'll have to get 15% return in order to beat option B. I don't think that's sustainable.

You should talk to a CPA about the tax implications, but I'm fairly certain that you'll do better tax wise to rent it out, since you can use depreciation to lower your tax bill.

Finally, where do you think real estate prices will be in 4 years? If you think they'll increase that's another reason to hold onto the property and rent it.

Finally finally, if you plan to rent it out long term (over 4 years), it will be a good idea to refinance and lock the current interest rate.

1

Another factor is, how far is your prospective rental property from where you live? vs. how comprehensive is your property management service? If you need to visit much or would simply like to keep an eye on it, a couple of hours drive could be a deal breaker. One more thought; would you be able to upgrade the property at a profit when it comes time to sell? If you have a realtor you trust he or she should be able to tell you if, say a $20k kitchen reno would reliably return more than $20k. It has a lot to do with the property's relative price position in the neighborhood. A cheaper home has more "upsell" room.

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If you can generate a higher ROI by renting than by cashing out and investing, then you should rent it out. Please consider your risk tolerance as well. It's always a personal decision whether to assume higher risk for a higher return.

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I don't see anything in this forum on the leverage aspect, so I'll toss that out for discussion. Using generic numbers, say you make a $10k down payment on a $100,000 house. The house appreciates 3% per year. First year, it's $103,000. Second year, $106090, third it's 109,272.70. (Assuming straight line appreciation.) End of three years, you've made $9,272.70 on your initial $10,000 investment, assuming you have managed the property well enough to have a neutral or positive cash flow. You can claim depreciation of the property over those rental years, which could help your tax situation. Of course, if you sell, closing costs will be a big factor. Plus... after three years, the dreaded capital gains tax jumps in as mentioned earlier, unless you do a 1031 exchange to defer it.

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    A discussion of the benefit to equity returns due to leverage is incomplete, without at least mentioning the additional risk + cost. If the 100k house appreciates 3% per year [3k earned on only 10k invested!], but the 90k mortgage has a 2.5% interest cost [2.25k], the 'net benefit' of leverage is an extra $750. The question is: is the extra $750 annually worth the risk of holding an extra loan [if, for example, there are extra repair costs or a renter can't be found for long stretches]? It may be, it may not be. Leverage is a double-edged sword, and not a universal positive. – Grade 'Eh' Bacon May 16 '17 at 13:15
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Heres what you need to know:

  • like other people have said, you run the risk of damage from renters.

This can be prevented by what a previous renter did to us. This is a smart, kind of a jerky way to do it but its VERY SMART, as long as your property is worth it, raise the rent higher. You must have a very nice, clean, everything working, house. You must be willing to have anything fixed. this is all to make up the high rent. You don't want the rent way out of proportion but just a bit higher. This is because, more than likely, people who are going to pay for a higher rent don't usually leave a mess, (higher class families vs lower class people living alone..) What might also help from the risk of damage is create a fee (also what my renter did) of any painting needed done like finger prints on the wall, nails in the wall, carpet stains, etc when the tenant is ready to move out. I would suggest a required professional carpet cleaning as well when lease is up. My renter was very nice, but very strict and did all these things. He has a few properties that are very nice middle class houses. Your home sounds like it could easily pass for this kind of business depending on where you live. If the tenant leaves before his lease is up you could charge a 1-2 month's rent to be able to find a new tenant. Be proactive on finding a tenant before the lease is up.

This would be a bit of work to first set up and usually maintain, but its a good thing to think about.

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    "what a previous renter did to us" or landlord?? – RonJohn May 17 '17 at 7:02

protected by NL - Apologize to Monica May 17 '17 at 14:48

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