Common Cash Sources for Real Estate Investments
Saving money from your monthly earnings will probably be the foundation for your real estate investing program. However, you may have access to other financial resources for down payments. Here’s a friendly little reminder: Monitor how much of your overall investment portfolio you place into real estate and how diversified and appropriate your holdings are given your overall goals.
Dipping into your retirement savings
Some employers allow you to borrow against your retirement account balance, under the condition that you repay the loan within a set number of years. Subject to eligibility requirements, first-time homebuyers can make penalty-free withdrawals of up to $10,000 from IRA accounts.
You still must pay regular income tax on the withdrawal, which can significantly reduce the cash available.
Borrowing against home equity
Many real estate investors begin building their real estate portfolio after they buy their own home. Conservatively tapping into your home’s equity may be a good down payment source for your property investments.
You can generally obtain mortgage money at a lower interest rate on your home than you can on investment property. The smaller the risk to the lender, the lower its required return, and thus, the better rates for you as the borrower. Lenders view rental property as a higher risk proposition and for good reason: They know that when finances go downhill and the going gets really tough, people pay their home mortgage to avoid losing the roof over their heads before they pay debt on a rental property.
Unless your current mortgage was locked in at lower rates than are available today, it’s not generally recommended that you refinancing the first trust deed loan and free up equity that way versus taking out a home equity loan or line of credit.
A variation on the borrowing-against-home-equity idea uses the keep-your-original-home-as-a-rental strategy. You build up significant equity in your owner-occupied home and then need or want a new home. Refinance the existing home (while you still live there for the best owner-occupied rates) and then convert it into a rental. Take the tax-free proceeds from the refinance and use that as the down payment on your new owner-occupied home.
Before you go running out to borrow to the maximum against your home, be sure that you
- Can handle the larger payments: It’s not recommended that you borrow more than the value of your home, as you may be enticed to do with some of the loan programs that pitch borrowing upward of 125 percent of the value of your home. These programs are being routinely touted as not only a way to free up equity and pay down consumer debt but also encouragement for people to borrow in excess of the current value of their home so they can invest in more real estate. This excessive leveraging is dangerous and could come back to haunt you.
- Understand the tax ramifications of all your alternatives: Borrowing more against your home at what appears to be a slightly lower rate may end up costing you more after taxes if some of the borrowing isn’t tax-deductible. Under current tax laws, interest paid on home mortgages (first and second homes) of up to $1 million is tax-deductible. You may also deduct the interest on home equity loans of up to $100,000.
Be careful to understand the tax-deductibility issue when you refinance a home mortgage and borrow more than you originally had outstanding on the prior loan. If any of the extra amount borrowed isn’t used to buy, build, or improve your primary or secondary residence, the deductibility of the interest on the excess amount borrowed is limited. Specifically, you may not deduct the interest on the extra amount borrowed that exceeds the $100,000 home equity limit.
- Fully comprehend the risks of losing your home to foreclosure: The more you borrow against your home, the greater the risk that you may lose the roof over your head to foreclosure should you not be able to make your mortgage payments. That’s exactly what happened to too many folks during the late-2000s real estate market decline. Although you need to use your cash for investing in and improving real estate, our advice always includes keeping some cash in a checking or money market rainy day account (for example for a new roof, painting, and so on) and not cutting things so close that you could lose it all.
Moving financial investments into property investments
As you gain more comfort and confidence as a real estate investor, you may want to redirect some of your dollars from other investments like stocks, bonds, mutual, and ETFs into property. If you do, be mindful of the following:
- Diversification: Real estate is one of the prime investments (the others being stocks and small business) for long-term appreciation potential. Be sure you understand your portfolio’s overall asset allocation and risk when making changes.
- Tax issues: If you’ve held other investments for more than one year, you can take advantage of the low long-term capital gains tax rates if you now want to sell. The maximum federal tax rate for so-called long-term capital gains (investments sold for more than they were purchased for after more than 12 months) is now 20 percent.
If your modified adjusted gross income exceeds $200,000 for single taxpayers or $250,000 for married taxpayers filing jointly, you have to pay an extra 3.8 percent to help pay for the Affordable Care Act (also known as Obamacare). Investors in the two lowest federal income tax brackets of 10 and 15 percent enjoy a 0 percent long-term capital gains tax rate. Try to avoid selling appreciated investments within the first year of ownership. Be sure to check on the latest tax laws because there’s no guarantee these rates will continue in the future.
Separating investments from cash value life insurance
You may own a cash value life insurance policy — one that combines a life insurance death benefit with a savings type account in which some money accumulates and on which interest is paid. In addition to being a costly cash drain with its relatively high premiums, cash value life insurance investment returns tend to be mediocre to dismal.
You’re best off separating your life insurance purchases from your investing. If you need life insurance (because others are dependent on your income), buy a term life policy, which is pure, unadulterated life insurance. But don’t cancel your current cash value policies before replacing them with term if you do indeed need life insurance protection.