Q: I’m 20 years old. Last year my father passed away, leaving me with some life insurance money.
I purchased a condo for $163,000 in cash in October 2005 and now it is valued at $217,000.
I want to rent the condo that I own and buy another property. My real estate agent figures I can get about $1,200 dollars per month for the condo. I plan to rent out a room in my new townhouse for $400 to $500 per month.
I’ve found the townhouse I want, and it will cost $270,000. I am thinking of borrowing $54,000 on a home equity line of credit from my condo and then getting a interest-only loan with a 5/1 adjustable rate mortgage. I plan to sell the house before the five years are up.
After I purchase the townhouse, I’ll still have about $30,000 left over in cash plus $72,000 in an IRA. Taking the money out of the IRA would mean I’d have to pay federal and state income tax, which I don’t think is a good option.
Do you think this is too risky? I already gave the sellers my earnest money but I have 6 more days to change my mind. Please let me know what you think.
A: First, let me offer you my condolences on losing your father at such a young age. But he must have done a lot that’s right in raising you because you are making some very smart long-term investments in real estate that should help you grow the nest egg he left for you.
Now, let’s look at what you’re planning to do with your real estate. If you rent out your condo for $1,200 per month, you’re getting about an 8 percent return on your investment.
However, you will also have monthly maintenance fees plus real estate taxes. While you didn’t tell me how much those were, I’m guessing your taxes, insurance, and maintenance fees will run about $350 per month, bringing your net income to about $850 per month. That’s about a 5 percent return on your money, excluding your fantastic appreciation.
The $850 per month income plus the $400 per month you’re getting from renting a room in your townhouse means you’ve got $1,200 in income to help support your townhouse mortgage, taxes and insurance.
Borrowing against your condo is a good idea, but don’t use a home equity line of credit (HELOC). Those loans tend to be variable, and they’re quite high now, at prime or a point over prime.
You’d be better off taking out a regular mortgage on the house. Not only will you free up a lot of cash for your next purchase, but you’ll be able to write off the income you’re receiving from rent against the expenses of the property. Then, you’ll be able to minimize any taxes you pay on the amount of income you get from the rental.
Since you’re going to live in the townhome, you’ll reduce your overhead by putting more down on the property. I don’t have a problem with taking out an interest-only loan, especially if you put so much down on the property.
If something happens, you can always sell the condo and pocket the proceeds. Or, you can sell the townhome and move back into the condo as your primary residence.
One final thought: You’re only 20. While it sounds like you’re doing very well in real estate, please use qualified professionals, like a trusted accountant and good real estate attorney, to be sure you’re protected.