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Why Consider Investing in Real Estate to Grow Your Wealth
I have clients who are investing in real estate and believe there are several advantages. Beyond adding diversification to your assets, investing in real estate can offer a source of passive income now and in retirement. It allows you to deduct certain expenses related to the property, such as mortgage interest, property taxes, insurance and depreciation, from your overall tax liability. It can also be used as a second home for vacations for yourself and your family and give you something to leave behind for your kids or other loved ones.
That’s why I was excited to talk to Melissa Banich, Owner and mortgage loan officer for Honeybee Lending. We discussed how to come up with the money for a down payment on a property, the types of investment property loans available and other considerations.
1. What are the options for a down payment for investing in real estate?
I’m familiar with using cash or investment savings, taking out a loan on an employer’s 401k plan or taking a withdrawal from an IRA if you’re over 59 ½ to come up with the funds for a down payment. One can also take equity from their primary home through a home equity line of credit (HELOC) or a cash out refinance. What are other options to consider?
Home Equity Line of Credit
A HELOC is a revolving line of credit that allows homeowners to borrow against the equity in their home. It operates like a credit card, where you have a credit limit, and you can borrow and repay funds as needed.
When approved for a HELOC, you receive a line of credit based on a percentage of your home's appraised value minus any outstanding mortgage balance. You can access funds from the line of credit by writing checks or using a HELOC-specific credit card. The HELOC payment is separate from your mortgage payment.
Cash-Out Refinance
A cash-out refinance involves refinancing your existing mortgage for a higher amount than you currently owe, allowing you to receive the difference in cash. With a cash-out refinance, you apply for a new mortgage that is greater than your current loan balance.
The lender will pay off your existing mortgage, and you'll receive the remaining funds as a lump sum during your loan closing. The new mortgage will have a revised term and interest rate on which you'll make regular monthly payments to repay the entire loan amount, including the cash you received.
2. What are the types of property loans available for investing in real estate?
Conventional Loans
Like a mortgage for your primary property, conventional loans allow additional loans for second properties or investment properties such as long- and short-term rentals. These loans look at a borrower’s income, assets and liabilities, credit worthiness and overall debt to income ratio to determine the qualifications of this loan.
Debt Service Coverage Ratio (DSCR) Loans
These loans have become very popular. Debt Service Coverage Ratio (DSCR) loans are a type of mortgage loan that focuses on the property’s income-generating potential instead of the borrower’s personal income. The DSCR uses a financial metric that measures the property’s ability to cover its debt payment with its net operations income (NOI).
A lender will consider the loan amount, interest rate and loan term to determine the annual debt service payments, which includes principal and interest payment. The DSCR is calculated by dividing the property’s NOI by its annual debt service payments. For example, if the NOI is $100,000 per year and the annual debt service payments are $80,000, the DSCR would be 1.25 ($100,000 divided by $80,000.
An appraisal is used to assess the property’s ability to generate sufficient income to cover the loan payments, and most lenders look for a minimum DSCR of 1.2 to 1.5.
The table below shows comparisons between conventional and DSCR loans.
3. What are the benefits of creating a limited liability company (LLC) for an investment property?*
One of the benefits of forming an LLC is the limited liability protection it provides to the owner(s) of the LLC and investment property. It shields the owners’ personal assets, such as their homes or savings accounts from any liabilities or debts taken on by the LLC. This can also help protect assets in the event of legal claims or lawsuits. This structure can be especially advantageous if you own multiple properties or have substantial personal assets you want to protect.
Another benefit is tax flexibility because an LLC can be taxed in a couple different ways. By default, it’s considere a pass-through entity for tax purposes meaning that the profits and losses of the LLC “pass through” to the individual owners’ tax returns. This avoids the double taxation that can occur in business structures like corporations, where the company pays corporate tax and the owner pays income tax.
However, an LLC can instead elect to be taxes as a corporation which can provide additional tax planning opportunities in situations where you want to retain earnings within the company to reinvest in the property or even to invest in other properties, as corporate tax rates can be lower than individual tax rates.
4. Why might it be a good idea to buy now and rent out the property until you’re ready to move into it?
Buying a second home or investment property and renting it out can offer several benefits beyond rental income and tax advantages. Investment properties for potential property appreciation over time and provides equity to borrow against if you need it.
"The rental income and equity can help you build wealth, pay off the mortgage or even fund other investment opportunities. "
A second home can also provide flexibility for a future relocation. If you think you may want to relocate, downsize, retire or pass it on to your children, buying a second home now allows you to plan and secure a home you desire at current market prices.
In Colorado and other popular states, homes are appreciating between 10 to 20 percent per year. Buying now allows you to buy at current market values while letting the equity build up over a longer period of time.
*Consulting with a qualified attorney or tax professional is recommended to understand the legal and financial implications specific to your situation.
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Click below to watch a recent video interview with Melissa Banich and learn more!
Disclosures
No investment strategy assures success or protects against loss. Investing involves risk, including the loss of principal. The information in this post is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This information should not be relied upon as the sole factor in an investment making decision.
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