Afford Anything - Ask Paula: I’m Recently Retired. Do I Pay Off My Rentals Or Buy More Real Estate?

Episode Date: August 5, 2023

#455: Yvette recently retired with the goal of reaching a $10,000 monthly income from her real estate investments. Should she put her money toward debt payoff or portfolio expansion? Carly wants to buy a second home and convert her current home to a rental. What are the pros and cons of tapping into existing equity versus saving cash for a down payment? An anonymous caller plans to move back to her touristy hometown in six to seven years. Is it smart to buy something now and take advantage of a thriving Airbnb market? I tackle these three questions in today’s episode. Enjoy! P.S. Got a question? Leave it at https://affordanything.com/voicemail For more information, visit the show notes at https://affordanything.com/episode455 Learn more about your ad choices. Visit podcastchoices.com/adchoices

On the first Friday of every month, we put out a first Friday bonus episode. So welcome to the August 2023, first Friday bonus episode. Today, I am hosting a solo show. I am going to cover questions about real estate. If you're not interested in real estate investing, don't worry. Our normal weekly show, we just released a couple of days ago, episode 454, so check that out. Otherwise, if you are interested in real estate investing, if you're invested in real estate investing, you're going to enjoy today's special additional bonus episode. So welcome to the Afford Anything podcast. My name is Paula Pantt.

This is the podcast that understands you can afford anything, but not everything. Every choice that you make is a trade-off against something else. And that doesn't just apply to your money. That applies to any limited resource you need to manage, like your time, your focus, your energy, your attention. Two questions arise from that. First of all, what matters most? And second, how do you align your priorities with that which matters most? Now, answering those two questions is a lifetime practice.

That's what this podcast is here to explore. My name is Paula Pan. I am the host of the Afford Anything podcast, and we are going to kick off with a question from Yvette. Hi, Paula. My name's Yvette. I recently retired from my job after 12 years. They granted me an early retirement.

I'm currently 51 years old. I will receive $1.6 million over the next three years. I currently have four properties. One of them I live in as a current residence, and the other three are rental properties, totaling around $513,000 in mortgages. My question is, should I pay off those mortgages or should I just use the money that I have and invest in rental properties? The reason why I wanted to leave my job is so that I can continue to buy more properties and make around $10,000 or more in rental income every month. I already currently invest in the stock market and looking to diversify a little bit more in real estate investing because that's where my passion lies. I appreciate any help you can offer as far as if I should pay off those properties or should I just use the money to continue and invest. Have a great day. Thank you.

Yvette, first of all, huge congratulations to you on retiring. You are 51 years old and you've just retired. That is amazing, amazing. Big, big, big congratulations. Now let's talk about your question. So you have $1.6 million coming in and you've got outstanding loans on your properties of a little bit over half a mill. So easily you would be able, if you wanted to, if you wanted to, you would be able to write a check and get rid of your mortgage balances and be completely free and clear. But, but should you?

Well, I don't like telling people what to do. I like giving you food for thought and letting you make the decision for yourself. But let's walk through what I'm hearing from you about your situation, your goals, what answer is right for you. There are a couple of things that I heard within your question. One is that you're passionate about real estate. You want to spend more time, more energy, devote more attention to real estate. This is important because it distinguishes you from people who maybe want real estate in their portfolio, but they want it to be as passive or as residual as possible. Both are fine.

Neither is right or wrong. But there are some people who say, I love real estate. I'm passionate about it. I'm really interested in it. I want to be involved in it. I want to acquire more. And I don't mind if it takes up more of my time. In fact, in your case, I,

retired from my job so that I could devote more time to it, so that I can devote more energy to it. That's what I want to be doing. So that is amazing. And that gives me a hint as to where this answer should go. Because that is a very different state of mind from someone who says, you know, I'm so into my primary occupation that I don't ever want to think about real estate. I'm not, to me, it's just a means to an end. I'm not passionate about it, right? There might be another person who feels that way. And that's information as well, right?

So for you, you're passionate about it. You want to be more into it. The other thing that you stated is that your goal is $10,000 or more in cash flow, in net cash flow per month, right? there are many ways of getting there. You could have 10,000 of net cash flow per month by owning as few properties as possible and paying them off as quickly as possible. Or you could have a net $10,000 cash flow per month by owning many properties, each of which have mortgages on them, each of which cash flow less, but which collect. collectively across the basket of them, add up to cash flowing $10,000 per month.

And over time, over time that strategy is going to give you ultimately more money, more monthly income, more equity. It's going to create more wealth because you have more properties. So there are two ways to get to $10,000. You can do that in the simple way, which is buy. as few properties as possible that you would need in order to get to $10,000 and pay them off as quickly as you can, right? That way you own the least number of doors, the least number of roofs, you have the least number of toilets. And the drawback to that is that you have the least potential upside. So if the market rises, the equity gains that you'll make will be gains

on a much smaller basket of properties. But the least number of toilets is also the least amount of effort, least amount of work. It's ideal for the type of person who wants real estate to be in the background or in the margins of their life, but not at the center. Someone who wants it to be passive rather than passion. For you, however, you're in the opposite situation. You want to devote time and energy to it. And if you were to build to $10,000 in cash flow by having more doors, by having more windows, more toilets, more roofs, and more mortgages, right? That's going to be the strategy that requires more debt. You could still achieve $10,000 within a given time frame. And then once you've achieved that,

after that, that monthly amount, if all goes well, will only continue to improve or only continue to grow. More doors means more work. But it sounds to me like that's what you're looking for. So I guess I'm hinting fairly strongly at my answer. Yvette, I want to talk conceptually about a couple of different approaches that different rental property investors take as they're deciding how much of their own money they want to put into property acquisition. There are some people who want to put, and again, this goes back to

the way your approach is going to depend very much on your goals, right? Oftentimes the same people who want their rental properties to be as passive as possible are also people who don't want to put a huge amount of their own money into building out their portfolio. And so what I'll often see is a number of people who maybe put their own money in to get the first two, three, four deals. But then after that, they start letting their houses buy more houses. They basically start coasting on the number of houses that they have and they just reinvest the cash flow from their houses and let that either buy more houses or pay off the houses that they already own. To put some numbers on this example, let's say that you. you have used your own paycheck to get yourself the first four rental properties, right?

Let's say you've got four rental properties, just hypothetically. We're just going to use a hypothetical example. A person has four rental properties, each one cash flows 300 per month. So in total, this person is collecting $1,200 per month. That is $14,400 per year, if I am not mistaken. Let me actually punch that into a calculator. 1,200 times 12. Yeah, 14,400 per year.

Sweet. My mental math. I still got it. All right. So this person is cash flowing $14,000 400 per year. So let's say after they've put their own money in to buy those first four properties and they're cash flowing 14 for a year, they decide now from this point forward they just want to coast.

They don't want to put their own money into the deal anymore. So at the end of year one, they take that $14,400 and they use it as a down payment on yet another rental property. This becomes property number five. And that property also cash flows $300 a month. Right. So now they're making $18,000 per year. And so then the end of year two, they take that $18,000. They use it as a down payment on another rental property.

Right. Now that property also cash flows $300. a month. Now they're making, you know, let's see an extra three. So now they're making 21,000 something per year, you know, cash flowing a net total of 21,000 per year. They put that in at the end of year three. And so you see basically from this strategy, what this person is doing is after putting their own money into the deal to, it's like a starter culture. Like when you're making sourdough bread, it's that yee starter culture, right? You put in that energy up front. You start the flywheel, so the flywheel begins spinning. And then once you start the flywheel spinning, you then sort of coast on that momentum, you let the flywheel continue to spin, and then you use

the cash flow from your properties to buy more properties. And so under the example that I just illustrated, every year, you're using the cash flow from your properties to buy one more property. And you start buying at a rate of one additional property per year. And you do that until you hit some target number of properties. Maybe you want 10 in total. And then once you hit that target number of properties, then you switch to pay off mode. And then you just start using the cash flow from your properties to pay down your properties. And maybe it takes you another, let's say, 10 years to do that. And by virtue of doing that, you can essentially take the Coast Phi strategy of compounding houses and you let your houses buy their own houses without

having to put any of your own money into the deal, and then you let your houses pay themselves off. And so after you acquire at a rate of one property per year, you do that for, let's say, an additional six more years. So let's say there's this 10 years time span in which you're acquiring one property per year for the first 10 years. First four years, you're putting your own money into the deal after year four. Then you're using cash flow from your properties, right? You do that for 10 years, then for the next 10 years, you pay them all off. And so at the end of 20 years, you have 10 properties all paid off free and clear. That is the residual income approach. That is the more passive approach. The benefit is that it's something that a person can do on the

side as a side hustle while they're balancing a full-time career. The drawback is that it's a 20-year plan, right? You know, it takes 20 years to own 10 properties free and clear. That is either a long or not very much time, depending on where you stand. But that is how passive investors who want to do this on the side often approach it. By contrast, what you could do, Yvette, is something that is much more aggressive. You've got $1.6 million coming in. I assume that's pre-tax. So after taxes, you'll have about a million dollars coming in. That's over the next three years. So let's say you've got $325,000, 330,000 coming in. in per year, maybe $340,000 coming in per year each year over the next three years, you can, if you wanted to put that money into property acquisition, you can use that to buy a bigger and bigger portfolio. And then once you have that portfolio, assuming that everything in that portfolio is positively cash flowing with at like, let's say at least $200 per door, right?

So you've got a comfortable margin. and that's after factoring for vacancies, for CAPEX, repairs, maintenance, etc., right? Let's say you're cash flowing 200 a door. Once you've built a big enough portfolio, you can then switch and then start paying off your properties. But build that big portfolio first, because the bigger that portfolio, assuming everything is cash flow positive, the bigger that portfolio, the faster the portfolio can pay itself off over time. time. So there are arguments to be made on both sides, and certainly you could, if you wanted to, pay off your existing basket of properties, increase your cash flow, and use that cash flow to slowly acquire more. But that's going to be a much slower route. If by contrast, you want to

build quickly, and it sounds like that's what you want to do because you've quit your job in order to work on this, then the fastest, most aggressive rack, would be leverage in first, like acquire before you start to pay off. So you're going to be in two modes. You're going to be in property acquisition mode. And then you're going to flip and then you're going to be in aggressive debt payoff mode. But, you know, the most aggressive way to build a biggest possible portfolio is be hyper-aggressive about acquisition until you hit your target maximum. And when you hit that target maximum, then you flip and then you go into pay down.

And that is going to help you build a lot faster rather than the opposite plan, rather than plan B, where you pay down first and use the cash flow to then start acquiring slowly, you know, a house a year. The house a year is suitable for someone who wants to do this on the side. But if you want to do this full time, if you really want to dedicate yourself to it, aggressively acquire first. So I guess I am kind of telling you what to do. But I'm also giving you food for thought in terms of think about what your goal is, right? Is your goal that you really do want?

Because like if you were to take the more aggressive route, it's going to require a lot of time, a lot of energy. It's going to be a very, very full-time job. So my question for you is, do you want this to be your full-time job? Or do you want to like really be retired and enjoy retirement and kind of chill for a while and take it easy? That I think is going to be the deciding factor. Thank you so much for the question, Yvette. And like I said, if you want to enjoy retirement, then you can take the more passive approach, which is slower. But if you want to do this full time, then take the more aggressive approach in which you acquire first before you start to pay off.

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That's what being a fifth-third better is all about. It's about not being just one thing, but many things for our customers. Big Bank Muscle, FinTech Hustle. That's your commercial payments of fifth-third better. Up next, we have a question from an anonymous caller, and since I have a practice of giving every anonymous caller, some type of a nickname. You know, I was recently reading a paper from the Yale School of Management

about housing returns. It's published in the National Bureau of Economic Research. This paper was co-authored by a woman named Kelly Shoe. And so in honor of the co-author of this particular paper, and I'm going to link to this paper in the show notes. I would like to name this caller Kelly. Hi, Paul and Joe. I am a huge fan of the show

and value the wealth of information you share with your listeners. My question is the following. My boyfriend and I are thinking about, moving out of our current home to my hometown in about six to seven years, possibly sooner. We were originally thinking of saving for a 20% down payment for the next six to seven years. We have about 10% that we could put down as early as this year. Does it make more sense to put 10% down in the next year or so and rent or Airbnb and out until we are able to move in?

We spend a lot of time in my hometown already and have plenty of people that could help manage it. My hometown attracts many tourists and hotels are very expensive, so I don't think we would have difficulties renting it out. For some background, we are both 29 years old. We will be making almost $300,000 combined. We are currently maxing out our Roth IRAs, my TSP, and he is contributing to his deferred compensation and will receive a substantial pension in retirement. We bought our current home in 2022. Our current mortgage is only under his name, and we are both on title. We are thinking of having the second mortgage under my name and having us both on title as well. Looking forward to your thoughts and any resources you can point us to.

Kelly, thank you for the question. I want to talk through a couple of elements of your question. So first of all, in general, you seem to be on very solid footing. You and your partner will be making $300,000 combined. You're 29 years old. So to be earning that kind of an income while you're still in your 20s is in incredible and it speaks to a likelihood that you'll be making pretty good money throughout your careers, throughout your 30s, 40s, 50s. You, as you said, you max out your Roth IRAs, your TSP,

your boyfriend will be receiving a substantial pension. It sounds as though you're decently on track for retirement. I'm curious, you mentioned that you contribute to your TSP. I'm curious if you have any other, you know, what your overall retirement balance is. But so long as that is healthy and And there's kind of every indication that it is based on what you've said. You seem to be on very solid footing. So let's turn to the question of you want to move back to your hometown in six or seven years. Do you wait to buy something at that time when prices likely will be a lot higher? Or do you go ahead and buy something now and rent it out?

A few things come to mind right away. First, if you were to buy something in the future, you would be able to buy it on a primary resident mortgage, which means you would be able to get the best financing terms. A primary resident mortgage is the best available mortgage, both in terms of down payment requirements, as well as in terms of the interest rate that you'll get on that mortgage. So if you were to buy a home right now, let's say you were to get a second home mortgage on it, a mortgage on a second home or a vacation home is not quite as favorable as the mortgage on a primary residence, but more favorable than the mortgage on an investment property.

Depending on how often you intend to go back and how much personal use you intend to have for that property, you may be able to get a second home loan or you may have to get an investment loan. It really depends on your intentions of how you plan on using it. Is this going to be purely a vacation property for the next six or seven years? Or is this going to, since it is in your hometown, you do go back a lot. Will this primarily be a second home, but one that you rent out? So that's going to determine, can you get a second home loan?

Can you get an investment loan? If you end up having to get an investment loan on it, 10% down payment is not going to cut it. I don't know any lender who's going to give you a loan with 10% down if it's an investor loan. So if you go for the investor loan, you will likely need to put between 25, to 30% down, which means you're going to have to save for a little bit longer before you're able to purchase this home. And the interest rate on an investor loan is going to be higher. That's not to say you shouldn't do it, because certainly there can be some substantial advantages to getting in now versus waiting. And so then to solve for that question, let's just assume a scenario

in which you end up needing to get an investor loan. How do you know if it's worth? it, that is going to become a function of what type of cap rate do you expect to receive from this property, which is to say what kind of unleveraged dividend, so to speak, do you think that you will be receiving from this property? And how does that, assuming that the property just keeps pace with inflation, how does that rise in value plus the dividend that you would receive from the property, how does that compare to other missed opportunities from using that money in an alternate investment? I realize the way that I've just said it is maybe a little bit confusing,

so I'm trying to think of a more clear way to say this. Let's imagine that you bought this property. Any property is going to grow, is going to have returns in two ways. One way is price appreciation, which is growth in the value of, the asset, and then the other way is the dividend, quote-unquote, or income stream that comes from that property. Now, in a rental property, the best expression of that dividend, that income stream, comes through calculating the cap rate. Many people mistakenly conflate the cash flow from the property with the dividend from the property, the income stream, but that is not actually the case,

because if the property is financed, which yours will be, the cash flow is just what's left over after you pay financing. But the financing includes principal paydown, which is equity growth, right? So what you actually want to look at is the cap rate, which is an expression of that dividend that the property pays. What is the cap rate? And then what is the price appreciation? and that cap rate plus price appreciation equals total return on the property.

Look at what that will be, that total return on the property, and then compare that to what you would expect to earn from an alternate investment. So let's say that you were to take that same down payment money, and you were to put that into some type of maybe treasury bonds, maybe a series of laddered CDs. I mean, this is not something that you would want to expose to entirely to like a total stock market index fund, given that you need to tap it in six to seven years. It's kind of that midterm tier of timeline. But you might want to put it into, you could put it into a target date 2025 or target date 2030 retirement fund, for example. You could put it into a blend of total

stock market, total bond market, and then some cash equivalence, right? Based on how you were to invest to that based on the asset mix of how you were to invest that down payment if you were to basically take that same basket of money and put it into that alternate investment, what kind of returns would you get on that? And you compare those returns to what you would expect to earn on this property if you were to hold it for an additional six to seven years. And by running a comparison of those two return projections, you can calculate which one you expect to be a better use of money, which one carries the steeper opportunity cost. Step one in running this calculation is to figure out what kind of projected cap rate

you think you would get on this property. And that, I mean, I have a big detailed cap rate spreadsheet that I use to calculate that, but basically the cap rate that you are going to calculate on this property is going to depend on your assumptions of how much you think you would receive in rent. and for that, you're going to want to calculate a range, worst case, midcase, best case. You'll also want to calculate a range of what you think the vacancy slash occupancy is. You'll want to calculate a range of what you think the repairs, the maintenance, the major capital expenditures are. And based on all of those ranges, you'll then calculate a range of cap rates, worst case, best case, midcase.

that range of cap rates plus some reasonable estimate of what you think the price appreciation will be. And to be conservative, I usually like to say it'll match inflation, nothing more. That's a very conservative approach. But when it comes to market-based appreciation, I like to take a more conservative approach there. That is going to be your return projection on the property. Now, one thing that you said within your question, you said, my hometown attracts many tourists and hotels are very expensive. And that kind of makes me think that you're interested in this as a short-term rental. The short-term rental market right now

is not very good. In fact, it's awful. The Airbnb market right now is in a pretty unfavorable state for a few reasons. Number one, saturation. Airbnb is turning 50. this year. It started in 2008. It has become so popular there has been in many locations and oversaturation and that has driven, not just driven prices down, but more so driven occupancy rates down. The average occupancy rate, you know, time between tenants, the average vacancy in an Airbnb be a handful of years ago, used to be around 12 days as a national aggregate average. Now in some markets, it's up to 30 days, right? There are huge swaths of vacancy in between stints, in between occupancy stints. That said, every market is local. And so just because there's oversaturation,

broadly speaking nationwide, does not mean that there's necessarily going to be oversaturation in your local market. But the way that you'll want to study that in your local market is by looking at what is on the market from the point of view of a guest, right? Take a look at what's on the market right now. Take a look at the booking calendar 30 days ahead. See how many days are booked for the next 30 days and how many days are open over the next 30 days. Have a spreadsheet where you're tracking maybe 12 or 15 properties and you're tracking, you know, column A was like the address of these, or not the address, because Airbnb is not going to give you the address, but column A is maybe the URL for these properties. Column B is today's date as the header. And then as of

today's date, how many days are booked? And then column C, D, E, F is like every single day for the next 30 days. Just keep looking and what is the occupancy rate for the next 30 days and have a running tracker of that. And then do that for 30 days. You'll be able to look back on the the last 30 days' worth of data so that you'll know at any given point in the last 30 days, how booked were they 30 days ahead. And that's going to give you a good approximation of what kind of vacancy or what kind of occupancy you can expect based on the conditions in your local market. The one element of that spreadsheet that I haven't actually covered is price fluctuations,

Often prices decline, you know, prices are dynamic, right? So oftentimes hosts will price their property at X when you're three weeks out, but as you get closer and closer to the date and vacancy becomes more of an imminent threat, the prices drop. So actually, if you really wanted to make this a more robust spreadsheet, you would have to restructure the spreadsheet in order to also include not just what kind of occupancy they're looking at, head, but also how those prices shuffle. I'd have to give some thought as to exactly how you would redesign the spreadsheet.

Somebody who's really good at spreadsheet design could probably help you with that. Spreadsheet design is, I'm better at the broad conceptual. Like, here's what you should be thinking about. I don't exactly know how you would design a spreadsheet for that, but there's got to be a way to design a spreadsheet for that. But you would want that data as well. Because that data, the dynamic pricing,

merged with the occupancy rates, that's what's going to tell you exactly what you can expect. as you are looking at these comparison properties in your hometown. And that information is going to give you a pretty good sense of how much you think you could earn from this property. I want to put an asterisk here as well, because also the element that I have not discussed is seasonality. I don't know your hometown. I don't know if it's highly seasonal. If there are fluctuations, summer, winter, major holidays. You said it's a tourist town. So I'm assuming there's going to be some seasonality element to it.

And gathering that data to the best of your ability is going to give you a better sense of how much the information of any given month August 2023 should be reasonably comparable to August 2024, assuming, yes, there are going to be minor differences depending on, you know, do we think we're headed for a recession or not. But broadly speaking, especially if you're in a seasonal place, any given August is going to be comparable to any other given August.

If you want to get a year's worth of data, though, I mean, short of manually tracking for a year, you'll want to see if there are any major groups. Maybe there's like a vacation rental owners association that has broad aggregate data for your local town. The more, though, that you try to find local data, like hyper-local data, the harder it is to find that. You know, I've, there are a lot of people who collect data at the, at the national level, at the state level. It's much harder I find to find hyper-local data. You may find it, you may not, depending on the size of your town.

You might have to manually track it. You might have to, you know, you'll want to be sleuthing for that. Once you calculate those numbers, once you know what kind of price range you're looking at, and how that math's out with the occupancy rates and with any changes in season, any seasonality changes that would affect both occupancy and price, that's going to give you a really good sense of the type of revenue that you would expect to receive if you were to do this as a short-term rental.

And then once you, once you know that gross revenue, then it's relatively simple from that point forward to just subtract out management costs, you know, management utilities. consumables. I mean, there's going to be services that handle your Airbnb for you. You can easily contact them and find out how much they charge. And boom, now you know what to subtract out. So subtracting out the operating costs is easy. It's estimating gross revenue that's going to be a bit harder. But that, once you can estimate that gross revenue, that is really going to provide

you with the answer because then you can just find that gross revenue, subtract out the operation costs, compare that net that you expect to receive, that's going to be your dividend, and that plus the appreciation on the property, that's going to be your total return. So calculate that, and you'll know how that compares with some alternate investment. So that's what I would do if I were trying to make this comparison. Again, I'm saying all of that, assuming that you are going to rent this as a short-term rental, and I'm kind of making that assumption based on the fact that you said, we have tourists and hotels are expensive. If by contrast, you don't want to make this a short-term rental, if you want to make this a long-term rental or a medium-term rental, like a corporate rental or something, that's going to be

a much, much easier. Running the numbers on that is going to be a lot easier, simply because you have fewer data points to gather, right? A long-term rental has one turnover every 12 months at most. So you don't have to adjust for as many factors as you would if you were trying to run these numbers as a short-term rental. But high level, broadly speaking, those are the calculations that – that's the data that I would gather and those are the calculations that I would do in order to figure out investment A versus investment B. I know I've just given you like a big homework assignment. I know that probably – it probably sounds intimidating because it's a lot of information to gather. but your first step is basically, if you want this as a short-term rental, go to Airbnb and just start looking at what's currently on the market from the perspective of a guest and start looking at their booking calendars and see how booked they are and see how their prices fluctuate and then just make a big spreadsheet and just start tracking that daily. Make that part of your morning routine every morning with a cup of coffee. That's what you do.

As you do that, then you'll start to notice patterns over time. So that's your first step. Thank you for asking that question. I know I've given you a big homework assignment, but people win or lose the game by taking the time up front to math out the decision. Taking that time up front will spare you from a lot of potential heartache down the road. Make it fun. Make it party the morning routine. It sounds like a lot when I say it, but if you just, if it's just a daily check-in where you're just tracking some numbers and playing with a some cells on a spreadsheet. Over time, it actually gets to be a lot of fun. So enjoy it.

Enjoy it. And best of luck with sleuthing out the potential returns. We'll return to the show in just a moment. We have one more question today. And it comes from Carly. Hello, hello. I have a question about buying a second home. I own a townhouse. It has increased increased about $100,000. It is my primary home. I've had it for three years. And so what I want to do is use this home as a rental, run it out on probably a yearly basis or even do some longer short-term stays, such as one to three months. Then I want to buy a second home and have that be my primary home. My question is, is I could technically perhaps do an FHA loan for three and a half percent down. I'm self-employed and had to get a special business loan for the home I have now. With that,

I showed one year of business tax returns and I put 10 percent down. Is it better to take out, say, a fifth of the equity, use that an addition with maybe 5% of the amount to put down on the home. Or should I leave the equity where it's at in the house, don't touch it, and try to save more so that I can buy a home and put, say, three and a half to 10% down? Thank you very much. Carly, first of all, congratulations. The value of your townhouse increased by $100,000 in the last three years. Huge congrats to you. What a treasure. So that's a fantastic question. Should you tap into one-fifth of the equity that is in your primary residence plus add it to some cash that you've got from savings and use that combined to make a down payment on your next home? Or should you leave the equity alone and wait a bit longer? A couple of things come to mind right away.

Now, first of all, you mentioned that you got a special loan for your current home, and in order to get that special loan, you needed to show one year of business tax returns and put 10% down. The special business loan, so that's awesome that you have it, I don't know when you started your business. You will be able, once you have two years worth of self-employed, tax returns, you will be able to qualify with most lenders, most major banks and credit unions, will allow you to get the same type of financing, the same type of home loans that any

salary W2 employee gets as soon as you have two years of tax returns from your self-employment. So I don't know how long you were self-employed prior to when you bought your current home. It sounds as though you might have been self-employed only for one year, which means that you had to get kind of a special loan. But you've been in that current – you've been in your current home for three years now, which means that certainly you have three or four years at least of self-employed tax returns. What that means is that most lenders will be able to give you the same type of loan that they'll give to any W-2 employee. the way that your income is going to be calculated is they will look at your last two years of tax returns, and they'll look at your monthly income, and then that monthly income added up and then divided by 24, that will be considered your monthly income for mortgage-related purposes.

So, yeah, the reason they do that is, of course, if you're a W-2 employee, you make the same amount every month. I'm sorry, I'm saying this for the sake of everybody else who's listening, who kind of wants to understand how the system works. If you're a W-2 employee, you make the same amount every month. If you're self-employed, you might make $5,000 in January, $9,000 in February, $17,000 in March, $2,000 in April. Your income could be all over the board. And so what they do is they'll take your income from the past 24 months, as documented on your tax returns. They add all of that up together. They divide that by 24, and that number is considered your income and your monthly income.

And then based on that monthly income, they calculate how much they would be willing to give you for a mortgage payment based on what's called your front end ratio and your back end ratio. Your front end ratio is the percentage of your monthly income that you would spend on principal interest taxes and insurance. In other words, your mortgage. Plus, if there's an HOA involved, that's included as well. So that's the front end ratio. And then the back end ratio is the percentage of your income that you spend on all debts combined, including. your mortgage. So if you have student loans, credit card debt, car loan, the back end ratio is how much of your total income can go towards all debts. That's how they calculate your monthly

income, and from that calculate your front end and back end ratios, and from that determine how much of a loan that they are willing to give you. So all of that being said, you should be able to go through the normal mortgage channels now since you have two years of self-employed tax returns. All right. Now, with all of that established, let's talk about the best way to buy a second home and then convert your primary residence into a rental. If you were to tap into the equity on your current home, likely the way that you would do that, I mean, there are a few ways you could do that. You could get a home equity line of credit or you could do a cash out refi. You know, there are a few different loan options.

let's assume that you, you know what, I don't, I'm just going to say, I don't like the idea of getting a cash out refinance because the interest rate that you locked in three years ago is going to be way lower than the interest rate that you could get now. So if you have a low, I mean, if you got this home three years ago, necessarily the interest rate that you have locked in is going to be a lot lower than whatever you could get today. And if you get a cash out refi, you're going to be giving up that interest rate. So I don't like the idea of a cash out refi for that reason. So let's knock that off the table. If a cash out refi is off the table, your other option would be a home equity loan or a home equity line of credit, something that does not close out your existing mortgage. But if you got a home equity line of credit, I mean, that's a revolving loan. So loans are either installment or revolving.

An installment loan is something that you pay periodically. like a mortgage or a car loan, right? These are installment loans. You have a fixed monthly payment. A revolving loan, by contrast, is something where you don't have a fixed monthly payment. It's like a credit card, for example. With a credit card, you have just an open line of credit, and then you pay a different amount every month, depending on how much of that open line of credit you've used. A home equity line of credit is a revolving line of credit, where you have an open line of credit, and then you kind of kind of you pay whatever, depending on how much of that you've tapped. That kind of revolving line of credit is designed to be a short-term loan. There are some real estate investors who kind of use it as a de facto supplemental down payment. I've never been a huge fan of that because it's designed to be a short-term loan. It is a revolving line of credit. If you were to take the HELOC approach and use a revolving line of credit to supplement the down payment that you want to put down, I would prioritize, I mean, I'm not against it.

I'm not a huge fan of it, but I'm not against it. If you were to do that, I would prioritize paying off that home equity line of credit as fast as possible. So in the hierarchy of debts that you want to pay off, I would close out that revolving line of credit, that home equity line of credit as fast as you possibly can. Because it is, it is by its nature, by its structure, it is designed to be a short-term loan in the way that credit cards are designed technically to be a short-term loan. typically I've never been a fan of helix, but if you've locked in interest rates from three years ago, you don't want to give that up, so you don't want to cash out refi.

The negative part of getting a, the other negative part of getting a heloc is that you then have three loans going, right? You've got the loan on your primary residence. Then you've also got a helic, and then you would also have an FHA loan on the second home. Again, that's not a terrible thing. You, you know, fine, you have three loans for a little while. Again, you prioritize paying off the HELOC.

That becomes the first debt that you really focus on. And then eventually you get that paid off. And now you've got only two loans, the FHA loan on the second home and the mortgage that already exists on the first home. Yeah. As I talk through it, I don't have any major objection to the idea of getting that HELOC and combining that with some cash from savings in order to come up with a down payment. that would get you into that second home. Yeah, I don't have any problem with that plan. I would just prioritize paying off that he lock first, first and fast if you were to do that. So yeah, I think that's a great approach. I don't really have a strong preference between doing that versus waiting to save up

the down payment. I mean, I almost feel like, you know, six of one, half a dozen of the other, if you're getting an FHA loan, you're going to be eligible to put down a very, very small down payment anyway. And so the down payment that you're going to be putting down on the second loan, on the loan for your second home, should be not that big of an amount, which means it should be relatively easy, relatively quick to either save up the cash or take out a helock and then pay it off fast. That's the reason that I don't have a strong preference between the two options because either way, this seems to me, unless there's some math that I'm absolutely missing here, this seems to me like one way or the other, you should be able to have either of these options done in less than a year.

Like either it should take you less than a year to save up the rest of the down payment and just make that down payment in cash for an FHA loan. or get the HELOC, combine it with some cash, get the FHA loan, get that second home, pay off the HELOC. That entire process should take about, I don't see any reason for it to take longer than a year because I don't see any reason for the HELOC to be a very large amount. That's the reason I don't have a strong preference between the two. Either way, I like the plan. I love FHA loans. I think they're a fantastic vehicle for owner occupants.

So huge, huge supporter of taking out an FHA loan, that will enable you to make a relatively small down payment, which kind of renders the basic decision. Like, do you take out this additional loan for the down payment or not? Kind of renders that to be in the long term relatively insignificant. Just whatever you do, don't cash out refi the primary residence. Keep that mortgage for as long as you can. Congrats on the primary residence. And on now converting that into a rental property, this has clearly been a huge net worth boon for you. So big congratulations to you for the $100,000 in equity that you've grown, for now getting into your first rental property, for expanding your property portfolio.

All of this is fantastic. I love to see wealth grow in this way. So congrats, Carly. And that is our show for today. It's a bit of an abridged show. It's a bonus episode. It's the first Friday supplemental episode. If you have not caught our previous episode, episode 454, which was a traditional Ask Paula and Joe weekly episode. Make sure you catch that one as well. That has been one of my favorites. Our course on rental property investing, your first rental property, reopens for enrollment September 5. So in a month, our flagship course on rental property. investing, which is called your first rental property, is going to reopen for enrollment, all the details about that you can find at afford anything.com slash VIP list.

Affordanything.com slash VIP list. So head there, get all the information that you are looking for on rental property investing. It's got a ton of really, really great information that you'll get for free, no matter what, whether you enroll in the course or not, we'll send you a lot of information about rentals. So afford anything.com slash VIP list. I'll see you. there. And I hope also, if you want to enroll in the course, I hope to see you in class. Thank you so much for tuning in. My name is Paula Pant. This is the Afford Anything podcast, and I will catch you in our regular weekly episode next week. See you there. Here is an important disclaimer. There's a distinction between financial media and financial

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