Though we may spend oodles of time in an office or traveling, our home serves as the practical and emotional central nervous system in our lives. It’s not only the place to shield us from the elements and store our stuff, but it’s also the place where so many magical and meaningful moments may happen.
From family dinners to romantic interludes, those moments are so much of what makes up the narrative of our lives, and our home serves as the backdrop to many of them. From a practical standpoint, our homes can also work a little bit like a campfire; they need to be poked and prodded to keep working. But instead of feeding more logs and sticks, we feed them with our cash.
Does anybody remember the movie The Money Pit? We pour money in to keep it humming.
Whether it’s the new roof or the broken water heater or just the general upkeep it takes to run a home (not to mention the mortgage payments that we make to live there), there’s a reason why household expenses are such a big line on our lifestyle expense budgets.
It takes a lot of money to live, and it takes a lot of money to own a home.
Now some will argue that home is just a state of mind—it’s where the heart is, right? And while it is, it also has some very practical and financial implications when it comes to creating wealth. Pick the wrong situation and you can lose a lot of money, but pick the right situation and—get this—it is the most valuable and fruitful investment you can make.
That’s because real estate inevitably appreciates over the long term, and with an amortizing mortgage, you are paying into the principal, essentially keeping the money you’ve invested and watching it grow as it appreciates.
Even more so, when it comes to younger people just starting out on their wealth-creation journey, your home can be the very best way to create a lot of money in a very short amount of time.
We’ve already seen how the equity in your home (via HELOCs) can help you out of debt or help you use debt to your advantage, but thinking about real estate involves more than just finding an agent and falling in love with a certain house because you like the size of the closets or the bathroom tile with the funky green dots; it’s about how you can make this not just an emotional investment, but a financial one as well.
Now, there is one major disadvantage to using real estate as your investment strategy.
- There’s no liquidity.
It takes time to buy, sell, and make money, meaning you don’t have income coming to you like you might with other investment strategies. So if you need access to cash fast, then real estate isn’t going to provide that. But over the long haul, with a diversified investment approach in other areas, real estate is a wonderful and potentially big-bucks accumulation strategy for you. Here are my guidelines for how to best use real estate to your advantage.
Remove Some of the Emotions from the Home
This seems crazy to say, right? Homes should be emotional. Homes should have meaning. Homes should be about creating memories with the people you love. In the backyard, the kitchen, the bedroom—or even the time Junior threw a baseball through a window (not funny at the time, kind of funny ten years later). But what do I mean by this? I mean that the emotions of your home should revolve around the people more so than the property.
Why? Because this allows you, if you’re strategic, to create an incredible amount of wealth in a short amount of time. Now, this applies more to the younger set than those approaching or in retirement, but let me explain how and why.
- No other mode of investment allows you to create as much wealth, with such great tax advantages, as real estate does. It opens the door to a huge opportunity for building a portfolio and wealth.
If you are in a situation where you can move every, say, four or five years (Americans are currently moving about every eight years, according to U.S. Census data), the amount of money you can build up in a few moves is extraordinary. But you have to be willing to invest a little time, money, and energy.
Let’s say you’re in your mid-20s and looking for your first piece of real estate to buy. You take the plunge by buying a fixer-upper. Let’s say you research many opportunities, negotiate well, and buy a fixer-upper house for $200,000. You put some money, say $30,000, in it to make important, well-thought-out improvements, like kitchen or bathroom areas, that elevate it to one of the more desirable homes in the area.
Four or five years later—because real estate is one of the few places where we see values traditionally go up over time, rather than tank, except for some down periods or less stable geographic areas in the market—you can sell that house for $300,000. You’re now $70,000 ahead, not to mention the equity you have already gained from making payments over those years—and you do not have to pay taxes on the gain.
This is because, currently, the IRS allows qualified homeowners, who live in their primary residence for a minimum of two years out of the five years before the date of sale, an exclusion of up to $250,000 of their gains for single filers or $500,000 for joint filers. What other investment strategy allows you to go tax-free on those gains? Right—none.
Now keep playing that scenario out for two or three more house purchases. You can use that $70,000 gain as a down payment on a $350,000 home, put some money into it, and perhaps sell it for $450,000. You make another $70,000 on top of what you already used to pay for it. You can keep doing that, with either more expensive homes or with similarly priced homes, and keep making those types of gains. As a result, you can build a strong base of income, which you can then invest in the market to make even more money.
- Because of the potential market increases and the lack of taxes you have to pay on those gains, you’re creating a ton of wealth.
Now, there are quite a few disclaimers when it comes to employing this strategy.
Typically, you have to have a little bit of cash flow to pay down payments and invest in the home improvements that will raise a home’s value. You also have to be willing to go through the logistical and time hassles that are involved with purchasing a home and making improvements.
Finally, you have to be emotionally willing to move often. That’s not for everyone, because the emotional attachment to homes can be so strong, and for those people who think they’ve found their dream home, they’re not willing to move to another place.
Indeed, those are some pretty strong “if” statements.
However, if you just played that scenario out for a few moves, you can see the kinds of gains you can make. It should be noted that it’s not as if you have to move to different cities, townships, or even neighborhoods; you can make those moves and still stay local and retain the social, civic, and educational infrastructures that you prefer.
The last point I’d make here is that you have to do your research to know and understand what the market wants when it comes to resale value. If you can’t resell that home when you’re ready, then you won’t be able to take advantage of the potential wealth you’re trying to create. The wealth only comes when you’re able to sell and make money in the increased value without having to pay taxes on it.
What does that mean practically? You may have to look past what you want and focus on what the majority of others would want. Say you only need a two-bedroom house. Nobody wants a two-bedroom house anymore, so there’s no sense in investing your money in one, even if that’s all you need.
What about the school district? Your kids are all grown up so what do you care? You care, because you won’t be able to sell to a family of five with three kids in elementary school if you’re not in a desirable school district. So you need to think ahead, and balance your needs and wants – and what you expect the majority of other people to need and want when you’re ready to sell it down the line.
Take Your Time
I know I just said that to create wealth, you’ll be buying and selling every few years. And now I’m telling you that you should take your time.
What I mean by that is that you shouldn’t really rush into purchases just because you “love” a certain home, or that you could picture yourself living there forever, or that it just feels right. While I don’t want to discount those subjective attachments—and I do want your home to reflect you and your values—I don’t want you to have those emotional attachments trump doing your homework.
We all know the phrase that the three most important words in real estate are location, location, and location because it’s the location, not the actual home, that plays a huge role in prices. The same floor plan in the same condition can be tens of thousands (and in some cases, hundreds of thousands) of dollars apart in price depending on where they are.
You need to not only look at what you’ll live in but also where you’ll live in terms of neighborhood, desirable school districts, whether the house you’re looking at is the priciest in the area (not good) or one of the cheapest (good, so you can build it up and increase value for when you’re ready to sell).
The way that home price is largely determined is by “comps”—comparable homes that have sold in the area. So, be careful… if you’re at the high end of the price list when you’re buying, you’ll have little room to grow when you try to sell.
Certainly, with so many online resources and the ability to search for information relating to real estate, like info on property taxes and any municipal restrictions or future land planning that could affect sales price, you should be able to gather a complete picture of what you want.
Now, if your goal is to find a home and stay camped there forever, you may be able to ignore some of these factors, and your goal should be to find the place that will make you the happiest.
But if your goal is to create wealth by making sure it has some potentially high real-estate value, then you can’t jump into a purchase merely because you like the hardwood floors.
- Just as there is the potential to make a lot of money on a good real estate deal, you also run the risk of losing a lot of money if you can’t sell (i.e., if the value goes down or stays steady, or if it’s on the market a long time).
Real estate isn’t about the here-and-now purchase. It’s also about the in-the-future potential as well.
Find the Right Price
How do you know how much you can afford for a house? Good question, since the prices of homes are so large that it often comes off as an abstract number. The way you need to think about it is not in the total price of the home, the sales price. You have to break it down to a monthly payment.
- Rule of thumb: Your monthly payment should be no more than 30 percent of your monthly income.
Remember, building wealth is about living within your means and budgeting. To come up with that figure, you’ll need to be able to figure out the mortgage payments based on the rate you expect to get and how much of a down payment you’ll make, property taxes for the area in which you’re living, homeowner’s insurance, and a property repair and replacement fund to keep the property in good condition.
According to the Federal Reserve, you can get a ballpark number for insurance by dividing the cost of the home by 1,000 and then multiplying the result by $3.50.
The key number isn’t that sales price; it’s making sure that your monthly payment stays right around 30 percent of your income.
Game Your Mortgage
Some of you may be in a position to pay for a home in cash, but most of you will be taking out a mortgage—the loan from the bank that allows you to purchase the home, and then pay it off with a currently-low interest rate.
Cash buyers still have to pay things like property taxes and homeowner’s insurance, so even paying cash doesn’t erase expenses, but those using a mortgage will find that these payments–and the associated costs–will make up a significant portion of their monthly budgets. There’s a lot of paperwork involved in mortgage and closing on a house, which is why most people get an agent or a lawyer to seal the deal.
You’ll likely have someone to guide you on the fine print, but here are some things to think about concerning your mortgage:
- Get one with no pre-payment penalty. Some mortgage deals will penalize you if you want to pay off your loan earlier than the thirty- or fifteen-year deal that you have. The reason why is that they lose the money they make in interest if you do. If you are in a position to pay it off ahead of time, you should do that, and you need to negotiate upfront to have no penalty associated with that option.
- No points. When mortgage rates are low right now, you can get a very good deal on the rate you’re paying. What you don’t want to pay are “points”—up-front costs based upon the settlement purchase price of the house straight to the bank. Even if you have to pay a slightly higher interest rate, you want little or no points.
- Shop around. Start with your own bank, but be aware that most banks have specialties. Some banks may specialize in first mortgages, so their long-term rates are good and competitive. Others may specialize in HELOCs, so they don’t have much of a business in first mortgages, which means they don’t pay much attention to them, have higher interest rates, and don’t care whether they get your business for your first mortgage. Don’t assume that just because it’s your primary bank, you’ll get a competitive rate. You must shop around to make sure you’re getting a good deal not just in the percentage rate charged, but also other fees that you can negotiate.
- Find a bank or lender that will allow you to make two payments a month. Even though you’ll only be billed once a month, you can cut a year or two off the length of your loan by paying the same amount, just split in half every two weeks. So if you have a $2,000 monthly payment, it makes more financial sense to pay $1,000 on the first of the month and the fifteenth. Why? Doing that means more of your money goes to the principal rather than interest, so you chip away at the total amount that you owe the bank, and you’ll thus reduce the length of your loan in the process and pay it off early, leaving you with more wealth at the end of your loan. Do that and everybody wins (except the bank).
- Think about the length of your loan. You’ll likely have a choice between 15- and 30-year amortizing mortgages. Some people will opt for the 15-year plan because that means they’ll pay off the loan faster. But that also means higher payments and less cash flow for you along the way. So for most of us, unless you have significant cash flow and low debt, you’ll want the thirty-year option—for lower monthly payments and so you can chip away at the cost by making two payments a month.
Some of these decisions also depend on your age, the amount of money you have saved for retirement, and other factors. Most times, though, the 30-year loan makes the most sense, because as your house appreciates, you’ll be allowing that value to grow—meaning the real estate will be working for you, by making lower payments at a low interest rate, while your real estate is growing at a higher rate.
The other advantage is that if you choose the longer loan, you can always make larger payments along the way and pay it off faster, but if you pick the shorter loan, you’ll have larger payments and can’t choose to make smaller ones during times when your cash flow may decrease. So you’re locked in. The 30-year mortgage simply gives you the flexibility to pay off the loan as you wish, while the 15-year choice forces your hand with aggressive payments.
Buy When the Interest Rates Are Good
Right now, we’re in an era of unusual opportunity. The cost of borrowing money for mortgages is low enough that, for many people, if you can afford to buy a house, now is the time to do so. However, the interest rates do fluctuate – and have in recent history – so it’s important to consider the current average rate before jumping in and buying a house.
Think about the difference in monthly costs and make that a part of your decision.
For example, a $200,000 mortgage at a 3.5 percent interest rate over 30 years is an $898.08 monthly payment.
- The same mortgage at a 6 percent interest rate is a $1,199.10 monthly payment.
- The amount you pay over the life of the mortgage? $323,312.18 compared to $431,676.38.
If that’s not a reason to jump in and buy, I’m not sure what is.
Don’t Waste Time with an Investment Property
After everything I have said about what a killer investment opportunity that real estate is, it would seem to make sense that if you can, you should buy other properties to rent out and make money off them too, right? Probably not, actually. My experience is that those people who make those second-home investments to use as rentals spend so much time and money on general upkeep that it’s hard for them to get value from that second home because they have to pay maintenance people, collect bills from renters, and respond to every request from the renter (“The toilet is clogged again?”).
It can be a large headache and financially a wash.
Remember one of my main mantras: Your time is a key part of your wealth.
If you spend so much time in such endeavors that you can’t make money in other areas or you can’t enjoy the things that matter in your life, then that doesn’t seem to fit in the family and personal values you’ve created.
Another point: The tax breaks you get on your primary home don’t typically extend to a vacation home or investment property.
Therefore, any gains you would make do get taxed, meaning that you’re not getting the full potential of wealth gains that you do for your primary home. There are some exceptions, of course. If you are handy enough to do most of the upkeep (and have the time to do so), it may make some sense to take advantage of the value increase if you can find fixer-uppers that you can rent out, improve, and then sell (it’s called flipping). The other scenario that makes sense is if you can invest in some quantity of rental properties (say, at least five or six).
In that case, it may make sense to pay or partner with someone who can handle the repairs, upgrades, and maintenance to improve your profit-making potential. And then there’s a large enough volume of income from the properties to offset the expenses, and you can see the income as you sell and flip those properties. I’m not against buying properties to rent out; for example, one good option is buying a duplex or triplex and you or one of your offspring living in one of the units.
Because you or your children already live on-site, it won’t be as much of a hassle to take care of needs from the renter, and you can use that rental income to help pay the mortgage. I just think that you’ll be more efficient and make the most money either concentrating on your own home or investing in volume. Having one small property usually doesn’t prove to be worth it, financially speaking.
Is Renting Ever A Good Idea?
Given the fact that I’ve said that real estate can be the best thing since grilled salmon, I bet you think I’m going to say that you should never rent; that it makes most sense to buy. But that’s not the case.
- Renting can actually be a good idea, especially for people who are in transition or don’t know where they want to settle.
It makes more sense to rent for six months to a year (and essentially lose that money) than to buy hastily and get into a situation where you can’t resell the house because you made a bad decision about location.
The money you would lose is much higher than the money you’d lose from renting for a short time.
Do I think renting is a good idea over the long term? Typically not, because of all of the wealth and tax advantages received by purchasing a home. But for the short term, in the right situation, it can certainly be the better choice. You may even consider a lease-to-buy option, which would allow you to rent for a short period, with no obligation, and then that monthly payment could be used toward the purchase of the home if you decide you like it.
That’s a best-of-both-worlds situation for some potential buyers.
- For retirees, renting a home can also be the optimal choice, especially for those retirees who want to limit the repair and maintenance costs that come with home ownership.
When you move to a new city that is unfamiliar to you or your family, renting gives you ample opportunity to try out not only the house but the neighborhood, the school system, and the attractiveness of the area lifestyle-wise before you commit your life and a significant amount of money to that town.
Final Thoughts
Of all the potential investments you can make, real estate offers longevity in a way other methods don’t. There’s some risk, of course, but there’s a significant amount of risk involved with any investment.
Working with a personal wealth advisor will help guide you toward making the right decisions with your hard-earned money, but if you’ve got a plan to pay off your mortgage at an expedited rate and don’t have emotional attachments to a particular place, you can make these types of investments pay off sooner than you might think.
But not too soon. Remember: Real estate is not an immediate pay-off. It takes time, like tending to a garden, but the fruit that it yields can be well worth it. Not to mention, potentially tax-free. Who doesn’t love a tax-free investment?
Ultimately, you want to build a solid foundation for your financial future and make smart choices with your money, because the wealth you grow during your lifetime can fuel your family for generations – and real estate can help you accomplish that goal.