Need math help re: mortgages

[Done by Forty]

So my general lack of math skills is slowing down some financial decisions my wife and I are trying to make, and I'm hoping the MMM community can help us sort through this.  Here's the situation:

We recently decided that our investments for our next primary home purchase were a bit too risky, and as that purchase is 5 years away, we decided to move half of those funds to cash (with the other half in a 60/40 bond/stock fund).  That gives us a pile of cash earning 0.8% or so (approx $37k).

Now, it just so turns out that the mortgage on our current property is right around $37k (4.25% interest on a 15 year fixed).  Initially we'd thought, hey, let's just pay it off because 4.25% interest vs. 0.8% interest is an easy choice. 

Here's where we get confused: we are planning to purchase a rental home this year (a different home from the one we're saving for 5 years from now).  And completely paying off our current mortgage is supposedly a bad idea, according to our lender, since it's our only line of credit besides 3 credit cards.  So, here are the options:

Option 1:  Ignore what our lender says, pay off the current mortgage, save a little on interest, then take out a $150k mortgage on a rental property (30 year, say 4.25% fixed).

Option 2: Use $27k to pay down current mortgage to approximately $10k (giving us about a year to close on a rental property while keeping the current mortgage active).  Then use the remaining $10k to pay off current mortgage once we close on the rental, leaving us only with one $150k mortage on the rental property.

Option 3: Use $27k as an additional downpayment on the rental property, only borrowing $123k, but leaving us paying two mortgages for a while.  ($127k mortgage on rental, $37k mortgage on primary)

Option 4: Borrow $150k on the rental property, then pay the $27k as an additional payment to principal on the rental property's mortgage (again, this would leave us paying two mortgages for a while)


At this point there are so many variables that I'm coming up with weird outcomes.  For example, it somehow seems to save us a bunch of interest when doing option 4 when compared to option 3, which makes no sense to me.  Can anyone please give us some advice? 

[Another Reader]

Before you start fooling with the numbers for how to do this, what type of rental property are you planning on buying and what are the proposed numbers for that property?  The reason I ask this question is that you live in South Scottsdale and I invest in the larger Phoenix market.  I am not seeing much I would invest in with the recent run-up in prices.  Unless your numbers are realistic and make sense, I would likely not buy a property in your shoes. 

[Done by Forty]

We're looking to buy in Tempe, primarily to access funds that are locked in a trust.  The short version is that my wife has $53k her grandmother left her that is locked in a savings account earning 0.25% until age 40 (14 years from now), unless it is invested in a property that shows to be net cash positive. 

We have not yet found the specific property, but of course welcome any parameters you'd like to advise on.  We are looking to purchase a single family home just west of ASU's campus, between $130k and $200k.

[Catbert]

I'd leave the 37K in the bank until to decide on and close on the new property.  Mortgage companies can be pretty picky/screwy these  days about what they want in a borrower.  What if the potential lender on the new property would give you a better rate if you have cash sitting around?  Or won't lend to you because all your money is tied up in real estate.  Or if you need some of that 37K to get the property you want?

Once you new property closes you can pay off your principle residence loan.  It's not the best answer mathematically, however, it gives you the most flexibility.

[Another Reader]

I own a number of houses in Tempe, but none that far north (85281).  The lowest price house in 85283 last time I checked was $165,000 and it would rent for no more than $995.  Similar prices and rents are found in 85282, although I haven't looked in a couple of months.  The Tempe sale market is up by almost 30 percent over the last year, but rents are up slightly if at all.

In short, I don't see much that would be cash flow positive today if you factor in reasonable vacancy and expense estimates.  Have you put numbers to paper/spreadsheet yet?  Have you looked at any properties?

[Done by Forty]

Hi, Another Reader:  No, we haven't started looking yet.  We are going to view starting next week, and we're in the planning phase now.  Would love to hear guidelines on reasonable vacancy rates (e.g. - 1 month) and expenses (e.g. - 3% of home value). 

Essentially though, we are specifically looking for advice re: which of the options above would be most advantageous re: the cost of the mortgages, not whether a specific rental property itself is a good buy when compared to letting inflation eat away at that cash for 14 years.  That's obviously important but it's somewhat a separate issue, right?


Hi, mary: part of me thinks you may be right and sitting on the cash for now may not be the worst idea. 

[Another Reader]

If the answer is that you cannot find a rental with real positive cash flow, then that's the most important hurdle.  It might be a good idea to talk to an agent familiar with investment properties in the area and get some current listings, pending sales, and sales closed in the last 30 days.  Also get current and recent rental listings from the MLS.  Craigslist does not count, because some of those folks ignore tenant quality in favor of higher rents, which is a very bad idea.

If you are getting the $53k as the downpayment on the rental, who makes the decision whether you get the money and what are the criteria?  In your shoes, I would understand that process before I expended a lot of effort getting approved for financing and looking at properties.

In your shoes, I would take a good look at whether a property purchase as you describe is feasible.  If it is not, I would consider paying off the mortgage and adding the payments to my savings for the next house or other financial goals.  If you go ahead with the purchase, work with the lender to arrange the assets and liabilities to suit the lender, at least until the purchase is completed. 

[Done by Forty]

We're already working with a realtor who is sending us MLS links, and for properties we're interested in, she's providing rental estimates ($50 range).

The decider of the cash is ultimately the court.  We've gone over the process with the executor of the trust but it essentially involves us creating a financial analysis of a specific property, providing that the executor of the trust, who then submits it to the court who gives a 'yes' or 'no' based on a reading of the trust and whether they agree the home is cash flow positive.  Then the executor writes a check to the escrow company.  We'll write in a longer closing time and an offer that's contingent upon court approval.

Sooooooo....assuming we find a property that is cash flow positive, your advice is to hold onto the $37k and do what the lender advises?



I'd really love some help on figuring out whether it's advantageous to borrow less via using the cash as an additional downpayment, or borrow more and then pay it down, or neither (because it's the same either way).  My math is showing me that borrowing the entire $150k, then making a $27k payment to principal (Option 4) pays less interest overall than simply using that $27k toward the downpayment and only borrowing $123k (Option 3).  It just doesn't seem right.

[Another Reader]

You are probably not going to be able to borrow 100 percent on an investment property.  LTV will likely be around 75 percent.  Maybe 80.  Your rate is going to be higher than for an owner-occupied property.  Your leverage is positive (helpful to you) if the overall capitalization rate is higher than the mortgage rate.  The OAR is the net income from the property before debt service divided by your assumed purchase price. 

Your agent should be providing actual rental comparables, not "estimates." 

If something is reasonably priced, it's likely selling in a few days with multiple offers.  No one is going to take an offer contingent on court approval in the current market.  I'd like to see an analysis of one of the properties you would consider showing that it is cash flow positive.  My guess is that if you use realistic numbers, it is not, or just barely.  I'm not trying to disillusion you, I'm trying to be realistic.  I have owned multiple properties in Tempe for 16 years, and there is nothing I would buy at today's prices.

[Done by Forty]

So, to clarify: we have $53k in cash to put down on the rental property from the trust.  With just that, we'd be around 75% LTV on a $200k home (approx $150k loan value).  We also have an additional $37k in cash that may be used for that property...and that's kind of the point of my original question.  What's the optimal use of those funds.  Not buying a home may be the right decision, but it should be taken into account that not purchasing the home means that it sits in cash for 14 years (or, could be used for a rental home later, in a different market, or for something like a business start up).

I appreciate all the helpful advice from such a seasoned investor.  It's quite possible that the right thing to do is not to purchase a rental property.  It's just, you know, I have that original math question re: mortgages that it'd be nice if someone could help out with.

[babysteps]

Agree that *if* you are set on getting an investment property you shouldn't pay down your own mortgage until after the investment property loan closes - maybe even wait 2 months.  Lenders want to believe you might not pay off loans early, it won't help to give them an excuse to think otherwise - unless you can get to a don't-need-no-stinking-banks place, which is ideal :)

1-Can you access the trust funds to pay down an investment property mortgage (instead of as purchase money?)

2-Is there a market near you where $37k down on an investment property would work?

3-If you used the $37k as a down payment, do you have any other money for unexpected first year rental property expenses (there is almost always something that comes up)?

If the answers to all 3 are "yes", you might consider using the $37k as the downpayment, get a loan for the balance, then use the trust money to pay down that loan.  That way you don't have to ask for extended closing time.  As a seller I would want to make sure you paid top $ if I'm giving you "extra" time.  Check loan doc's for partial prepayment penalties, investment property lenders have been known to write in fees that you owe if you make any additional payments in the first year (or whatever initial period) of the loan.  Lenders have more leeway to make loan terms "interesting" when it isn't owner occupied property.

If the answer is "no" to any of the questions, it might mean a little more time building the 'stash before buying an investment property.  Seems like you are close though!