The IDEAL Investment

Rental homes can be the IDEAL investment in today’s market because they offer a much higher rate of return than alternatives without the volatility of ups and downs in the stock market.

IDEAL serves as an acronym to identify the advantages of rental properties:

• Income from the monthly rent contributes to paying the expenses and a return on the investment
• Depreciation is a non-cash deduction that contributes a tax shelter
• Equity grows monthly as the mortgage amortizes due to some of each payment being applied to the principal
• Appreciation is achieved as the value of the property goes up
• Leverage can increase the return on investment by using borrowed funds to control a larger asset

The combination of these characteristics working together makes rental real estate a very good investment for today’s economy and years to come. Increased rents, high rental demand, good values and low non-owner-occupied mortgage rates contribute to positive cash flows and very favorable rates of return.

Contact me for more information about actual opportunities in our local market.

Risk Determines Rate

Regardless of what a lender quotes on mortgage rates, the actual rate paid by a borrower is based on a number of variables. Lenders determine whether to loan money and at what rate based on the risk involved with the transaction.

Factors that increase the risk that the loan will be repaid will proportionately increase the interest rate charged to the borrower. If the risk becomes too high, the loan will not be approved.

• Loan amounts – conventional loans for more than the conforming limits set by Fannie Mae are considered jumbo loans and generally have a higher interest rate.
• FICO score – the lowest interest rate is reserved for the highest credit scores; the lower the score, the higher the rate borrower will pay.
• Occupancy – borrowers occupying a home as their principal residence are considered a better loan risk than second homes and investment properties.
• Loan purpose – purchase transactions generally have the lowest interest rate while refinancing a home is generally higher.
• Debt-to-Income ratio – a borrower’s monthly liabilities divided by their gross monthly income develops a ratio that helps lenders to assess the borrower’s ability to repay the mortgage.
• Loan-to-Value ratio – the lower the percentage of the loan to the appraised value of the property will generally lower the interest rate.

Any combination of these factors could limit a borrower’s ability to secure a mortgage at the rate initially quoted. Being pre-approved by a trusted mortgage professional is the best way to know what rate you can expect to pay. Please call for a recommendation.

Deductible Is the Point

Points refer to prepaid interest on a home mortgage and can be fully deductible by the buyer in the year paid if the right conditions exist. The points must be used to buy, build or improve a taxpayer’s principal residence but not all fees charged by the lender are necessarily deductible.

According to IRS Publication 936, “The term ‘points’ is used to describe certain charges paid, or treated as paid, by a borrower to obtain a home mortgage. Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points. A borrower is treated as paying any points that a home seller pays for the borrower’s mortgage.”

If you purchased a home in 2011, have your tax professional evaluate your closing statement to see if there are loan fees that may be used as a deduction on your tax return regardless of whether you or the seller paid them.

Refinancing a principal residence or purchasing an investment or income property require that points must be deducted ratably over the term of the mortgage rather than deducting them fully in the year paid. Borrowers in these situations should consider the benefits of lower interest rates from paying point to higher interest rates without points.

This article is meant to provide information that can be discussed with your tax professional about your specific situation and is not to be considered tax advice.

Choose Your Deduction

One third of all U.S. households, 75% of households with more than $75,000 income and most homeowners itemize their deduction on their federal income tax returns. It makes sense because the interest paid on their mortgage and their property taxes probably exceeds the allowable standard deduction.

However, with interest rates as low as they have been in the last two years and the price of homes having come down considerably, it is possible that the standard deduction may be the better choice.

Each year, the taxpayer can compare the total of the itemized deductions to the standard deduction to select which method will result in the most benefits. The 2011 standard deduction is $11,600 for married couple filing jointly and $5,800 for single filers.

The Housing and Economic Recovery Act of 2008 allows homeowners to take the standard deduction and the lesser of their actual property taxes of $1,000 if filing their return married jointly. For more information, see Schedule L found on www.IRS.gov and consult your tax advisor.

Forced Savings…Really?

Part of the American Dream is to own a home. A home is a place to call your own; a place to raise your family and share with your friends. A home is a place to feel safe and secure. A home is a good investment?

In a recent report* by Beracha and Johnson, it is suggested that buying a home is the right thing to do but not necessarily for the reason that people expect. A home is, in many instances, the largest investment that homeowners have and it accounts for the majority of their net worth.

The report suggests that the self-imposed savings due to amortization has a significant contribution to a person’s net worth. The premise was determined by comparing the net worth of buyers to renters over a 31 year period of time.

When the savings in rent and down payment were reinvested, renters had a greater net worth than buyers after each 8-year cycle by a margin of 91% to 9%. On the other hand, when the requirement to reinvest the savings was dropped and renters were allowed to spend the savings on consumption, the Buyers had a greater net worth 84% compared to 16% for renters.

Appreciation, tax savings and amortization contribute to lowering the cost of housing and help homeowners build equity. The forced savings due to amortization benefits the individuals who may not be disciplined enough to invest the savings otherwise. Regardless of which benefits apply in different situations, owning a home can be a satisfying investment both emotionally and financially.

*Factor Sensitivities in the Making of Buy vs. Rent Decisions: Do Homeowners Make the Right Decision for the Wrong Reason by Eli Berach and Ken J. Johnson of Florida International University writing for the Journal of Housing Research.

The “Right Size” Home

Work hard, buy a home, start a family and continue to upgrade your home until everyone has enough room. This has been the blueprint for lots of homeowners for the last fifty years but there is certainly a shift in thinking that could change all of that.

Interestingly, Americans live in much larger homes than most people in other countries throughout the world. The U.S. Census reported in 2006 that the average single family home completed had 2,469 square feet which was 769 feet more than in 1976.

Once the children are grown and have moved out, homeowners are finding they have too much room. Even if their home is paid for, they have higher property taxes, insurance, utilities and maintenance on the larger home than they’d have if they were living in the “right size” home.

Some homeowners state thaty they’re keeping their larger home because it has luxury features that smaller homes don’t have. There’s a movement that seems to have started in the United States to find the “right size” home with the amenities and convenience that homeowners want.

This philosophy has been expressed by Sarah Susanka in her book Creating the Not So Big House. It proposes a house that “values quality over quantity with an emphasis on comfort and beauty, a high level of detail, and a floor plan designed for today’s informal lifestyle.”

“This Year I’m Going To…”

Every year, it seems like the same things are on the list but this could be the year you really do invest in a rental home.

Rents are climbing, home prices are cheap and mortgage rates are low for even non-owner occupied properties. A $125,000 home with 20% down payment can easily have a $300 to $500 monthly cash flow after paying all of the expenses.

There are lots of investment strategies that work but one that is easy to understand and execute is to stay with below average price range homes in predominantly owner-occupied neighborhoods. These properties will appeal to the broadest range of tenants while you hold them and buyers when you’re ready to sell.

Single family homes offer an opportunity to borrow high loan-to-value mortgages at fixed rates for long terms on appreciating assess with tax advantages and reasonable control

This is the year to make some real progress on your resolutions. First, invest some time learning about rental properties by attending a FREE webinar on January 4th at 7:00 PM Central time by national real estate speaker Pat Zaby. Click here to register.