I had a great conversation with some past clients at one of their kiddos birthdays this past weekend. We were talking about the housing market and now that they have 2 kids, they’re wanting to upgrade to a 4 bedroom. However, it seems challenging and daunting since prices have gone up so much. Now I am going to preface this by saying, I totally understand that this scenario is not going to work for everyone, but both of my clients happened to have purchased homes in the area 2 to 4 years ago so they have both made some solid equity in their homes over the last few years and have saved quite a bit. We talked about a few scenarios where they could buy something new and potentially keep the home they currently own. Here are a few scenarios we talked about as well as the numbers to help show you why this can be beneficial…
For the purpose of these examples, we are going to say that they are not carrying any other debt besides their mortgages. In addition, we are going to use a fictitious income of $120K per year for the family.
When it comes to mortgages, we talk about debt to income ratio. Most lenders do not want your debt to income ratio to exceed 45%. What that means is that the total of your monthly payments for your house, car, loans, credit cards, etc does not exceed 45% of your total monthly income. That means if we are talking about $120K per year, that breaks down to $10k per month and with no other debt, they could spend $4500/mo. on a mortgage. That roughly translates to a $800-900K mortgage.
Scenario 1, they just simply sell and upgrade:
They would walk away with $200-300K from the equity increase plus they qualify for an $800-900K mortgage which means they can get into a home that is worth around $1-1.2M which can definitely get you a good home in our market. (Keep in mind the downpayment on the mortgage.)
Here is what I encouraged them to think about instead though…
Scenario 2, they keep their home and long term rent it:
Most people aren’t really aware that you can count 75% of a 12-month lease on your home towards your income. Just to keep numbers simple, I’m going to say they could rent their homes for $3600/mo. That means $2,700 can be counted towards their income. Now, overall, their monthly income goes from $10,000 to $12,700. Of course by keeping their home, now they have additional debt that affects their debt to income ratio
Instead of being able to spend 45% of $12,700 (about $5,715 on their mortgage), they have to take out the current mortgage payment. That is about $1,750 per month). That means that now they can spend $3,965 on a new mortgage ($5,715-1,750). Now that does reduce their overall qualification mortgage amount to about $750-800K. These guys were good savers, and have 10-20% down, that puts them into an $800-1M home which will likely still get them everything they want. Here is the cool part, and it’s often overlooked. Not only is someone paying your mortgage on your original home, but also you are pocketing almost $2,000 per month on top of that!! Plus their original house gets to sit there and grow equity while someone is paying the mortgage. With a 5%+ equity growth, someone else is paying your mortgage while the home is gaining $35,000-50,000 in value each year. Plus then if you choose to sell it within 3 years, you can still take the primary residence tax deduction. A married couple can gain up to $500K tax free for their primary residence. They must have occupied it 2 of the last 5 years though so they can rent it for up to 3 years while it is essentially growing tax free for them (assuming they don’t exceed a $500K gain). Yet another upside is now they have two properties hopefully making those gains each year instead of just one!
Third scenario to consider, Equity:
One of these couples has more than $200-300K in equity. In fact they are probably closer to $400-500K in equity. If they wanted to take some of that equity out, they could either do a HELOC and take out some money for an additional down payment to bump them to a higher price point or they could do a cash out refinance and pull out even more than they would with a HELOC. The big bonus on a HELOC is that most HELOCs are interest only payments which means when you are talking about your debt to income ratio for qualification, it doesn’t affect you nearly as much. They might be able to take out $100K and only pay $100 per month on it. A cash out refinance might allow you to take more like $200K out, but it will restructure the mortgage payment and instead of it being $1,750 (original mortgage) + 100 (HELOC), it may look something more like $2,300 new mortgage. That still can be extremely beneficial. It just depends on whether you need that much or not.
The nice thing is that a lender who really knows what they are doing can make this happen for you all simultaneously.
I love having these conversations with clients because it’s not just about buying and selling homes (although of course I enjoy that). What I am more passionate about is helping my clients grow their wealth, and showing them the opportunities real estate can afford them. It has made such a powerful impact on my life, and I really want to pass that on to those around me.
Of course no one can ever always assume real estate will go up for ever, but historically it has trended that way. And of course, not everyone is going to be in the same situation as these clients. You will also always want to speak with your tax advisor as well! No matter what your situation is, let’s talk through all the various scenarios, and figure out what is going to be the right one for you!
– Anne Skinner