Moving from 30-yr to 40-yr mortgage for cashflow: Good or Bad Idea?

Question

Greetings-

My wife and I live in a condo whose value has appreciated considerably in the last few years.  Instead of selling it as we move to a bigger place, we would like to refinance to get a lower monthly payment, then rent it out.

As I do the math, the property has a negative $251 after tax cash flow at the end of year one and a positive $27 cash flow at year five with a 30-year mortgage.

If I switch to a 40-year mortgage at the same rate (not sure I can get this, but just an assumption for now), after tax cash flow is positive $498 at the end of year one and $862 at the end of year five.

This property is located in a college town with a strong political presence from overzealous environmentalists that makes building new housing very difficult, and our location is a short walk from everything.  Even with the current economic conditions, I believe the fundamentals for long term appreciation are outstanding.

Obviously, the 40-year means I'm paying more interest, but it seems like from reading this board that I should be willing to do that if I can make the property cash flow positively.  The money the property builds up could be used for a capital improvements fund first, and then eventually to pay down the mortgage faster.

I'm looking for anybody to second-guess me on this.  If I have a 40-year mortgage on this house, is it going to be harder for me to get a new mortgage for a primary residence?  A second rental?  Is there something magic about a 30-year in the eyes of lenders that makes a 40-year seem more risky?

I'd appreciate any insights from the more experienced hands on this board.  Thanks!

Colleen Sheridan · Answer

You said you were going to "switch to a 40 year mortgage"  So my question is how long have you had the 30 year mortgage, what are the terms and where are you in the payment schedule.  If you have had it longer than 5 years, you are probably paying down a lot of principle and less interest and this continues to improve as time goes on.

I don't look at a cash flow "loss" as necessarily a bad thing if the negative cash flow is going primarily to paying principle.  You will end up owning the condo debt free and then your return is very good.

You need to look at the deal at the end of you holding period to see if you are actually doing OK.  If you plan on holding it for a long time, you could find that even without a lot of appreciation it may be a good investment in the long run.

Herb Daly jr · Answer

To me anything over 30 years is not good. Just multiply 120 extra payments times the mortgage amount , Ouch! You would be better off getting an amortization schedule and paying off the principal of the following payments therfore eliminating that payment. Each payment shown has so much principal and so much interest. In the beginning you will have principlals that are very very low , it will be mostly interest. Keep it simple.

Harrison Painter · Answer

Real Wealth is created by the equity and paying off of the asset, not the cash flow. 
            
            Cash flow is just icing on the investment cake, and should be saved in an account to cover any major expenses that could happen down the road.
            
            You will pay more interest on a 40 year loan than that little extra cash flow will ever make you.
            
            From what I know about NC, it has been one of those markets doing pretty good compared to the rest of the country, but they tend to run behind the national averages and could catch up this year. So I would not base my numbers on an appreciation rate of 7.5% right now, at least not for a couple of years.
            
            While many might argue values are going to drop another 10%-20%, I do not agree with that. I could be wrong, but prices are very low right now, and nobody really knows what fair market value is anymore. 
            
            We will see supply and demand equalize in the next 12-18 months, and that will be the number that will show us the official bottom. (Of course, we will not know it was the bottom until 6 months after it hits!)
            
            My investment firm is basing most of our numbers on 0% appreciation right now. Just a flat line appreciation rate for the next 2 years. If it goes up, great! If it goes down a little, not a big deal. If an investor is buying correctly, it should not have any major impact over a long term hold investment plan.

As you can see from the folks above, your cash flow is not good, so you would be making a speculative play here. If that is your goal,  you must be comfortable with paying to play here. If not, my advice would be to try and sell it, as you can find better deals out there right now.

Do not try and force an investment, it just doesn't work.

Jon Holdman · Answer

A very simple analysis of your condo is:
            
            Rent: $825
            Expenses: $412
            NOI: $413
            P&I: $614 with the new loan
            Cash flow: -$201
            Ouch!
            
            Those expenses are just estimated from the 50% rule.  I think this rules is optimistic for condos where you have an HOA that can end up generating huge bills.
            
            Tax assessments are for tax purposes.  Using them for investing is a sure way to lose your shirt.  Zillow's values are useless.  
            
            Using the tax assessors values to predict future appreciation is like trying to drive a car sitting backwards in the back seat.  These guys are looking at the past.  Not to mention, they are dealing with the fallout of falling prices combined with local (and state and national) governments assumptions prices would rise forever.  Instead of assuming these values mean prices are going up, you should find real evidence of price trends (sold data, current listings).  One sale in your complex does not make a trend. You are likely to find both a basis for protesting your assessment (every county has a procedure) and reducing your taxes, as well as a better understanding for possible investments.
            
            7.5% appreciation is not going to happen unless we hit a period of very high inflation.

To your original question, a 40 year loan payment, at 4.88% would have P&I of $550.  That helps a little, but you're still losing money.

4.88% is not an investor loan rate right now, unless you're paying a lot of discount points.  So, I think you're applying for an OO loan.  I guess that's OK.  If your plan is to go buy another place, keep in mind the rental income will be ignored, and you'll need to have enough income to cover both notes.

Michael Rossi · Answer

I think that you're being VERY optimistic.

MIke

Mark N.A · Answer

I see by your profile you are 'just learning'.  If so, upon what are you basing your assumption that you  "believe the fundamentals for long term appreciation are outstanding"?

Betting on appreciation is a gamble that many have lost.  Betting on cash-flow from day one is about as sure a thing as there is in real estate investing.

Sell the condo.  Find an investment property that cash-flows from day one.

Good luck and keep us posted.

P M · Answer

Here are my assumptions:

1.  Cost inflation is 3.5% per year

2.  Rent increases 3% per year

3.  Property appreciates 7.5% per year.  (I address appreciation further below)

Current condo situation: 30-yr fixed at 6.875%, monthly P+I of $830.03; monthly taxes at $154.39.  About 2.7 years into the 30-year mortgage.

Local mortgage broker has quoted me a refi of 30-yr fixed, 4.88% with a P+I of $613.88, will have enough equity for no PMI.

I believe I can rent the unit for $825/month starting in June.

As to the appreciation issue, our tax re-assessments just came out countywide, with the average county reassessment being 22% increase in value since 2005.  Our complex's units are all valued the same, with the value representing a 46% percent increase over 2005.  Incidentally, the 2009 valuation is almost exactly what we paid for the unit in 2006.  As recently as December, a nearby condo with nearly the exact same floorplan and sq footage sold for $14,000 OVER our 2009 valuation.  Zillow pegs our unit at $10,000 over the 2009 valuation.  These pieces of data encourage me on the appreciation issue, as does the nearby comparatively recession-proof job base (UNC-Chapel Hill).

So that's the upside.  The risks are vacancy, of course, and potential difficulty in raising rents each year by 3%, not to mention a potential tax increase. (though I think a revenue-neutral rate is likely, several county commissioners have already mentioned this as a goal in the newspaper)

MikeOH- I hear what you are saying on rents nationally, but I believe that the local market fundamentals are different here.  That said, I readily concede that I do not know HOW different.  Any recommendations on how I can learn about local rents beyond rentometer.com?

Michael Rossi · Answer

Why would the property have a negative cash flow today and a positive one at year five?  If you have a fixed rate mortgage, the payment will be the same at the 5-year point and contrary to the guru gibberish that is often strewn about, expenses are going up at least as fast as rents.  In fact, according to recent reports, rents are decreasing nationally (you won't ever see a guru say that).

As to your question, I would not get a 40 year mortgage; an interest-only mortgage; or any other gimmick loan for the purpose of forcing cash flow.  If it won't cash flow with a 30 yr mortgage, it's simply not a good rental.

Good Luck,

Mike