Here's My Situation... How Would YOU Finance My Next Rental?

Question

So last month, I finally bought my first rental. I did it on a 5-1 Option ARM. I also have the same thing (5-1 Option ARM) on my private residence. Now... I'm making interest-only payments to keep from going into negative amortization. I COULD be paying in the low $400's as a minimum payment, but I've so far sent the Interest-Only payment of low $900s

The only reason I did Option ARMs on the houses in the first place was to have the (duh!) option of sending less money should the need arise. The payments are locked for 3 years by the way.

So... the meat of my question: to buy my 2nd rental, what would YOU do? Would you make minimum payments on my personal and 1st rental houses and SAVE that money that WOULD have gone to make "regular" payments? If I do that, I figure I can save approximately $800 per month. In 2 years, I'll have socked away just over $19K. I could then use that as a downpayment on another rental.

Whaddya think? Again, the only reason I got the Option ARMs were for investment purposes; not trying to afford a house I really can't afford (like a lot of people do then get screwed later with higher payments). I do realize that both mortgages will go into negative amortization, so that's where my questions arise.

Help?

Emrah

Jason Barnett · Answer

In all things business you have to ask the question: where am I creating / destroying value?

A simple way to do this exercise is to check out the property analysis tool on this website and plug in all of the numbers. Create multiple reports; keep all assumptions the same, but change the financing. Look at where you are earning most of your value (ie. your return on investment) and then scrutinize the underlying assumptions.

N/A N/A · Answer

Thanks for the honesty. Over the course of the past year, I've always appreciated your candor in your posts towards others.

I DO think of this as a business, and the properties (personal and rental) are being paid for without resorting to "minimum payment" options as it is. In other words, I didn't get the Option ARMs to be able to afford a house that I otherwise would not have afforded.

I only mean that in order to come up with more money for a downpayment on yet another property, what the best solution (strategy?) would be to best use my money.

If I DID decide to go towards a minimum payment route (to save money for a downpayment), I wouldn't let the mortgage rise to a point that it outpaces appreciation!

I think I need to run the numbers around a little better and come up with "what-if?" scenarios.

Emrah

John Worley · Answer

Well Emrah, that depends on what your ultimate plans for your next rental are. What I mean is, how long would you plan on holding your next property as a rental? Having this in mind is the key to chosing whether or not to use the Option ARM or any kind on Interest Only loan program. If you plan to sale the property in say 1 to 5 years, then there is no real need to worry about building long term equity as you will simply make your profit when you sell. For this, I would recommend the Interest only program in order to keep your payments as low as possible so you can make better use of that money in other ventures. However if you are plan to hold the property as a rental for a good number of years, say 6 to 10 or more, than I would say to stay away from the Interest only programs, like the Option ARM, because now you are going to want to have as much equity built up in the property as you can. And personally, I wouldn't have recommended that 5/1 Option ARM on your primary unless you plan to move out of there before the 5 years was up (at which point, your payments are going to get real ugly, real fast). I would think that with your primary, you would be more concerned with building equity quickly, but then again, that may just be my personal preference.
Hope this helpped.

Frank Adams · Answer

Let me state by saying that I'm a bit more financially conservative than you are. IMO each rental ppty has to pay for itself. I'm not a believer in the "well these two lose money, but it's made up for by the other six rentals that make money" theory. That's a quick way to end up BK. So I'm a bit troubled by a couple of things in your post:

You wrote;

How much free cash is the rental throwing off now? How much free cash will your (current residence) next rental throw off? If EACH isn't paying it's own way then you have, in effect, "bought more house than you (the rental market) can afford!

Since you're not making any contribution to principle and you say there's only "modest" appreciation, I hope the current rental and your residence when it becomes a rental each throw off lots of free cash.

If appreciation is only modest (I live in TX so I understand that) you need to be very careful with the use of leverage. Leverage isn't magic, it ONLY WORKS when the rise in ppty value EXCEEDS the cost of funds. Lots of folks in high appreciation markets like CA will subsidize a $500/month negative cash flow on the assumption that they'll sell in a year of two for a quick $100K + gain. Of course a lot of those folks are now sitting on houses wondering "where are they buyers?".

If I were in your shoes I'd "digest" what I've got, make sure my cash position is very strong and save the money for my next down payment. Then I'd convert my current residence into a rental when I buy my next residence. Rental ppty is a BUSINESS. It only works if it's PROFITABLE. I see lots of posts from folks who seem to be doing it for the ego boost they get telling their co-workers, "I've got 4 rental ppties". That's a quick way to financial disaster.

all cash

N/A N/A · Answer

I plan on keeping both long-term, though on my own residence, I don't plan on living in it for more than a couple more years. I WILL turn it into a rental though.

On both properties, I can refinance after 3 years (which I'll probably do to a fixed rate) before my payments shoot up a bunch. Again, the purpose was to have the flexibility to either:

1. Cover potential missed rent or vacancy should the need arise temporarily

2. Save away money (by making minimum payments instead of Interest Only or Fixed Rate payments) to have enough for a downpayment on yet another property

I realize the more I let the mortgage rise (by making the minum (less than Interest Only) payments), the less equity I'll have. Especially with the modest appreciation in the region. So, I'm stuck with the dilema of Do I "sacrifice" equity in the first 2 homes (my personal and 1st rental) to kickstart my fledgling "empire" :wink:?

Would I be better off using money from my HELOC as a downpayment (I did that to buy the first rental). Do I open a (highest interest rate of them all) Unsecured Line of Credit to do that?

Opinions?

Emrah

Here's My Situation... How Would YOU Finance My Next Rental?

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