starting out using home equity - sell or rent my current house?

Question

I’m a 37 yr old IT professional, husband and father of two, looking to get into real estate as a long-term investment. I’ve done a flip in the past and it was profitable, but my thoughts keep gravitating toward rentals. I plan to keep my full time job for a steady income and insurance benefits. I currently own a house and am looking at moving my family into something bigger so I need to develop a plan for how to best invest the equity I have in my current house. Your input is greatly appreciated.

Here’s the details:

3 bedroom 2 bath house located in Sioux Falls, SD

Value is about $170k (based on my realtor’s analysis)

$91k remaining balance on the mortgage, 10 years left until payoff

Financed at 3.125% interest

Monthly mortgage payment is $1120 which includes taxes and ins

I’ve got $10k in cash to work with, though I’d rather keep it for a rainy day

I think it will cost me about $17k to sell, so my usable equity will be about $62k

I think I can borrow up to 80% of the value with either a HELOC or a refinance, so my usable equity would be about $45k if I keep the house.

I think my current house would rent for about $1400, but this is a bit of a WAG based off of Zillow and Craigslist housing ads for similar-looking properties

Our new home will likely be in the $250 - $275k range. I’ll need about $13k of my current home’s equity for a 5% down payment on our new home, which leaves me with $49k if I sell or $32k if I refi/heloc.

Does my math look good so far?

I know I’d be stuck paying PMI on our new primary home for a while, but if I can cash flow enough I guess that would be ok.

Here’s the main options that I’m kicking around. I’m definitely open to other ideas.

Option A: Sell my current house and use equity to purchase a rental

Pros:

I’d have enough money to put 20% down on two rentals in the $120k price range

Cons:

The market in my area is booming right now which makes it hard to buy something at a good price.

I have no rental history so my debt/income ratio may not allow me to buy 2 rentals after buying a new primary home.

Higher interest rate from the bank compared to what I’m paying on my current house

Option B: Rent out my current house

Pros:

Low interest rate as long as I don’t refinance

Builds equity faster than a new loan

Cons:

May be more difficult to find renters at this price? I’m not sure about this tho. Maybe I will get better renters?

Other cons? What am I missing?

Option C: sell my house and buy a duplex or 4-plex

Option D: try to partner with someone who knows what they’re doing

Option E: ??? Whatcha got?

Joe Splitrock · Answer

Your taxes will be around $2600 as non-owner occupied, so adds about $50 per month.

Peter Kottwitz · Answer

Something else to consider, (I'm not a CPA and don't claim to be) :)

If you rent out your current primary residence and decide to sell a few years down the road, the profits become taxable at whatever the capital gains rate is, whereas if you sell today, the gains would be tax exempt.

If I were in your shoes, I would refinance the entire mortgage and pull cash out like you said, Vs. getting a HELOC as the rate will be much better.

Cody H. · Answer

Thanks everyone for the input - you've given me lots to think about. The more I read, the more I think I should refinance this house and go for cash flow. I think I can refinance this house, pull out $45k in cash and still get 10% cash on cash return. This assumes a rent of $1200/month, 8% vacancy rate and a best guess on insurance, taxes and mortgage rate. I've got some inquiries out to refine the best guess numbers with real numbers.

@Joe Splitrock do you know what kind of tax percentage increase I could expect to see in Minnehaha county for a non-owner occupied house? I'm currently at $2000. My house was built in 2006 and has never been re-assessed.

Joe Splitrock · Answer

@Cody H. I own multiple 3 bed 2 bath homes in Sioux Falls that would list today for $165K and sell quickly. I would not be able to get $1400 rent for any of them. I have not seen your home but I suspect planning for $1150-1250 range is more realistic. If you want to PM me the address I can give you a more accurate estimate. Lots of houses on Craigslist show up in that higher range and sit and sit, then ultimately rent for less after price drops. Just my experience. If you rent the house, don't plan ANY cash flow unless you refinance. You may even need to subsidize it a little just because your payment is so high. Oh and your taxes will increase considerably when it is non-owner occupied.

Cody H. · Answer

Thanks all for the input. Here’s a summarized reply for a little more clarity.

The $1120 monthly payment includes property tax and insurance (escrow), though I realize they would go up slightly if it were non-owner occupied. Unless I’m missing something, I should for sure break even and maybe have a small cash flow if I rent it without refinancing, as long as I managed it myself which is what I’d prefer.

The $10k I mentioned was rainy day money specifically for the rental(s). I’ve got a separate personal emergency fund along with some money in a 401k and an IRA that I intend to not meddle with.

I lean toward debt aversion, but I’m not afraid of debt if I know that I’m earning more than what the loan is costing me. With only 10 years left, I’m definitely not thrilled about leaving my current home but I want to get my kids into a better school district. The house is also getting a bit cramped for us and frankly my wife and I are just ready for a change of scenery. I’d strongly consider making it work if it weren’t for the school thing, however. My son doesn’t start school for 2 years so we’ve got some time to make a decision.

Good point about known issues with the house. My house is tip-top with a new roof, exterior paint, water heater and new deck all in the past 2 years. I recognize the gamble with buying something else.

Curtis Steineke · Answer

Cody, one thing to consider as a PRO for your house as a rental, you know the property, you know what maintenance was done and by whom etc.  You know the "hidden issues" already vs those that come along with looking for new properties.  Unless there is something that would not make your house a good rental ie location etc  it might make for a good rental, it all depends on the math.  If you run the math on keeping it, know that your taxes will go up slightly on your current home,for non owner occupied. Check with the city on the amount, they should be able to tell you, it will probably be around 200-300 more a year.   Add the maintenance set aside to your monthly and yearly expenses, as well as property management fees to your math, right now that would lower your cash flow quite a bit possibly even negative if you have to pay for property management.  Depending on that cost, your cash flow might be low initially but your rent rates will grow as time progresses increasing your cash flow.  If your at a negative cash flow in that situation, then selling, using equity to finance new and lower cost rental may be the way to go.

You could always refinance the current debt on the current house to a longer mortgage, helps to lower the math, (probably about $400 a month for payment) - the tenant is paying the payment now so that shouldn't concern you as much with the longer term on the loan. Buy the new house with equity from current home for down payment, keep current home for rental,  hold your 10k for the rainy day  or vacancies- no tenant = no rent, and then sit for a year or so to see how you like being a rental property owner, if you have the money and the math is working, start to look for your next property.   I don't know that you will get a better interest rate looking for new rentals vs what you currently have on your current home, so that's another think to think about as well.

If I run the quick math based on what you gave us, here is what I see.  I break the yearly costs down to monthly averages, but some things like taxes you don't pay monthly but it helps you see the cost spread out over the cost of the lease - typically a one year lease.

1300 monthly rent

- 1120 for mortgage

- 104 property management fee ( @ 8 %  of monthly rent)

- 63  one time placement fee averaged out over 12 months ( @ 4.9 % of annual rent )

- 50 for maint reserve ( some people say $100 - I did 50 since its your house, you know the maint history)

-183 for taxes (assuming 2,200 for property tax)

- 40 a month for insurance

= (260) negative cash flow

I used the property management fees, based off of what Real Property Management Express charges. I have spoken with Derrick there a few times, he can probably help with more info if you are looking for a property manager.

Hope this helps some.

Ernie Cruz · Answer

Hey Cody,

I am just starting out like you and I've gone through this scenario a million times in my head.

Firstly, I think your financial preferences play an important part in this decision. For example, are you debt friendly or debt averse? Do you like keeping your savings as an emergency fund or are you ok with not having one until your future rentals are up and cash flowing?

IMO you're best bet is keeping the house you already have and finding a good deal that you can afford. You can leverage your savings, obtain a HELOC, or save like crazy for the next year so that you wouldn't have to borrow and/or be without savings. I would not feel comfortable leaving a house that only needs 10 years to be paid off for another 30 year mortgage. I am, however, debt averse so I have my bias. You can also explore house hacking options. Is there a room you could rent out or a space in your backyard you could build an efficiency in?

Whatever you decide, I definitely have to complement you on the completeness and detail of your question. it seems like you're final decision will be very calculated and informed. Good Luck!

starting out using home equity - sell or rent my current house?

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