Buying A Second Home

Need a Way to Finance College Education, Fund Retirement, Additional Monthly Income?

Pacific Beach Real Estate, Mission Beach Real Estate, San Diego County Real Estate

Second homes aren't only for wealthy folks who are concerned about financing their children´s college education, finding an alternative to languishing company 401K plans or individual IRAs in order to have a secure retirement, or simply for a way to attain additional monthly income. In fact, you may be surprised to learn that second homes have become mainstream, whether they're used for rental income or as vacation homes. Today, more than 9 million dwellings in this country are second or third homes, accounting for better than 6 percent of residential sales. Three-quarters are considered vacation homes and the rest are investment properties or undeveloped land, according to a 2002 survey by the National Association of Realtors. Most folks think that you have to have a wad of cash on hand to buy a second home. Not true! While having a large amount just lying around with nothing else to do with it would be most welcome, in today´s cash-strapped world, it is not typically realistic3;especially here in the San Diego area where we pay a greater proportion of our net disposable income on housing than anywhere else in the U.S. So, while we recognize the emergent need to pay for college education, find a different method to enable retirement dollars to appreciate at a secure and high rate, augment our salaries with rental income, or enjoy a vacation home, where will the funds to initiate such a plan come from? One very good answer is to use the equity in your primary residence. At this point, you are probably wondering "why real estate"? "Why not some other type of investment"? Let´s start by briefly demonstrating the income and wealth accumulation potential of 3 types of investments: Savings: If you were to invest $40,000 in a certificate of deposit (CD) at 5%, compounded daily, your investment will grow to $84,675 in 15 years. Mutual Fund: Now for comparison, let's invest $40,000 in a mutual fund growing at 10% annually. In 15 years, your original investment will grow to $176,090. As you can see, there is a significant difference in the yield of a mutual fund earning 10% and a CD earning 5%. The increase in yield in this case explains why investors will take on the increased risk associated with stocks, bonds, and mutual funds. Real Estate: Let´s now invest the same amount, $40,000 (20% down), in a $200,000 real estate investment, financed using a fully amortized 15-year loan. After payment of taxes, insurance, maintenance, property management, and mortgage payments, let's assume that the income and expenses of the property break even. This allows us to focus on the increase in equity that results from paying off the mortgage along with the increase in equity resulting from a VERY low 5% annual appreciation. The value of an investment property appreciating at 5% a year for 15 years will grow from $200,000 to $415,785. Let's take a look at the equity build-up of this investment.
Future value of property in 15 years

$415,785

-7% overall cost of sale

$29,105

-Loan balance (paid in full)
=Net proceeds from sale before tax

386,680

In the above examples we determined that if we invested $40,000 for 15 years, we would be able to accumulate wealth (before tax) in the following amounts:
Certificate of Deposit

$84,675

Mutual Fund

$176,090

Real Estate

$386,680

Note: One other benefit. You should know that Section 1031 of the Internal Revenue Code permits, under certain situations, the defferal of capital gains taxes upon the sale of investment real estate. Which of the above investments is the better one for you? Maybe the graphic below will help to clarify my point. OK, now that we've discussed the merits of real estate investing for income and appreciation to fund your current or future income needs, let's go to Part II which is how to get the cash so that you can execute your plan. The over-riding issue is to find out how much equity you have in your existing home and to ensure that the benefits of pulling out equity in your home are greater and make more sense than traditional borrowing. It's always about the cheapest cost of borrowing. So, you have some equity in your primary residence, you've decided to use that equity to fund a second home purchase, and now "what next?" Well, here are two options to consider:
  1. Refinance the mortgage on the primary home for more than the current loan balance. That's called a "cash-out refi" because you borrow more than the current balance, pay off the current loan and get the remainder in cash. You then use the cash extracted from your primary home's equity to make a down payment on your second home, or even to buy it outright.
  2. Home Equity Line of Credit (HELOC). A cash-out refinance isn't the only way to extract equity to buy a second house. You also can use money from a home equity loan or equity line of credit. Rates on lines of credit usually are below rates on new refinance mortgages and the up-front costs of acquiring a HELOC are minimal3;generally between $250 and $500. In fact, I personally just finished the purchase of an apartment building by use of a HELOC on my personal residence. I should mention however, that one downside is that the rates on lines of credit are generally tied to the prime rate and are therefore variable.
The purchase of second homes or investment real estate to achieve additional monthly income to pay for college education, a more secure retirement, a vacation home or simply as an alternative to traditional forms of equity investments, is on the rise. Hardly a day goes by when I do not receive an inquiry from someone asking for information on such a purchase or clarification on investment tax rules. I realize that what I have provided herein only briefly "touches" the subject and invite you to call or write for additional information.

Comments are closed.