Why I’m Buying Rental Property While Still In Debt

I mentioned in my review of April that I’ve been considering purchasing another investment property.  I’ve come to this decision after a very long thought process and a multitude of discussions with my brother.  We’ve crunched the numbers together and what came out at the end made so much sense to us, that I’m willing to share it here with you.

If you listen to the news, it would make you run in the opposite direction of buying property at a time when you probably should be running directly to real estate.  Apparently many of you do not watch the news either because, according to the U.S. Department of Housing and Urban development, existing home sales were up 5.3% in the first quarter of 2012 versus the same time last year.  The housing affordability index is at its best, because of low housing prices and record low mortgage interest rates. The average interest rate for a 30-year fixed-rate mortgage was 3.88% during the first quarter of 2012. If you’re in a stable financial position and have been waiting for the right time, now might just be the best time to buy.

Personally, I’m not looking for a home to live in.  I’m looking for a home that you or your friends would want to rent from me.  Yes, I’m shopping for rental property that I plan to never live in.  If I see the house more than four times per year it would just be for maintenance and changing the batteries on the smoke detector.  That would pretty much be it.

Since purchasing my first investment property two years ago, I’ve learned quite a bit about how to make a better selection.  It’s not that my first purchase was a bad decision, it probably just wasn’t ideal.  Going forward I would like to see the following in any home that I purchase:

  • At least two units.  Three would be ideal.
  • Outside of flood zone
  • Less than $5,000 in remodeling work/repairs needed
  • No major repairs such as roof, heater, gas lines needed
  • Close to hospital (the main employer for the area) or good school district.
  • Off street parking
  • Gas or electric heat
  • Delivered with no tenants

Of all the things that I mentioned, price was not one of them.  The price itself does not concern me, as long as when I crunch the numbers, the math ends up being where I need it to be.  To get to the income level that I’d like I’m doing the following:

[(Monthly Rental Income x 12)- 20%] – [Owner paid utilities (annualized) + real estate taxes + fire/liability insurance + lawn maintenance/snow removal] =  Potential annual income

To translate I’m calculating the total rent by twelve to get the annual rental income.  Then, I subtract about 20% for vacancies and/or unseen expenses.  I then subtract all of the expenses that I would be responsible for to get to my annual income.  I didn’t include fees for evictions, maintenance, etc.  I’m looking at the maximum return here.  For the property prices in the range that I’m buying, I hope to have a number close to $10,000 at the end.  If it’s $9,000 that’s fine too, but $10,000 would be ideal.

How do I plan on buying property with so much debt?  I’m doing something completely unconventional that most personal finance gurus would tell you to NOT do.  I’m borrowing 100% of the cost of the property from my 401(K).  I can hear the collective gasps right now.

Are you shaking your head thinking, “Oh, no she isn’t!”  But, oh yes, I am!

Hear me out.  My 401(K) is actually doing pretty well.  It’s been averaging about 10% returns so far this year.  I’d love to continue riding that 10% wave for a long time, and honestly, I have more than 30 years before my official retirement age.  What I am looking at here is the potential for property to add to my income right now instead of 30 years from now.  Although, if I keep the property long enough, it can probably supply me with income into my retirement.

But wait, you’re giving up the tax savings by not stashing money into your 401(K), you’re thinking.  No, I’m not.  I’m going to continue putting the same amount of money into my 401(K) to get my company’s match and I am going to pay the loan back into my 401(K) as well, plus interest.  A strategy that I might employ is taking out a first mortgage on the home once I have held it for at least six months and using that money to pay off the 401(K) loan while having a tax deductible loan for the home in my name.  I can see the light bulbs coming on now.  Genius, isn’t it.

But, as you know, the best laid plans sometimes doesn’t come to fruition.  I fully realize that I can be turned down for a loan.  This is why I am contemplating selling the first property.  I would use that to pay the loan off and bank the extra money, since the property has appreciated in value by about $20,000 since I purchased it.

I don’t know if it will all work out, but I hope it will.  Just in case you think that no one else has done this successfully, reader Mildred wrote in to tell me that how she retired in her 50’s on income producing property that she purchased as a nurse.  When I grow up one day, I want to be like Mildred!

So, do you think that I’m crazy?  Is my plan nuts?!  Would you do this?

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21 thoughts on “Why I’m Buying Rental Property While Still In Debt

  • This is a great formula! I will try using it. BF and I have been looking into buying an investment property as well, and BF has school loan debt. I will have school loan debt too, but we have 20% for our down payment. Our hunt has been really difficult since the investment property we are looking for will only be an investment until we want to live in it. So it’s been difficult to find one that has everything we want in a rental property but also for our future home!

    • This is pretty difficult since the home you’ll want to live in is probably going to be more expensive than one that you would consider as just a rental. What about a two family home? Have you thought about that until you’re ready for a family? It works for some people.

  • Now is the perfect time to buy! Since I am neither a psychologist nor a psychiatrist, I have no idea if you are crazy. Approach it conservatively and do a lot of planning. The front end work is worth it. Good luck.

  • I would be MUCH more cautious before taking this leap. There are a lot of things that could go really wrong in this scenario.

    You could lose your job and have to pay back the 401k loan immediately.

    You could fail to qualify for a mortgage on the property to cover the 401K loan. (And if that happens after you lose your job, that would be REALLY bad).

    You are assuming that the property will always be occupied. From maintenance costs to difficult people, there are several variables that can affect whether or not your property has paying tenants.

    The housing market could change and you could owe more than it’s worth (which would make it hard to get a mortgage on it or refinance if rates drop).

    I’m not sure I understand the idea of borrowing money to pay back borrowed money…. especially from someone who seems to want to get out of debt so badly.

    I don’t think your plan (as it stands) is the key to a successful future.

    • This is why I love you guys! You give me a good 360 degree view of what I’m doing.

      So, I would borrow to pay the 401K loan off for the exact reason that you mention. Just in case I lose my job, I don’t want to have that entire amount due within 60 days. That’s why I would get the loan. Also, it’s very difficult to get a loan for less than 50K unless it’s a line of credit on a home that is already paid for.

      You’re right about my need to kill my debt. It does weigh on me terribly, hence my hesitation.

      Thanks for the feedback! It’s much appreciated.

  • Now is a great time to buy. I’ve been eying a city north of me since prices are so much more reasonable and slowly convincing Mr. LH that we need to go and check it out and buy something. Of course, getting a job in that area would help. But if I can buy something within the year, I’d be thrilled.

  • Sandy,

    I like the idea, but I don’t understand the logistics.

    1) How much could your 401(k) possibly have in it? Didn’t you start a new job a couple years ago, so even at 3 years of max pay out that is only 47K + Growth.
    2) If you are talking about your old 401(k) I would question whether you can even get a loan
    3) If you get fired you are literally F’ed! You would have to pay your loan off in 60 days (or get taxed on it + 10% penalty) and there is NO shot that an unemployed Sandy is then going to get a mortgage.

    Just seems like a very aggressive move with very little upside (you don’t deal with banks) and a terrible amount of downside risk (financial ruin).

    • Let’s see. Logistics:

      1) I’m rolling my old 401K into my new one. No biggie since they’re both with Fidelity. It’s literally me signing a form with no check to be cut.

      2) I can get a loan for up to 50% of the value of my portfolio. That 50% is enough to buy a home. I’ve had a 401K since I was 20 or so, so I have a fair amount of money in there.

      3) If I get fired I am sooooooo screwed. You have no idea how screwed. That’s the monkey wrench in my plan. That’s kind of why I would want to pay off the 401K loan as quickly as possible by getting a line of credit or mortgage on the new house. It’s just hard to get a mortgage to PURCHASE a house that costs less than $50K.

      I should write a follow-up with all of the numbers so that everyone has the particulars. But, I like all viewpoints. I don’t want to screw myself here.

  • I think it’s a great idea! You’ve got to take risk to gain reward – and it sounds like you’ve done your research and are taking a well calculated risk.

  • As Evan said the biggest worry I would have is what happens if you suddently have to pay the loan back. It would be a scramble that is for sure. As long as you have a back up plan and it is what you want go for it.

  • I’m not sure Sandy… I think buying rental property is good, but what does that say about your seriousness in paying down debt?

    Will the banks lend you money? If so, I guess why not!

  • Too risky for my blood! Definitely don’t get fired, heh. That’ll trigger a payback of the loan pretty quickly.

    Have you considered the fact that you’ll be paying yourself back into the 401(k) (with interest) on after tax dollars? That changes the math a little, but if you’ve considered the risk it’s certainly doable (although I definitely wouldn’t suggest it).

    Here’s how I’m looking at it:
    Real Estate, unknown appreciation
    Mortgage replaced with a 401(k) loan, let’s say 3%, your marginal state plus Federal let’s say 32%. So like 3/.68 = 4.41% equivalent mortgage. A bit more expensive interest rate than a mortgage, but not horrible.

    The opportunity cost is what your 401(k) would return versus real estate.

    Of your options, *if* you did this I would buy it then be ultra careful for 6 months, strip the equity with a mortgage and pay off the 401(k) loan – bam, backdoor mortgage (and one of the options you mentioned)

    Keep us posted, and good luck with whatever you choose!

  • This is the first time I’ve come across your blog, so I know nothing of your debt or financial standing. But, because I’ve been mulling the same thing (using my IRA to purchase investment property), I’m wondering if you ever considered a self-directed IRA? You can use the funds in your 401k to purchase the property – no loans, no payback, no interest. Of course you lose the opportunity cost of leaving the funds in the market, but if you believe in real estate over equities, then does it matter? You have to move your funds to a managed self-directed IRA in order to guarantee that it is indeed an investment and not just cashing out or you trigger early withdrawal and income tax penalties.

  • Gotta side with those that would fear for your job and having to pay back the loan in a hurry. Now if you had another source of funds as a back up, maybe, but those might be needed for living if you had no income. Why the big desire to own real estate if making 10% on the 401(k)?

    • My goal is to permanently retire my job. It’s nice that I’m earning 10% in the 401K, but I need replacement income from my job now since I want to be self-employed within the next 10 years.

      I realize everyone is fearful of what happens if I lose my job, but it occurs to me that the worst case scenario is that I pay tax and penalty. There are people who lose their jobs with mortgages that they can’t pay.

  • Gotta side with those that would fear for your job and having to pay back the loan in a hurry. Now if you had another source of funds as a back up, maybe, but those might be needed for living if you had no income. Why the big desire to own real estate if making 10% on the 401(k)?

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