I've been working on a series of articles on why it makes sense to take equity out of your home and invest, ideally in rental real estate. Here's the third articles in the series, the rest of the articles and many more can be found at http://www.januaryfinancial.com/mortgage/articles.html. Enjoy!

To Pay or Not To Pay Off Your Mortgages: Part III

In Part I of this article, I mentioned that we’ve all been taught by our parents, grandparents and conventional wisdom that we should pay off our home mortgage in order to own our home free and clear so that the bank can never take our home from us. I explained why that thinking is outdated. In Part II, I presented some ideas on using mortgages as a tool to increase wealth as well as making sure our financial houses are in order and we’re prepared to invest. Now in Part III, I’m going to cover some reasons why I think investment real estate should be an essential part of every investment portfolio.

Although I’m a big proponent of diversification and don’t advise that you create a portfolio dominated by any one asset class (i.e. stocks, bonds, real estate, etc.), I also believe that investment real estate has some major advantages for investors over other classes like stocks and bonds. One major advantage is that there are four ways to build wealth through real estate, as opposed to one or two ways with other asset classes. Other advantages include the amazing benefits of leverage and the relative stability of real estate.

Let’s talk about building wealth first. When you buy a stock, you have only one or maybe two ways to make money. One is if the stock appreciates. A possible second is if the stock pays a dividend. Real estate on the other hand provides four ways to build wealth! They are appreciation, depreciation, tax advantages, and principle repayment.

· Appreciation is simply the amount that the sales price of a property rises in the time you own it. For example, if you purchase a 4-plex for $500,000 and it’s now worth $800,000, you’ve experienced $300,000 of appreciation. For most investors, appreciation will be the single biggest factor in wealth accumulation over time.

· Depreciation is a strange concept for most beginning investors, but is essentially the government’s way of rewarding you for taking the risks involved with providing high-quality living space for people who want to rent. In a general sense, depreciation is an allowance for equipment growing old and becoming less useful. For example, if the useful life of a copier is five years, the government will allow you to write off the cost of the copier over a period of five years and deduct that amount from your taxable income.
Since real estate is generally more hardy, and land doesn’t deteriorate, the government allows you to depreciate the value of improvements (value of the entire property less the value of the land), over 27.5 years for residential property and 39 years for commercial property. This can result in hundreds and usually thousands of dollars each year in tax savings, which have no effect on your bottom line in terms of expenses!

· Other tax advantages of investment real estate include the ability to deduct mortgage interest, property taxes and other expenses. When you do your taxes at the end of the year, you’ll be able to claim all of these items (including HOA dues, management fees, repairs, etc.) against your taxable income.

· Principle repayment is the increase in your equity position (the value of the property less any outstanding loans) due to paying down the loan. Obviously if you have an interest-only or “neg am” loan this won’t be the case, but if you have a traditional amortized loan then the principle on the loan will decrease each month and your wealth will increase. The real beauty here is that your tenants are the ones paying down the principle on the loan, not you.

Another incredible benefit of buying investment real estate is leverage. Leverage simply means purchasing investment vehicles with someone else’s money, or leveraging your profit potential. When you buy stocks or bonds, you generally will not be borrowing money to buy those stocks or bonds unless you’re using a margin account (and even then, the max on margin is around 20-30%). However, buying investment real estate with leverage is very much the norm. Generally speaking you would have about 70-80% leverage on an investment property, but some banks will lend up to 100% of the purchase price these days! I’ll illustrate the incredible benefits of leverage on building wealth. If you purchase a $100,000 property with cash and it appreciates to $150,000, you’ve make 50% ROI (return on investment). This is calculated by dividing your return ($50,000) by your initial investment ($100,000). However, if you’d gotten a loan for 80% of the value, then your ROI jumps to 250%! That’s your return ($50,000 still) divided by your initial investment (now only $20,000).

Yet another advantage of real estate is its relative stability. When you buy a stock, it’s possible that the company could go bankrupt and your investment could be completely wiped out. However, it’s extremely unlikely that the value of a house would go to zero. It’s possible that the value could decrease as much as 20-30% (historically as bad as it’s ever been, on a national scale), but highly unlikely that it would decrease more than that. Generally speaking, the only way to lose money is if you have to sell too early. If the value dips but you hold on, the value will increase and you’ll get your investment back. The returns may be sub-par for a few years, but that’s part of the risk. Compared to stocks, real estate is significantly less risky.

As you can see, real estate is an excellent investment vehicle for many reasons. There are MANY ways to build your wealth through real estate, not just appreciation or principle repayment. Leverage allows you to borrow a bank’s money to purchase a property, but you get to keep all of the profits! And compared to stocks or bonds, real estate is significantly less risky and is something you can actually touch and feel. People may no longer want to own stocks (especially after the dotcom bust), but they will always need somewhere to live!

If you’d like to find out more about the many benefits of investment real estate or would like to investigate adding rentals to your investment portfolio, please feel free to call (877.483.9186) or email (carey@januaryfinancial.com) any time!

Needless to say, things have been busy. Although the year has been somewhat slow loan-wise this year, I've been swamped with preparing for the future and creating an environment and culture so that we're ready to grow when the time comes. I've been putting a lot of work into our website (http://www.januaryfinancial.com), trying to make it very user-friendly as well as interesting in terms of content. I've got some big plans for the website, but need to make sure I don't bit off more than I can chew.

This time I'm posting an article I wrote regarding 40-year loans which I think you'll find interesting. Please let me know what you think about the site and the article at carey@januaryfinancial.com!

The Pros and Cons of 40-Year Fixed Loans

With interest rates going up and property values starting to appreciate at a slower rate or flatten out, a new kind of loan has started to become more popular. The 40-year fixed loan allows you to amortize the loan over a 40-year period instead of the usual 30 years. This results in a lower monthly payment, which can come in handy when rates are higher. There are some pros and cons to this type of mortgage. I will explain why I personally don’t like these loans except in special circumstances.

The main advantage of a 40-year fixed loan is that your monthly payments are lower. Since this loan is typically fully amortized (a small amount of principle is paid down monthly), the loan balance will slowly decrease each month. This is the main advantage of a 40-year fixed loan over an interest-only loan if your goal is to pay down principle. Another advantage is that while most interest-only loans have minimum FICO requirements of approximately 580, a 40-year fixed loan is available if your FICO score is as low as 500.

One of the main cons of getting a 40-year fixed loan is that over the course of 40 years, you end up paying a LOT more interest than a 30-year loan, with a payment difference that is fairly negligible. For example, on a 30-year fixed loan of $300,000 a borrower will end up paying $647,000 in principle and interest over the course of the loan. This is scary enough, but on a 40-year fixed it’s much worse – with the same loan amount the borrower ends up paying $843,000 after 40 years. And the worst part of all is that for the extra $196,000 the borrower ends up paying after 40 years, they end up with a monthly payment that’s only $45 lower!

Another disadvantage of 40-year fixed mortgages is that you end up paying a higher interest rate for the privilege of paying the lender so much more interest. Rates for a 40-year fixed are about 0.5% higher than a comparable 30-year fixed loan. This doesn’t sound like much, but over 40 years it adds up to a significant amount more interest – almost $200,000 in our example above! This is also part of the reason why the monthly payment difference isn’t very big between the two loans – although the payback period is lengthened, the interest rate is higher and the two almost even out.

One last thing that most people, including loan officers, don’t realize about 40-year fixed loans is that most of the time, especially in the sub-prime market, you can’t even keep the loan for 40 years. Most lenders write the loan with a balloon payment, which means that although the mortgage is amortized over 40 years, it’s actually due in full after 30 years. If you’re considering a 40-year fixed loan, make sure your loan officer explains the program to you completely and read the note carefully to make sure you’re getting what you think you’re getting.

As you can see, there are a lot more cons to getting a 40-year fixed mortgage than there are pros. So why would anyone want to get a 40-year fixed? The only time I recommend them is when the monthly payment difference of $50-100 makes a huge difference to you AND you don’t qualify for an interest-only loan. Interest-only loans are a much better way to keep the payments down, but as I mentioned above there are minimum FICO requirements that not everyone can meet. Only in these situations do I recommend 40-year fixed loans.

If you’re considering one of these loans I would highly recommend you look at a 30-year fixed loan instead if you plan on keeping the loan for an extended period of time, or an interest-only loan instead if the lower monthly payments are more important and you qualify. Just like any other mortgage, a 40-year fixed loan is a tool to accomplish a certain goal and it might be the right tool for you. Regardless it’s important that you speak with an experienced mortgage consultant who can guide you through the process.