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7 Reasons to Consider Buying an Investment Property Before First Home
Approximate Reading Time: 15 Minutes
Summary: In this article, we will discuss 7 reasons why buying an investment property before your first home has many advantages, especially with current trends in the real estate market. We’ll learn about the rising real estate market in the United States, first time mortgage loan options, factors in qualifying for different loans, interest rates, tax benefits of owning rental property, and buying investment property to create monthly cash flow.
If you are in the market to buy your first home, but aren’t necessarily excited to live in the houses or neighborhoods you can afford, consider buying an investment property instead. Below we will discuss the reasons so many first time home buyers are investing in real estate, instead of going the traditional route of buying their first home.
Reason #1: Home Values are at an All-Time High
The first reason to consider buying an investment property before your first home is because home values are at an all-time high. To be precise, home values across the United States have risen 7.6% in the last year, with an additional 6.4% increase expected within the next year. The average home value, in the U.S., is currently $220,100. The average listing price to buy a home is $275,000. Median rent in 2018 is now $1,650.
According to the National Association of Realtors (NAR), existing single-family home values have increased 90% in most metro areas. The cause for this dramatic increase is due to extremely low inventory of houses for sale, leading to higher home values than ever before. While home sales slowed a bit in the second quarter of 2018, appreciation of homes continued to rise. Because the demand for homes is so high and supply so low, sellers are receiving multiple offers well above market value, thus contributing to the increase in home appreciation.
Homebuilders are struggling to keep up with demand due to high costs and labor shortages. Additionally, permits, zoning and regulations, particularly in metro areas, are creating time consuming roadblocks for many builders. This presents challenges for first-time home buyers and middle-class families, as there aren’t enough affordable homes being built to satisfy demand.
Several factors are affecting real estate, including a healthy labor market, economic growth and a large millennial population, wanting to buy their first home or rental property. Trends in the real estate market will continue upward, as long as the economy maintains current levels. However, if demand continues to be high, number of home sales will decline, while prices will increase.
This is one of the major reasons first time home buyers are deciding to invest now, while the housing market continues to steadily increase, creating leverage or equity on a property in a short amount of time. We will discuss this in more detail later in the article.
Check out a home value map, available online, to get a better idea of the cost of homes in your area or around the country.
Reason #2: Interest Rates Remain Low
While the days of quick and easy mortgage loans are over, due to the housing market crash in 2008, interest rates still remain low (typically under 5%). Your interest rate will depend on multiple factors: (1) down payment amount, (2) credit score and (3) debt-to-income ratio. These factors will greatly impact which interest rate you qualify for.
Down Payment Amount
Many first-time home buyers are putting down between 3% and 5%. This includes an additional monthly cost of mortgage insurance, based on the price of your home. If you are planning on buying your first home as an investment property, mortgage insurance is not offered, and a down payment of 20% is required. Putting more money down on a home, will help you qualify for a lower interest rate.
Banks are looking for ‘strong borrowers’ when deciding to accept or decline potential mortgage loans. Borrowers with credit scores above 740, present a lower risk to lenders. In turn, you’ll likely qualify for a low interest rate. If your credit score is below 740, interest rates will go up because lender risk increases. Just like any investor, banks are looking at risk versus return on investment or ROI. If the risk outweighs the reward, lenders will either reject the loan you are applying for or require a high interest rate to ensure they get their money back.
If you are finding it difficult to qualify for a loan with a low interest rate, due to a small down payment, lower credit score or other circumstances, consider applying at a smaller bank. Typically, smaller banks have more lending flexibility than big, national banks.
Lenders also consider borrowers debt-to-income ratio. Again, the lower the perceived risk, the greater chance your loan will get approved, and with a low interest rate. Having money reserves in the bank to cover your expenses for 6 months, will increase the likelihood of qualifying for a low interest loan.
Whether you are buying your first home or considering first time investment property loans, it’s important to understand what lenders are looking for. Below we will break down types of mortgage loans for first time buyers.
What is an FHA Loan?
The U.S. Federal Housing Administration (FHA) offers a home loan that makes it easier to qualify for first time buyers. This loan is unique because it protects private lenders, like banks and credit unions, from losing money on ‘higher risk’ borrowers. In short, if you don’t repay your loan, the FHA will pay the lender instead. The details of an FHA loan are outlined below:
- Requires smaller down payment (3.5%)
- Get approved with a lower credit score
- Buy single-family homes, condos, multi-unit properties, and manufactured homes
- Extra funding for repairs and renovations with FHA 203k program
- Mortgage insurance premium required (1.75%)
- Must live in property for minimum of one year (Please note: buying multi-unit properties and living in one while renting out the other units counts!)
What is a Conventional Loan?
Conventional loans differ from other home loans because they are not insured by the government, meaning they are a non-government sponsored entity. Because these loans are not backed or guaranteed by the government, they are more rigid and difficult to qualify for, as lenders are assuming all of the risk. More details of conventional loans are outlined below:
- Requires larger down payment (20%)
- More difficult to qualify for than other loans (higher credit score)
- Several different types of conventional loans are available
Reason #3: Where You Want to Live Isn’t Affordable
Are you ready to purchase your first home, but can’t afford to buy in the area you want to live? With home values on the rise, many first time home buyers may find it nearly impossible to purchase an affordable property in the neighborhood they actually want to live. If the area you want to live is too expensive, adds too much time to your commute to work or has a less-than-desirable crime rate, it’s worth considering buying an investment property to rent out. While you continue to rent in an area you want to live, you’ll get your foot in the real estate door, generate monthly cash flow and build equity, until you can afford to buy a home in the area you want.
As mentioned earlier in this article, home values in metro areas are so high that the possibility of buying your first home anywhere close to a major city is nearly non-existent. Instead of settling for a house you don’t want, simply because you can’t afford anything better, consider looking at rental properties to invest your money.
Being a first time home investor does have its perks! You have the opportunity to buy in a growing area, take advantage of time in the market, while maintaining your current lifestyle, rather than buying and getting overwhelmed with a hefty mortgage payment.
Reason #4: Flexibility In Your Lifestyle
If you’re young, single, or married without kids, flexibility may be important to your lifestyle. Buying a home limits your ability to relocate, which may not be appealing to everyone. While the stability of owning and living in your own home may be desirable to some, being tied to a mortgage payment every month may not fit your current lifestyle. However, that doesn’t mean you shouldn’t buy at all. Buying an investment property allows for flexibility to move, but you won’t miss out on getting in on a growing real estate market.
Reason #5: Tax Benefits of Buying an Investment Property
Rental real estate has more tax benefits than almost any other investment out there. Failure to take advantage of rental property tax deductions, can cost landlords thousands of dollars a year. So why are rental property owners paying more in taxes than they have to? Simply, because they have no idea there are multiple tax deductions they could be taking advantage of. Check out the following tax deductions that you shouldn’t miss out on:
Save on Interest
Interest on rental property is typically the biggest tax deductible expense for owners. This includes, interest on your mortgage loan, or other loans used to improve the property, and if you use a credit card for anything relating to the rental property, interest can be deducted.
Don’t Pay for Depreciation of Rental Property
Depreciation is the loss of value in an asset over time. Essentially, wear and tear. Because a rental or investment property is a long-term (lasts more than a year), tangible asset, ( i.e. buildings, cars, appliances, etc.), it falls into the tax category of a capital asset. Which means, depreciation is not tax deductible during the first year of ownership. After the first year, rental property owners can deduct depreciation in smaller amounts, over a longer period of time.
Claim All Property Expenses
Many first time real estate investors aren’t aware of the many different types of property expenses that can be deducted each year on taxes.
Cost of Repair
Any reasonable cost of repair (not including improvements) to your investment property is tax deductible within the year it occurred. Common repairs include, fixing leaky pipes, broken windows, and repainting.
Use of Personal Property
If you choose to use your own personal property to furnish your rental (i.e. appliances, furniture), these expenses can be deducted after a year, (for property costing up to $2,000). Be sure to take advantage of this deduction from now until 2022.
Cost of Insurance
Any premiums you pay on insurance for your property are tax deductible. This includes fire, flood, theft, and landlord liability insurance.
Don’t Forget to Claim…
- Travel Expenses
- Legal Services
- Home Office Deductions
Take Advantage of Other Types of Tax Deductions
Pass-Through Tax Deduction
This is an income tax, not a rental tax deduction, made by the Tax Cuts and Jobs Act. Depending on your income, landlords can deduct (1) up to 20% of net rental income, or (2) 2.5% of initial cost of rental property, plus 25% of cost for any employees or independent contractors used (if applicable). This deduction is scheduled to end in 2025.
As you learn about tax deductions that may affect the return on your investment, be sure to also speak with your accountant about how to save the most money using tax deductions. Remember, the more you know, the more you save.
Reason #6: Invest in Monthly Cash Flow Potential
Instead of buying a home and paying the mortgage yourself every month, consider a first time buyer investment property to rent out. Other people pay your mortgage, and you’ll start building equity on your property right away without paying a dime toward a mortgage. Plus, charging more for rent than your monthly mortgage payment will produce extra cash flow that can go towards debt, bills, rent or savings for the down payment of your next house.
Reason #7: Create Leverage or Equity to Buy a Home You Actually Want or Pay Off Debt
As discussed earlier in this article, another great reason to buy an investment property before your first home is to create leverage or equity. First time home buyers are either buying their first home, usually a starter home in a less-expensive area, or buying investment property to rent out. The latter option allows rental property owners to sell, refinance or use monthly cash flow from the rental to leverage buying their first home a few years down the road. When property owners have leveraged enough cash to buy a home they actually want to live in, selling their rental property or hanging on to it as an investment, will open up more opportunities to qualify for loans or put down a large down payment to secure a very low interest rate.
Explore Distressed Properties & Homes
What does distressed property mean? Distressed sales are homes or properties that have usually been foreclosed on that the bank is willing to sell at a loss in order to clear its books. These distressed sales also help drive down the cost of all properties in the area.
Distressed properties are enticing because (1) low price, (2) instant equity potential, and (3) a few repairs can increase value rapidly. By taking advantage of low mortgage rates and inexpensive financing, first time home buyers are able to buy a bargain property, make a few improvements, and likely sell it sooner than later for a profit.
As the real estate market become more and more competitive and homes become difficult to afford for first time buyers, exploring and learning about your options, will help guide your decision to make the best investment possible.
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