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Ask Bob: Should I Use Home Equity to Purchase a Second Home to Use as a Rental?

Most people use a cash-out refinance or home equity line of credit to dip into their home equity. But each option will have pros and cons, according to Tim Kenney, CFP, founder of Seawise Financial.

Question

I am 62. I have $112,000 in an IRA, $40,000 in stocks, $250,000 in home equity, and an expected inheritance of $300,000 plus. My expected Social Security payment should range from $1,400 to $1,700 per month. 

I am considering tapping my home equity to purchase another house paid in cash to use as income property. If I lease both my residence and this rental property while traveling for five years or more, is this a viable option? What is the best way to tap into home equity?

Answer

Having an additional source of income and someone to pay your mortgage when you travel could be a good option for you, acknowledges Tim Kenney, CFP, founder of Seawise Financial.

Just make sure, he says, you are aware of the potential pitfalls of this strategy. Most people use a "cash-out refinance" or home equity line of credit to dip into their home equity. Each option will have pros and cons.

“Home equity lines of credit (or HELOCs) allow you to borrow off of the equity of your home without impacting your current mortgage,” explains Kenney. HELOCs are usually flexible in that you can pay them off as you see fit and can be as easy as just writing yourself a check once they are set up. “I find that they are best used to fund home improvement projects but have seen them used to fund real estate down payments,” he says. “Unlike mortgages, their interest rates usually float after a certain lock-in period so make sure you have a good understanding of your loan terms to make sure there are no surprises if interest rates spike and you are subject to higher payments.”

“Cash-out refinances essentially reset your mortgage with new terms and, depending on the new loan amount and interest rate, can make a lot of sense in this environment,” Kenney says. If you wanted to tap some of the $250,000 in home equity, you could essentially calculate the amount of cash you'd like to take out (subject to some minimum equity requirements from the lender) and add it to your current loan amount and reset your loan. “I've seen loans refinanced that have taken six-figures in equity out of a home that have barely increased the old mortgage payment amount due to the low interest rate environment,” he notes. “It sounds great, but the biggest thing to consider is the length of your mortgage,” cautions Kenney. You'll likely extend the loan period, perhaps by decades depending on how old your mortgage is. If you refinanced for 30 years you could have a mortgage payment for the rest of your life.

With the rental property, consider if you want to be a landlord. “Plenty of people have rental properties and have successfully used them to grow wealth and fund retirement,” he says. Keep in mind you'll have to decide whether to use a property manager or manage on your own. “You'll also have to fund repairs when they come up (as a former rental property owner, those repair requests from tenants usually happened in the middle of the night for some reason),” he notes.

“Lastly, have a contingency plan in case of a prolonged period where you may not be able to receive a rental payment due to a vacancy. Ask any property owner about their experience through the pandemic when millions of renters stopped paying their rent due to COVID hardships,” Kenney warns.

“My recommendation would be to get firm quotes on both HELOC and cash-out refinance options and see what works best for your situation. Run some numbers and account for additional expenses for repairs, management costs and vacancies” Kenney advises.

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Email Robert.Powell@maven.io

Question

I am 62. I have $112,000 in an IRA, $40,000 in stocks, $250,000 in home equity, and an expected inheritance of $300,000 plus. My expected Social Security payment should range from $1,400 to $1,700 per month. 

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