YES! You Can Still Invest in Real Estate: Busting Housing Myths and How to Save on Your Mortgage

The Federal Reserve has been hell-bent on curbing inflation, raising interest rates seven times in 2022. Consequently, it’s no surprise that many potential home buyers—folks who have been saving, getting their credit in order, and who have good jobs—are now worried that they may be left out in the cold, unable to buy or build their dream homes.

I get it. As the graph below shows, we saw incredibly low mortgage rates for decades, but those days look like they are over—at least for the near future. Economists say the Fed will probably raise rates at least a couple more times this year, albeit at a slower rate.

Source: FRED Economic Data

But look closely at the graph. You can see that in the past 50 years, mortgage rates climbed as high as 18%. And you know what, people still bought homes with mortgages! In fact, my first mortgage was at a rate of 14%. The high rates didn’t last that long, and as soon as they began to subside, I refinanced at a much more attractive rate.

And that’s one of the reasons why you might consider buying a home right now. Rates will come down, offering many chances to refinance; there are plenty of mortgage options that will allow you to pay below-market rates, and housing prices—which are not rising as fast as last year—are still going up, which will help you build equity (making your upcoming refinance even more attractive).

The following chart shows the rise in home prices from October 2022 to November 2022 (on the left side of the chart) and the forecast from October 2022 to October 2023, on the right.

Source: CoreLogic.com

So, let’s talk about the ABCs of getting the best mortgage—from research to preparation to application to home ownership.

The 7 Most Popular Mortgages

Conventional. This is the mortgage that 75% of borrowers use. It’s predictable, the same every month, and the interest rate never changes throughout the entire life of the loan. This type of mortgage also comes with flexibility—30, 15, or 10 years. About 90% of homeowners go with the 30-year option. However, the 10- and 15-year terms will build your home equity faster, as you won’t be paying as much interest as you would with a 30-year. Of course, your monthly expenses will be higher with the shorter-term mortgages.

The other advantage to the shorter terms is that the interest rate is usually more attractive. For example, as I write this, today’s rate with a 20% down payment, averages 6.884% for a 30-year mortgage, and 5.391% for 15 years (with a 700-719 credit score; the minimum credit score for a conventional loan is generally 620).

If you were to purchase a $350,000 home with 20% down ($70,000), leaving you with a mortgage of $280,000, your payment with the 30-year mortgage would be $1,841 monthly, while the 15-year would cost you $2,272 per month. Over the life of the loan, you’ll be paying $662,760 for your home, but if you took the 15-year loan, your total payments would be $408,960. That’s an extra $253,800 to put into your retirement account! And that’s not counting any interest or appreciation from investing that $253,800!

Now, here’s a hint on how to get most of the benefits from the 15-year loan without being tied down to the 15-year term. Just get the 30-year loan and pay it off in 15 years! Your monthly payment would be at the rate of 6.884%, so your monthly outlay would be around $2,499, and your total cost over the 15 years would be $449,820, instead of $408,960. And lastly, instead of saving $253,800, you’ll save $212,940. The advantage to this is that it gives you flexibility, just in case you run into financial challenges down the road—you don’t have to make the larger payment. But it’s a really good idea to do so, as you can see.

FHA Loans are government-backed mortgage loans that allow higher debt ratios, lower credit scores (minimum 580), and smaller down payments (3.5%) than conventional loans. And you may even qualify for an FHA loan if you’ve had a bankruptcy or other financial issue.

However, FHA loans do require mortgage insurance, which will cost, upfront, 1.75% of the base loan amount, as well as a monthly premium, ranging from 0.45% to 1.05% of the loan amount.

There are also maximum loan limits with FHA loans. In my area, here in Tennessee, the maximum loan limit is $472,000. Here’s a link to find the loan limits in your region: https://entp.hud.gov/idapp/html/hicostlook.cfm

Additionally, FHA loans have extra benefits, including:

They allow borrowers to accept up to 100% of their down payment in the form of a gift from a relative, friend, employer, charitable group, or government homebuyer program.

They allow you to borrow against other property types, in addition to single-family residences, including two-unit homes, three- and four-unit homes, condominiums, mobile homes, and manufactured homes. But you can not use an FHA loan for a strictly investment property; if you buy multiple units, you must occupy one of them.

Today’s FHA rate is 6.324%.

Source: Mortgagecalculator.org

Veterans Administration (VA) loans are guaranteed by the U.S. Department of Veteran Affairs and can be used by veterans and active-duty military members. The biggest advantages are no down payment is required, there is no minimum credit score, and the rates are usually more attractive than conventional loans. Today, the mortgage rate for a VA loan is 6.304%.

Source: Mortgagecalculator.org

U.S. Department of Agriculture (USDA) Loans are available to rural home buyers with low to moderate incomes. These loans do have maximum income limits, but also require no down payment, the mortgage rate is better than the conventional rate, and borrowers can finance their closing costs right into the loan. Today’s USDA mortgage rate is 6.192%.

Source: Mortgagecalculator.org

Adjustable-Rate Mortgages (ARMs)—in the past—were offered at below-average, 30-year rates, but in today’s world, some fit that criterion and some don’t. The ARMs whose rates are close to the average 30-year mortgage rate aren’t as attractive right now as they have been in the past. However, if you think mortgage rates will begin to decline by next year (as some economists predict), you can get an ARM now at a rate that should go down over the next few years.

Here are some of the most popular ARMs right now:

10/1 and 10/6 Hybrid Adjustable-Rate Mortgages (ARMs) have a beginning interest rate that is fixed for the first ten years of the loan. With a 10/1 loan, after 10 years, the rate adjusts annually, and with a 10/6, the rate adjusts every 6 months. They both are 30-year term loans. These loans are currently priced at rates around 6.994%. But if you think that rates will be declining, you may not want to lock in for 10 years, right?

7/1 and 7/6 Hybrid ARMs have a beginning interest rate that is fixed for the first seven years of the loan. After the 7 years is up, the rate then adjusts each year or every six months (for the 7/6 loan) for the remainder of your 30-year loan term. Today’s rates are around 6.938%.

5/5 And 5/1 Hybrid ARMs have the initial rate locked in for five years. After that, it can change every five years (5/5) or every year (5/1). Today’s rates are about 4.375% and 5.56%, respectively.

3/3 And 3/1 Hybrid ARMs retain the same initial rate for three years. At the beginning of the 4th year, the interest rate on the 3/3 mortgage is changed every three years, and annually on the 3/1 ARM. Today’s rates are about 3.99% and 4.06%, respectively.

As you can see, the ARMs with the shorter terms to adjustment are the most attractive, rate-wise today. And if you think rates will be lower in three or five years, or you think you may be moving again in three to five years, they may be a good option for you. Let’s look at your potential initial savings for the 3/3 and 5/5 options, compared to a 30-year conventional rate mortgage today, using the same criteria I mentioned above:

As you can see, the savings using an ARM can be substantial in the first few years.

Balloon Mortgages can be attractive if you are planning to move within a few years or if you think rates are going to come down when the balloon is due. They work like fixed-rate mortgages, in that you amortize them over a longer term (such as 30 years), pay the principal and interest, and then the rest of the mortgage comes due in 3-5 years (for residential) and 5-10 years) for commercial loans.

Because this type of mortgage is riskier to both the borrower and lender (what happens if you can’t refinance and aren’t ready to sell?), the rates tend to be a bit higher than the regular conventional mortgage rate.

Bank Statement Loans are just what they sound like—no tax returns or W-2s required. The bank just wants to see two or three years of your bank statements and will qualify you for a mortgage, based on those documents.

These loans went out of fashion after the 2007 recession, as they were part of the sub-prime lending market that helped put the kibosh on the mortgage rates and the economy. Thousands of buyers who couldn’t really afford to buy a home, bought one anyway, using these kinds of loans. And when they couldn’t pay, the bottom fell out of the housing industry, leading to more than six million foreclosures and a two-year recession.

But they are coming back! And while you may think they are risky (they are!), they may be just the ticket for small business owners, entrepreneurs, freelancers and gig workers, whose tax returns usually look a little lean to a banker.

In my research, I found several local banks and mortgage companies that offer these loans, with rates about 2% higher than the conventional 30-year mortgage rate.

If you think one of these loans may fit your personal circumstances, I’d recommend that you go local—talk to lenders in your area. And be aware of costs, as you will probably have to have a higher down payment, and there could be other non-traditional costs associated with these loans.

And speaking of costs, let’s next talk about the actual costs to secure a mortgage.

What’s it Going to Cost?

Let’s just say, it isn’t cheap! If you’ve never bought a home, you may be surprised by the variety of costs you’ll be charged at closing, including:

Interest. The lender will escrow a few months of your loan interest upfront, at closing.

Down payment. If you don’t get a VA, USDA, or FHA loan, your lender will require a minimum of 5% to 10% of the purchase price.

Appraisal fee. Most home loans will require an appraisal, which will cost you, on average, $500-$800 at the time of loan application.

Credit report. This is run so your lender can determine your creditworthiness (and your interest rate). It should cost $50-$75. (These just doubled, due to an increased fee by FICO—the credit scoring agency).

Home inspection. This is not the time to be cheap. And don’t try to inspect the house yourself. Hire a licensed home inspector to see if there are any major issues with the home you are buying. The inspection will not cover every single thing in the house—just the major items such as rooms, plumbing leaks, electrical problems, appliance issues, etc. It is not a cosmetic report, so don’t expect all the nail holes to be spackled! This should cost you $400-$600.

Termite inspection. Don’t opt out of this. If you find out your home has termites (after you move in, it’s on you!) Expect to pay $55-$100 for this inspection.

Loan origination charges are not charged by all lenders. But if your lender charges this fee to underwrite and process your loan, it will probably be about 1% of your loan amount.

USDA loan guarantee, about 1% of the loan amount.

VA loan funding fee. Around 1.4% to 3.6% of your loan amount, depending on the down payment, and whether this is your first VA loan.

Discount points (also called buydowns) have returned. They are optional fees you pay upfront to lower your interest rate. One discount point equals 1% of the loan amount and usually drops your interest rate by a quarter of a percentage point. So, if your rate is 6.884% on a $280,000 loan and you pay one discount point, it will cost you $2,800 to buy the rate down to 6.634%. Using our previous example, that would take your mortgage payment from $1,841 to $1,795, saving you $16,560 over the life of your 30-year mortgage. If you plan on staying in your home for the long term, this may be advantageous.

Private mortgage insurance (PMI). If you put less than 20% down on your home, your lender will require PMI of 0.22% to 2.25% of your mortgage, depending on how much you borrow (the higher your loan, the more you’ll pay for PMI, and your credit score (the lower your score, the more you’ll pay for PMI). This will be added to your monthly mortgage payment. The good news is, once you have paid your mortgage balance down below 80% of the property’s value, you can query your lender to remove the PMI.

Property taxes. These will vary, depending on where you live. Most lenders will require taxes to be added to your monthly mortgage payment. They will escrow them until your local tax authority requires its annual payment of the taxes. Your closing agent will most likely require that you pay taxes at your home closing, depending on the time of year you close and when taxes are due.

Insurance. Your lender will require that you get an insurance policy to protect your property. This will also be added to your monthly payment and escrowed until the insurance company requires its annual payment. Your mortgage lender will require that you pay the first year’s premium upfront, and then they will escrow 1/12^th of the next year’s premium from your monthly payment.

Homeowner’s association dues. If you live in a community that has a property or homeowner association, you will most likely be required to escrow the first quarter’s payment at closing.

Transfer or amenity fees. More and more, communities with homeowner’s associations are requiring an upfront, one-time payment, to join the association. They sometimes call these payments transfer or amenity fees. In the last community I lived in, that fee is now $1,120.

Radon inspection. Not every house has a radon problem; radon is more prominent in certain areas of the county. But it is a poisonous gas, so it’s probably worth it to pay the $125-$150 for the test.

Well test. Although we see fewer of these every year, if you have a well, have it inspected. It will run about $250.

Flood determination. With the crazy weather we have been seeing all around the country, this is a must. Realtor.com shows the flood risk for many properties in the U.S. Go to this site see if the home you want to buy is in a flood zone. Or you can hire someone to check it out for about $50.

This site has additional information about flood zones and how they’re classified.

The average cost of flood insurance through the National Flood Insurance Program (NFIP) is $771 per year, but the amount you pay depends on your location.

This is a necessity. In my local area, a builder erected a huge development of several hundred homes, and no one checked the flood map! Needless to say, there are a lot of houses with wet crawl spaces, and lawsuits on the way!

Government recording fees are collected to update local property ownership records, and cost around $125.

Tax monitoring and research fees may or may not show up. These fees are for checking how much property tax you owe and making sure the taxes are paid. They run around $150.

Title-related costs. If you take out a loan, your lender will require that you buy Lender’s title insurance, to compensate them if you default on your loan or there’s a mistake in the title search and someone makes an ownership claim on the property. It costs about $1,000, depending on where you live and how much your home costs.

I would highly recommend that you also buy Owner’s title insurance. This will protect you if there’s an ownership claim on the property. It will vary, depending on where you live and the purchase price of your home, but averages around $800.

Title search fee covers the cost of researching public records to make sure the person selling the property is the legal owner. It will cost you about $500.

If you elect to use an attorney, the fee may set you back another $750 or so.

All in all, you can expect to pay 2%-6% of your mortgage amount in closing costs.

Finally, there’s one more potential cost to consider. If the appraisal on the house you are purchasing is less than your agreed purchase price, this could also cost you more money. If the seller is not willing to renegotiate down to the appraisal price, you can either walk away from the deal or come up with cash to make up the difference. Note that this is a risky tactic; I don’t advocate paying more for a house than current market conditions warrant, but if you really want the home and plan on living there for a long time, it’s something to consider.

3 Ways to Reduce your Loan Costs

• Put 20% or more down on your loan, so that you eliminate PMI.
  
• Have a good credit score. In our example, a person with a credit score of 700-719 would be eligible for a mortgage rate of 6.884% (conventional), 6.324% (FHA), and 6.305% (VA). Alternatively, if your credit score is 800 or above, your rates would be 6.337%, 6.18%, and 6.171%, respectively. Over 30 years, that good credit will save you thousands of dollars!
  
• Ask your seller to contribute. There are a bunch of new loans around, such as the 2/1 Buydown program. The seller pays to buy down your interest rate for the first couple of years. In this case, the buydown reduces your rate by 2% the first year and 1% the second year. Then, it reverts to your original interest rate. Effectively, the seller is prepaying part of your interest for the first couple of years. Here’s how it works on a $280,000 loan:

Year 1, normal payment is $1,841

Buydown buys the 6.884% down to 4.884%, giving you a monthly payment of $1,483.

Seller pays $1,841-$1,483= $358. $358 x 12 months =$4,296

Year, 2, normal payment is $1,841

Buydown buys the 6.884% down to 5.884%, giving you a monthly payment of $1,658.

Seller pays $1,841-$1,658= $183. $183 x 12 months =$2,196

Total for 2 years = $4,296 + $2,196 = $6,492. This is what the seller would pay to bring your rate down for the first two years of your loan.

Why would the seller do that? Well, if he or she is having trouble selling his home, it’s cheaper to do this than continually reducing the price. And it will probably help him or her sell his home faster, which will save the ongoing costs of maintaining a home he or she no longer wants.

How Much House Can You Afford?

There are primarily two debt ratios that lenders use to qualify you for a mortgage loan:

Front-end ratio: This shows what percentage of your income would go toward housing expenses. The lender will include your monthly mortgage payment (principal and interest), property taxes, homeowners’ insurance, and homeowners’ association fees, if applicable.

Back-end ratio: This shows how much of your income would be needed to cover all monthly debt obligations, including all of the above expenses, plus credit cards, auto loans, child support, student loans and other debts. Typical living expenses, such as utilities and groceries, are not included in this ratio.

The lender will divide each of these accumulated expenses by your gross monthly income to get your debt ratios.

These ratios are not set in stone, but typically, lenders like to see the front-end ratio no more than 28% and the back-end ratio no more than 36%.

But…there are numerous exceptions. Some lenders will accept up to a 50% back-end ratio. Your personal ratios may be loosened if you have a big down payment, a great credit score, and a nice-sized savings account.

Preparing for Your Loan Application

As you know, in addition to my investment business, I also own a real estate company. And one of the biggest pushbacks I get from clients is that they get so upset with their lenders because of all the personal information the lender now requires.

Years ago, when I first got into banking, the mortgage application was two pages. Today, it’s the size of a small book! I just tell my clients, “just give them what they ask for or you won’t get a mortgage.” Nothing is off-limits; prepare to give up your first-born, so to speak!

Prior to sitting down with your mortgage application, you’ll need the following information:

Know your credit score. You can get it for free at myFICO or from any of the credit bureaus, or even your bank. My Visa card sends me my credit score every month.

The minimum credit score for a conventional loan is usually 620, but if you are applying for a government-backed loan, you’ll probably need a credit score of at least 580.

Proof of income and employment. You’ll need your W-2s for at least the past two years; recent pay stubs or the bank will send out a verification of employment to your employer; and if self-employed, at least two years of tax returns and 1099 forms. If you haven’t been in your present position for at least a year, you may have difficulty obtaining a mortgage.

Divorce decrees and child support documents, if alimony or child support will be needed to qualify for the mortgage.

Bank statements, at least a few months, but the bank may require a couple of years to verify any other income, such as alimony or child support if needed to support your mortgage qualification.

A list of your assets. This will include savings and retirement accounts, property, investment accounts, and any pricy collections you may own.

A list of your liabilities and repayment obligations, such as loans, lines of credit, student loans, and credit card balances.

A copy of your home purchase contract. If you are just getting pre-approved or pre-qualified for a mortgage, obviously, you won’t have this yet.

Property type that you want to purchase. Investment or business property will most likely require additional financial qualifications and will also come with a higher interest rate than your personal residential property.

Explanation of any adverse credit issues, such as bankruptcy, liens, etc.

Proof of any gift funds.

Now, if you are just beginning to search for a property to buy, your Realtor will most likely require that you get a pre-qualification or pre-approval letter before she lets you in her car! Listen, it doesn’t make any sense to go out looking at houses blind, without knowing what price range your banker approves for your personal circumstances. When I ask people, what price range they are looking in, I get the craziest answers. “I don’t have a range,” “I don’t know,” “Why do you care?” Well, I usually say, “so you want to look at million-dollar properties?” That usually narrows down the field.

Here’s the difference between a pre-qualification and a pre-approval:

Pre-qualification doesn’t require verification. For this letter, the banker asks you how much you make, how much you owe, and takes you at your word, although she might run a credit report.

Pre-approval means that the banker has begun her investigation, and so far, your assets and liabilities have had some verification. This will make your Realtor happy!

I know this sounds worse than tedious, but hey, if you want to buy a property, this is what is required today!

Bank, Mortgage Broker, Online Lender, or Credit Union?

Fortunately, when it’s time for you to make your home purchase, you have a lot of choices as to the type of lender you employ.

Your local bank or credit union (if you are moving to the same area in which you live), in my opinion, is the best place to start. One, they know you and your financial health, and they have a lot of flexibility. Say, for instance, you may need a more creative loan than a standard 30-year fixed. You may not have yet sold your current home, and need a bridge loan until that sale happens. Or perhaps, you can use the funds from a home equity loan or home equity line of credit to finance your new home (if you have enough equity in your current home). You won’t find either one of those loan vehicles at a mortgage broker or online broker. Your bank may be able to put your creative loan in its own portfolio, rather than selling it in the secondary market where investors love plain old vanilla loans, not anything “creative.”

Banks located in the location of your new home. While you probably can’t do the bridge or home equity loans with a bank where your current home is not located, the local bank will be familiar with the various neighborhoods around your new home, and can also be creative in structuring a portfolio loan, depending on your financial situation.

Mortgage brokers work with a variety of lenders and investors, so they may be able to find you a better deal than your local bank. But beware, you may pay for their services with origination fees, so make sure you watch your dollars and cents.

Online and out-of-state lenders. When clients tell me they are going to use one of these lenders who spend zillions of dollars on advertising, I just want to cry. My experience with them has pretty much been 0 for 10. Here are just a few examples (names withheld to protect me!).

Example 1: A well-known, out-of-state bank (my client’s current bank) assured my client that she was approved to purchase a condo in a nearby resort area. That is, until about a week before closing when the lender determined that more than 50% of the units were rentals. They pulled the rug out from under my client. Had she used a local lender, the bank would have been familiar with the property.

Example 2: My client applied and was approved for a mortgage from an online lender. All was fine until five days before closing when the lender demanded proof of his wife’s part-time job (which was not needed for income qualification). The lender delayed, delayed, delayed. We finally did close the deal about a week and a half late.

Example 3: A good friend and client bought a gorgeous lakefront home. He assured me that he had used this famous online lender many times, for refinancing his homes in Arizona and Washington, D.C. I tried to explain that there are several very good reasons not to use this particular lender, including the most important one—they usually don’t use local appraisers. And why is that? Because the local appraisers are very busy with our local lenders; they don’t want the online bank business (for numerous reasons!). I begged him; I pleaded with him; to no avail. And guess what? His appraisal came back $42,000 less than the contract purchase price. And may I note that the current sellers of the property had just had an appraisal from a local appraiser a few months prior to our contract, and it was at the same price as my client agreed to buy the property. I presented the appraiser with a list of local comparative properties, but he wasn’t interested. Consequently, there was a lot of negotiation going on!

Enough already! You get the point.

Why Buy Now?

As I said at the beginning of this article, while rates are still on the rise, they should begin to fall in 2024. So, if you buy now at the current rates, you can refinance when the rates drop.

And believe me, if history repeats itself, when rates begin to decline, the banks and mortgage lenders will be pumping out those refinance offers. Sure, you may have to pay closing costs. Or not. Many lenders will offer no closing costs loans to attract business, or the ability to roll your closing costs into your mortgage. And as long as you plan to stay in your home for a couple of years following the refinance, you’ll save money in the long term. The last time I refinanced my home, I dropped the rate by more than 3% and saved $1,500 per month!

Buying vs. Renting

Historically, when home ownership becomes pricy, folks begin renting instead of buying. But in this last real estate cycle, not only did home prices rise 29% from COVID to the beginning of 2022 (and even higher through last spring), but so did rental costs.

Here are just a few statistics from ipropertymanagement.com:

• The current asking rent is 77.1% higher than the nationwide median gross rent of 2020.
  
• The current asking rent is 12.95% lower than the average monthly mortgage payment.
  
• 35% of households live in rental properties.
  
• Rental rates increased 31% over 10 years.
  
• 41% of renters spend more than 35% of their income on rent.

The current national average apartment rent was $2,016 per month as of the end of the second quarter of 2022.

The following table shows you how fast rents have risen since the pandemic began:

National Average Asking Monthly Rent Prices

Those are some major price increases! As you can see from my earlier housing example, you could buy a $350,000 home with 20% down for a monthly payment of $1,841. Which do you think is better?

The following is a chart depicting the average rental rates in each state. I’m not sure about this information, as our rental rates in my local area of Tennessee are right around $2,000 per month!

Source: ipropertymanagement.com

However, price is just one consideration as to whether to buy or rent. Let’s look at the pros and cons of each:

Buy

Pros: build equity, provide tax deductions (for mortgage interest, insurance, and taxes), and you can get fixed payments (if you have a fixed mortgage)

Cons: you are responsible for maintenance and repairs, taxes, insurance, etc.

Rent

Pros: fewer homeowner responsibilities, just one monthly payment

Cons: no control over rising rents or the property

If you want to do a quick, breakeven calculation, try this, the 5% Rule:

First, add up the three major expenses of buying a home:

1. Property taxes, which are generally around 1% of the home’s value
   
2. Maintenance costs, also around 1% of the home’s value
   
3. Cost of capital, which is assumed to be around 3% of the home’s value. This is the cost of carrying your debt.

When you add up these three costs, they come to around 5% of your home’s value.

Next, multiply the value of your property by 5%, then divide by 12. That is your breakeven point for what you pay each month to own your property.

Finally, compare that point to the average rent you would pay in your area.

Let’s use our previous example, buying a $350,000 home with a $280,000 loan that costs $1,841 per month.

Property tax: 1% x $350,000 = $3,500

Maintenance costs: the same, $3,500

Cost of capital: 3% x $350,000 = $10,500.

Add those three costs together and you get $17,000. Now, divide that by 12 and the answer is $1,458. That’s your breakeven cost. And that means that if the average rental in your area is $2,016, it’s definitely cheaper to own than rent.

However, to be more precise, you can use the real cost of capital. At a 6.884% interest rate, the first year’s interest will be about $18,500 ($270,000 x 6.884%, divided by 12). Yes, I know this isn’t totally accurate, but it should be close!

Now, add those three costs together and you get $25,500. Now, divide by 12, and the answer is $2,125. That’s your breakeven cost. And that means that if the average rental in your area is $2,016, it’s slightly cheaper to rent vs. own.

Is It a Good Time to Invest?

For real estate investing, there are two questions: do you want to buy, renovate, and flip, or is it your intention to rent the property out for a few years, gaining steady, monthly income?

If you want the first option, you will need to buy low, keep renovation costs reasonable, and sell at a higher price, reaping the difference as your gain. This is simple math, but, of course, if you need to get a loan to purchase and/or renovate the property, you will have to consider those costs. And don’t forget the selling costs—marketing and real estate commissions.

However, if you plan on buying and keeping the property as a rental, you want to make sure you can create a solid monthly income. There are several methods that investors use to determine if the property is going to be a good investment, including:

For this prospect, investors often use the Rule of 72, which helps determine how long it will take for your investment to double in market value, based on your return rate.

Here’s how it works: Divide 72 by the annual rate of return, and that will tell you how many years to expect it will take your investment property to double in market value.

Years to Double = 72/Annual Rate of Return

Annual Rate of Return = 72/Years to Double

Simple, right? Unfortunately, it’s not. You must first estimate your rate of return. Here’s how you do that:

Net Operating Income = Rental Income – Operating Expenses

Cap Rate = Net Operating Income/Purchase Price × 100%

For example, let’s look at a home purchase for $250,000 home. Let’s say we could rent it for $2,500 per month (who knows?). Let’s pretend your closing costs were $6,000, and you need to put about $10,000 in for renovation. Your total investment would be $266,000.

Your collected rents are estimated at $2,500 x 12 (for the year), or $30,000. But you know you will likely have maintenance, tax, and insurance expenses (pretending you don’t have a mortgage, so no interest costs). So, let’s say those are $5,000 annually.

Now, your total annual return would be $30,000 - $5,000, or $25,000.

To calculate the rental property’s ROI, divide the annual return ($25,000) by the total investment on the property, $266,000.

That gives you a Cap Rate, or total return of 9.3%.

So, using the Rule of 72, estimated years for your property to double are: 72 divided by 9.3% or 7.74 years. And if that happens, you will gain a doubling of your property values, as well as the net rents you have been receiving over that 7.74 years.

The 1% Rule, means that the gross income of your investment should equal at least 1% of the original purchase price, including taxes and fees.

Here’s a simple calculation for our above example property worth $250,000.

$250,000 x 0.01 = $2,500

So, your loan payment should be less than $2,500 (which it is!) and your expected rental should be enough to cover your expenses and make money; in this case, around $2,500 a month.

Cash-on-Cash Return (cash flow). Here’s the formula:

Gross income from the property minus your operating expenses. This does not include mortgage, taxes, HOA, insurance, etc., or emergencies. A good goal is 8% to 12%.

The 50% Rule. This rule says that to make money, you need to save 50% of your income to cover property expenses. So, if your rental property is bringing in $2,000 per month, you’ll need to save $1,000. You can use your gain to maintain the property, cover your loan costs, and bank the rest.

The 10% Rule actually involves three rules:

• Put no more than 10% down.
  
• Buy at least 10% under market price. After the crazy winter and spring we had last year when homes were selling well over listing price, prices have come down, somewhat. But I think it’s still difficult to buy less than listing price in this market.
  
• Never pay above 10% mortgage interest. Well, at least we aren’t there yet!

It Pays to Keep Current on the Market

You can Google the best loan rates and you’ll find a horde of lenders from which to choose. But as I mentioned earlier, there’s a lot more to consider in addition to the rate. It’s essential to know your lender and compare each loan offering in detail to make sure you get the best deal.

And stick with lenders with good reputations. A recent worrying event is now occurring in the industry—banks getting out of the mortgage business. The volume of new mortgage loans in the U.S. dropped 47% in the third quarter of 2022 vs. the prior year—the largest yearly drop in 21 years. Consequently, some mortgage lenders are running for the exits, either via bankruptcy or selling to the highest bidder.

You’ll want to make sure the bank that is providing your new mortgage loan is not in the middle of selling off its business, and there’s no guarantee that the new lender will offer the same terms.

Wells Fargo is the largest lender that has recently announced it is exiting the mortgage market (although the bank will still lend to its existing customers). If you have a current mortgage with the bank, it’s no big deal. It will be sold off. But if you are in the process of getting a mortgage loan, you may want to change lenders.

Non-conforming lenders (specialty and high-value mortgages) like First Guaranty Mortgage Corp. and Sprout Mortgage are kaput. First Guaranty filed for bankruptcy and Sprout closed its doors in the past year.

Others are facing severe layoffs, including Pennymac, Redfin, Wells Fargo, and USAA Bank. Even Citi and JPMorgan reduced their staff.

So, make sure your lender plans to be in business, at least until your loan is closed!

The other pressure on the housing industry right now is lack of inventory. According to tradingeconomics.com, total housing inventory in the U.S. averaged 2,300.54 thousand from 1982 until 2022, reaching an all-time high of 4,040.00 thousand in July of 2007 and a record low of 860.00 thousand in January of 2022. Although it has improved in the past year, as you can see below, our housing inventory is less than half of what it used to be, on average.

And that means that while prices have subsided a bit, they are not sinking. With fewer homes available, sellers can still command pretty good prices.

To improve your odds of winning the contract, do this:

• Have your pre-approval letter in hand before making your offer.
  
• Use cash if you can.
  
• Provide substantial earnest money to show the seller you are serious.
  
• Be reasonable with home inspection repair requests (I wholeheartedly recommend that you do get an inspection!).
  
• Don’t use a stipulation that you have to sell your existing home first. However, if you do have a contract and a closing date on it, give your Realtor a copy of the contract.
  
• Offer above listing price, but don’t go crazy!
  
• Be flexible on closing dates (and the time the seller can stay in the home after closing).
  
• Offer to rent the home back to the sellers for a short period of time (if you can).

Bottom line, if you find a home you really like, don’t dilly-dally about making an offer. You don’t have time to wait in this environment!

I hope these tips will help you find the right lender and mortgage or just decide whether the time is right for you to buy, rent or invest.

Happy house hunting!