If you want to grow your
wealth fast and better, buy residential
property to rent out. Your investment will
grow faster because of the leverage that a
mortgage gives you, and it grows better
because rental income, tax laws, and
responsible mortgage decisions keep your
risk extremely low for such a high return.
Here’s how…
Leverage gives you
high investment returns
Owning residential rental
income can give you high returns at very low
risk. The high returns come from the
leverage of buying your property with a
mortgage. Your investment is your equity -
the value of the property less the mortgage
amount you owe on it.
When you buy a house, you
put a fraction of its price down. The bank
pays the remainder through a loan (i.e. a
mortgage) you now owe.
Each monthly mortgage
payment you make includes a portion for
interest with the balance of the payment
going toward paying off the principal of the
loan. The principal payment portion
eventually kills off (amortizes) the loan.
Early payments in a
25-year mortgage are mostly for interest;
ending payments are mostly for principal.
These two components are equal at about year
18. Very little principal (loan) is repaid
during the first 10 years.
Here’s how your equity
grows fast:
Suppose you put 20% down
for a $200,000 house – which gives you
$40,000 in house equity and a $160,000
mortgage. If house prices rise just 5% over
the next year, your $200,000 house will be
worth $210,000. Since you still owe about
$160,000 on the mortgage, your equity has
grown to $50,000. That’s a 25% equity growth
rate for your equity due to a 5% growth rate
in for the house.
The leverage factor, L,
is 5 (= $200,000/$40,000) before the
increase. So equity grows L times faster
than house price growth. You get a high
investment growth rates even for relatively
low house price growth rates.
Because your equity grows
faster than you house’s value, the leverage
factor slowly reduces. But at a 5% annual
growth rate for your house value, it takes
about 10 years for your original 20% down to
become half the value of the house.
Neglecting a small mortgage change, your
house would then be worth $320,000 with an
almost $160,000 mortgage. Your leverage
factor would only be ‘2’.
You can always
‘remortgage’ the house to pull money out and
increase the leverage to keep your
investment rate high.
Better by taxes, rental income and a
responsible mortgage
The
high investment rate your property gives you
doesn’t have to put you in a state of high
risk. That’s because you can keep the cost
of holding on to your property as low as you
want by putting enough down so your rental
income will always cover your holding costs.
And tax breaks for rental income owners go a
long way to help you out.
Rental income can cover
your costs. Owners claim their rental income
on a Schedule E (Rentals) form. But they
also get to deduct not only their annual
mortgage interest paid, but other annual
costs of owning the rental property such as
maintenance expenses and an annual
depreciation amount.
Depreciation is a
book-keeping deduction that presumably
allows you to set aside money for
replacement of your house. It represents no
actual expense outlay; and the value of the
house doesn’t go down – like a machine
depreciates. It actually goes up! Here’s how
it helps you.
Ideally, when you buy a
rental property, in the early years, you
want the rental income to just cover the
costs of the mortgage payments and
maintenance expenses that come out of your
pocket. That way the ‘rental’ is costing you
nothing because the rental income is paying
all the out-of-pocket holding costs.
But the depreciation
deduction –that pulls nothing out of your
pocket - can create an ‘apparent’ yearly
loss on the rental income/expense sheet. You
can then deduct this ‘apparent’ loss against
your regular job income on your 1040 to
further reduce your tax on your own working
income.
These
depreciation deductions lower your house’s
tax basis. So when you eventually sell, your
capital gain – sales price less house basis
- will be larger. But low capital gains
taxes and other tax techniques can keep your
profits high.
Conservative Investing
But if you keep your mortgage costs low with
smaller mortgages and a fixed rate, you can
probably always keep renters paying your
costs of ownership. That way you’ll weather
any price or interest rate storm that
threatens your investment.
