Here's an email that a reader sent to me to be included in my Reader Profiles series, but I think it's a better fit for my Help a Reader category. As such, I submit the following for your consideration:
Hi Readers,
I have a bunch of friends that read this blog, so i'll keep this pretty general, and only include my information not my spouse's...but I do need some advice.
I'm in my early 30s, married with no children. Remember that I'm only including my income in this profile. I bring home about 6k a month. I also have two rental properties, in addition to my main home. Which adds another $2700 in income. I have very high student loans from graduate school, $130k. $100k is at 2% and I'm not planning to pay that off early. After a lump sum bonus payment, I'll be paying off the 30k that is at 6% in November. After paying off the high interest student loans, my monthly expenses will be about $4300 a month (that includes all mortgages, remaining student loan payments, and utilities). I don't have any other debts. My savings is abysmal. $20k in emergency saving, $23k in my 401k.
My monthly expenses were not always $4300. Let me explain:
One of my mortgages has an ARM, which just reset to a much lower rate. Before then my monthly expenses were much higher (appox 1k higher). Also, I have been putting every free dollar I have towards paying off my student loans, but will no longer need to do that after this lump sum payment.
After November, I'll have $4400 to use wisely. I plan to put $1k towards entertainment, travel savings (this is non-negotiable, travel is the one area where we don't compromise), some bills / repairs that always seem to come up unexpectedly, and being a bit more carefree.
The other 3400 is where I need your help dear readers. Here are the options:
1. I have a second mortgage on a rental property that needs to be paid down in order to refinance ($36k). I am planning to put $2k towards that, and pay it off in 18 months (which when my ARM resets again, and the point at which I would want to set a fixed rate). I would put the other $1400 in a mutual fund or index funds.
OR
2. I could save aggressively, and buy another property in about a year. As long as this new property is cash flow positive I could still pay down the second mortgage referenced above in another year or so ( although it probably wouldn't be the full $36k)
I am admittedly not a good saver. I purposefully tie my money up in properties or paying down my loans so that I don't spend my savings. I feel the urge to buy another property coming on again given the amount of free cash that is coming my way, but after reading several other reader profiles I feel woefully unprepared from a cash/savings perspective. I know that more money doesn't sound like a problem, but November is coming up soon, and I'm truly confused about what to do.
My spouse does not have debt either. Both of our cars are paid off, nothing fancy, but they've got around 60k and 80k miles on them and we're not planning on upgrading anytime soon. I did not include spouse's income because it's significantly less than mine, and is used for other bills I don't cover (repairs, medical bills, cable, both of our parent's needs when the come up).
So, what's your advice?
Given the amount of free cash flow he has and the current economic situation, I think saving to buy another rental property is a good choice.
1. The conomy is unlikely to pick up significantly in the next 2 years. While I absolutely hate ARM loans, the odds are that his will not go up enough that he will find himself unable to afford it in that time.
2. I don't believe the housing market will come back for quite a while (possibly as long as a decade). Given that, now is a great time to pick up additional properties while the prices are low.
3. Because so many people have had to give up on owning a home (at least for now), demand for rental units has picked up. Most rental units are demanding higher prices (at least in my area) so now is a great time to get units set up and rented, hopefully with long-term tenants.
There are of course some risks. First of all interest rates could explode, which could hurt him with the ARM. Though I believe most ARMs have a limit as to how much they can adjust up in a single year, so even if ARMs were to go through the roof he'd only see his go up a couple percent before he could pay it off. The odds of his ARM payment jumping enough to put him at risk in 2 years is minimal.
Second is the chance that the housing market could recover sooner than we expect (I consder this very unlikely.) If people start to shift back into buying homes rather than renting, it could lead to a drop in rent rates as demand decreases. On the other hand, this would have the advantage in lifting real estate values from a pick up in demand, so he would probably be able to sell at least the new property (and maybe even the others) for a profit.
The biggest risk would lie in what he plans to do with the ARM. If the banks pull bank on making loans again (after a default by Greece and/or other European countries, for example) he may find that he is stuck with that ARM and cannot refinance for a while. While I think the odds of a default by at least one of the PIIGS is very high, we should see it within the next year and have at least some idea of the impact by the time he is talking about purchasing another property (1 year). If at that time the credit market is looking ugly, he could always take the money he had saved for a down payment on rental #3 to instead pay down the ARM.
Posted by: Robert | October 05, 2011 at 07:35 AM
It doesn't matter that your student debt is at only 2%. You owe a huge amount of money. Secondly, you can also run into problems if you end up with vacancies in rental properties. Despite the fact that you admit to being a poor saver, you do need to increase your emergency savings to not only protect you from potential job loss, but also to cover any surprise expenses on the rental property. You should build it up to about $60K. After that, I would max out the retirement and start paying off your debt. I would not buy any more rental property until the debt is gone.
Posted by: JimL | October 05, 2011 at 07:35 AM
I echo Jim's sentiments. It generally feels like it is very real estate heavy. There are other ways via securitization that you could get involved with real estate. REITs are one example and it is generally more liquid. As for the loan, I would want it paid off. Personally, the loan is for classes you took years ago--most of which you are not using and therefore it is a depreciating asset. In general you want to either not finance depreciating assets or pay them off ASAP. Why pay interest on a dining hall dinner you ate back in 2006 right?
Cash cushion is even more key. While I hope thatching get better, what if they don't and you can't find a job making what you usually make? That doesn't even consider the rentals.
Posted by: Easychange | October 05, 2011 at 07:57 AM
As someone who has had rental properties before, I have to say your cash reserve is below what it should be. The only advice I have is to add to your cash reserve and to your 401k -- the 401k is important because of the tax deduction. So maxing out your 401k with your income level should get you an instantaneous 25% to 28% return because of the taxes you save (depending on your marginal income tax rate of course).
Posted by: Michael Goode | October 05, 2011 at 08:27 AM
It sounds like you have a lot already tied up in real estate- not only your rental properties but your main residence. I suspect it would be something like 80% of your net worth is tied up in properties. That isn't very diversified. I agree with Michael's advice- add to the cash reserves and 401K.
-Rick
Posted by: Rick Franics | October 05, 2011 at 08:51 AM
Yeah I echo Jim as well. You need more savings than the average Joe because of the two rental properties you have and the high student loans. Sounds like you have a spending problem. You should take time out of your life to examine your negative behaviors. Maybe start with your attitudes like non negotiable travel fund. We all have needs and should save and spend for the near term, but $1000 per month is a bit excessive. To be rich means delayed gratification, and you are in that position to do that in maybe 10 years, but not now. Take care of your family security needs now (life insurance etc.) and play it safe.
With the extra money after padding emergency savings, I'd invest in the market. Don't worry about refinancing your ARM.
Posted by: Luis | October 05, 2011 at 09:02 AM
Pay off your debts and increase your savings.
You don't need another rental property.
Max out your 401k, increase your cash savings to at least $50,000 to cover any big issues with the rentals, and vacancy costs. Also look into opening a Roth IRA if you still can.
All economic signs point to interest rates staying low for a while. If in a year you have excess funds and you've already maxed out retirement, then it would be a better time to buy another rental property.
Posted by: tom | October 05, 2011 at 09:23 AM
I wouldn't do anything but stack money for the moment. You need more reserves for your current situation, let alone if you were to take on additional debt(risk).
At a minimum (if you are good at this), I would have $30K sitting in an account for you and your wife before doing anything else. After that a good strategy might be to split paying down your student loan and setting aside money for another house at a dollar to a dollar rate. $20K can get hacked up pretty quickly, exposing you both.
Getting full mental control over spending/savings habits is essential if you are going to move forward with property, otherwise you could experience a big money default some day. The more control you have, the less reserves you need, to a point. You owe a lot of money that isn't producing any income (student loan). The house debt is a different story.
Also, don't really fret about the 401K, you are investing in properties for your future, just not in an account with a catchy title. As long as you don't spend the earnings, it doesn't matter where the money is.
For what it is worth, I am 30 and have six rental properties.
Posted by: ryan | October 05, 2011 at 09:40 AM
Pay off your rental mortgages, set it up so that the rental income coming in each month exactly offsets the depreciation and maintenance on the house so you will owe no taxes.
Pay off your student loans, then accumulate a cash cushion.
Yes, you are cash flowing each month but if you had an emergency in your rental properties or a job loss you would be in trouble too quickly- and that is not good.
I think you can get turned around in the next 3-4 years with a rock solid cash cushion, no debt and pay down the properties.
-Mike
Posted by: Mike Hunt | October 05, 2011 at 10:10 AM
"Personally, the loan is for classes you took years ago--most of which you are not using and therefore it is a depreciating asset."
LOLWUT? How is education a depreciating asset? At 2% interest it makes almost absolutely no sense to pay this loan off aggressively. That rate is lower than inflation. The only upside to paying a aggressively on the student loan is the psychological benefit it may bring to be free of the debt. This of course doesn't have a specific value, but it sounds like he's looking for what would make the most sense. I'm lucky enough to be in the same boat (i.e. 0.22% on about 25k, and 2.5 on another 75k) and I have no intention on paying it down early, even in this economy I can find things that generate a better ROI than that without much difficulty.
Posted by: Brian | October 05, 2011 at 11:14 AM
This sounds a lot like me. Same age group, same income, same problem with savings, and same solution. In this case, I would say that if you deem it wise to increase savings, one way to do that while keeping it out of sight out of mind is in your 401(k). You can always borrow against it if you *really* want another property later, but it will keep you from frittering it away. Alternatively, a ROTH can serve as a backup e-fund.
I know people say "just get better at saving", but if you know you will spend it (like me) it is wise to find ways to keep it out of your hands.
Just be careful how you invest it within the 401k if you plan on borrowing against it for another rental - the market is weird right now and you may be better leaving it inside the account in cash (or cash equivalent).
Posted by: Des | October 05, 2011 at 12:22 PM
I'd beef up emergency savings and pay down that loan before buying another property.
Your savings are ok but not that high really. You've got like 4-5 months savings give or take there. But with rentals you need to have extra in savings to account for unexpected rental costs. You don't want a job loss & rental vacancy to hit you at once. Don't get stretched too thin with the rentals ... I think you could be heading there.
I agree that 2% student loan debt is not a high priority. All your mortgages are higher interest rate and should be paid down before you pay extra principal on that 2% loan.
Are you taking advantage of employer 401k match? If not then you should absolutely do that. Just curious since your 401k balance is not too high, so I wonder how much your contributing there.
Posted by: jim | October 05, 2011 at 01:29 PM
ARMs make me nervous, so if I were in your shoes, I'd go with plan A. Pay off that 2nd mortgage while socking some money away so you can get into a fixed rate mortgage.
Set it up so these payments & savings transfers happen automatically, if you need to keep yourself from spending it. Works for me.
Posted by: Rich Schmidt | October 06, 2011 at 01:50 AM
Brian. I am glad you disagree. Here's my thinking. In my job (programming) you have to keep retooling your skills constantly. I use very little if what I learned in school ten years ago. So yes, depreciating asset.
When you owe any large sum on something you have already consumed, yes there is a psychological toll. But even just the numbers bear it out. There are very few safe investments out there that can give you a tax-free 2 percent return that are easy to get in/out of. My savings account is high yield and pays only 1 percent and I have to pay taxes on it!
The loan gets twice that and no taxes are due. Certainly there are mutual funds etc, but in this economic climate returns are far from certain. The safe bet is to pay off debt and save cash, not carry debt and get into even more properties. This is an insane amount of risk to carry in my opinion.
Posted by: Easychange | October 06, 2011 at 07:30 AM