Today I will cover the most important topics involving real estate that you may need to know when you start looking into buying a house for yourself, as a rental property, or are deciding between buying and renting. I will go over the basics of a mortgage, the entire house buying process, whether rental properties are right for you or not, and taxes on real estate profits.
Basics of a Mortgage
A mortgage is a loan for the purpose of buying a house. This loan will require a downpayment of at least 3.5%, however, if you pay less than 20% as a downpayment then you will have to pay something called private mortgage insurance(PMI) to insure the lender of the loan. A 20% mortgage is known as a “traditional mortgage”. In terms of the length of the mortgage, you can typically see a range of 15-30 years, with 30 being the most common. Recently, the government just approved a 40 year mortgage, though.
In terms of interest rates you will pay, they can either be fixed or variable rates, but most commonly they are fixed, and there isn’t a ton you can do about this other than contacting a decent amount of lenders to compare rates. Don’t simply go to one lender and take their rate up front, because many lenders will match an interest rate from another lender. In times of very high interest rates it may not be wise to take on a mortgage, because if you wait a year or even longer for rates to decrease, you will pay exponentially less in the long run and not have to worry about refinancing.
The Buying Process
The buying process is really complex and has a lot of steps. The process will take a lot of time, as you can see in the timeline below.
The first step is to get a pre-approval letter from a bank or private lender in order to show that you are able to get a loan when hiring a realtor and talking to sellers. Nobody will take you seriously without one of these. Secondly, you will need to find a realtor and sign a contract to help connect you with house sellers. Realtor commissions should be taken into account, since they are 3% per realtor(buyer and seller). Next, you will want to start looking at houses and make an official offer.
When you make an official offer, you will settle on a closing date and discuss the price. Additionally, you will settle on closing prices which include processing fees, realtor fees, attorney fees, appraisal fees, etc and you want to negotiate with the seller to pay for some of these. Next, you will discuss what stays in the house, and what they will take with them. After this, you will give earnest money to a third party to hold as “collateral” essentially to the seller in case you back out on the deal later than the due diligence period, which is a period of a few weeks where you can back out any time without losing your earnest money. Earnest money is usually 1-2% of the house value.
The seller will then usually send a counteroffer after all this before the due diligence period begins, and within this period you should get the home inspected. The house will then get an appraisal on the house. After this, you will need to finalize the loan, and then close and buy the house officially!
Buying vs Renting
As you can see buying a house is a very complicated and extensive process. The closing costs usually are also very hefty compared to what you may have thought they would be. This makes us have to ask the question: is buying a house worth it?
For many people it is, but for a lot of people it is not. You must understand the closing costs and actual process of buying a house is not easy. Renting, however, is much easier and more straightforward. Renting also puts a lot of the upkeep of the house on the landlord, rather than the renter.
Buying isn’t all bad, because at the end of the day homeowners have an asset they can eventually sell for(hopefully) a profit. However, if you already invest, buying a house may not be the best decision, because you are allowing your money to grow elsewhere and not lock up the money you could have in the stock market. Especially in times of high interest rates, it doesn’t make sense to buy.
Essentially, if you don’t plan on living in the house for more than 7-10 years then it is better to rent than buy, at the end of the day. Both options aren’t amazing, but you need a place to live, and so you must look at your situation and what you want in order to decide whether to buy or rent.
Should You Buy a Rental Property?
Rental properties have their benefits, but they don’t come without any cons. I will first cover the basics, then go into the pros and cons.
Since you are buying a house, you will need to go through the same steps in the house buying process I went through above. When you rent out a property you will receive two main “streams of payment”: rent and price gains. You should, as a typical rule, try to get at least 1-2% of the house’s value in rent each month. This is a potentially lucrative return if you consider the annual percentage returns. You would get 1-2% for 12 months, so about a 12% return per year PLUS whatever your house value increases in that year.
Compared to the 10% average return of the stock market, this sounds great! However, this doesn’t come without risks or fees. Rental properties have the risk of tenants not paying, needing you to cover expenses that may pop up, and a lack of people wanting to rent is always a possibility too. Some other risks are simply market risks, since the real estate market is very fluid and it requires skill to be good at it. Think about it, in 2022/early 2023, if you were looking for a rental property you would have a hard time finding anything because of how inflated the market has become.
For all of these reasons, real estate investing can be very risky and extremely expensive. If you are not going to buy the house and hold onto it for a long time, it is not worth it, because the fees will eat into too much of the return.
Additionally, you will need to understand how rental properties get taxed. Rent payments are taxed as income, and profit off of house value is taxed as capital gains tax. However, if you use the profits to buy another house, you don’t have to pay capital gains taxes. Capital gains taxes are usually less than income tax, and so I would encourage you to look at the image below for the differences between the two.
To sum up, real estate can give you more consistent cash flow, but it is much less liquid(easily turned into cash), and you have to do a lot more to keep up the property. It also requires a lot more money initially to get started.
Additionally to rental properties, there is another form of real estate investing that can be a solid investment. REITs(Real estate investment trusts) are basically traded like a stock and contain a lot of rental properties. This can be a much easier and cheaper way to get into the real estate market. You can look up REITs and invest in them through Fidelity, Vanguard, Etrade, etc. The graphic below shows how REITs work at a very basic level.
