A rental property is an attractive option for many. If it works out, the value of the property goes up over time and you get consistent cash flow from the tenants.
It’s a job, not an investment, money expert Clark Howard says. But many people, including Clark, have held rental properties to increase their wealth.
Aside from the hassle of finding good tenants and managing the property, how do you decide if a rental property is worth it? What makes a rental property a smart decision?
Should I Buy a Rental Property? And If So, How Should I Fund the Down Payment?
Should I buy a rental property? And if I can’t afford the down payment with savings alone, should I take out a HELOC on my home or borrow from my 401(k)?
That’s what a listener recently asked Clark.
Asked SJ in Utah: “I signed a contract with a builder for an investment townhouse which will be ready in May 2024. I own my current house.
“The hope is that interest rates will go down a bit and [that I] also save money for the down payment which is 20% for investment homes as you know. I will need about $50,000 more on top of my savings for the down payment.
“Is it a good idea to take a HELOC or withdraw from my 401(k)? Current household income is $130,000. The price of the townhouse is $470,000 and is a deal in this market here in Utah. If I don’t do a down payment the $2,500 initial deposit to the builder is non-refundable.”
First, Clark says that the nonrefundable $2,500 initial deposit is absolutely worth it. That’s about half a percent of the price tag on the $470,000 home. And it’s better to risk the $2,500 than to forfeit a big downpayment if the builder gets into financial trouble.
We’ll get into what Clark thinks about raising the money for the downpayment in a bit. But the bigger question is whether a rental property is a good idea at all right now.
Key Decision: Can You Make Enough Rent To Cover Your Monthly Carry?
Clark thinks the housing market will remain sluggish for several years. That’s thanks to the aggressive rise in prices in recent years as well as the higher mortgage rates.
Home values typically rise equal to the cost of living plus 1.5%, Clark says. But in recent years values have grown much faster than that.
“You have to go back to where it’s affordable for people to buy a home,” Clark says. “Otherwise you end up like we are now with so many people on buyer’s strike. Prices went up so much from 2012 to now and particularly the last four or five years. That’s not what I’m expecting as we look forward.”
So you need to discount the potential that the property will be worth significantly more in a matter of years from your decision.
“Whether it makes financial sense for you to buy this as an investment property should be based on what rent you can earn on that property,” Clark says.
“What rent can you earn vs. the monthly carry on it for the cost of the loan you have, which is a higher-cost loan because it’s an investment property?”
You’ve got to consider the opportunity cost on the $2,500 deposit. The property taxes. The homeowners insurance. Maintenance. All the hidden costs that go along with home ownership.
“If you are upside down each month [in] effective rent vs. what you’re paying for it, I don’t advise going forward with the townhouse,” Clark says.
Wall Street enterprises — giant corporations that were buying thousands of homes to rent out — have stopped adding to their inventory “because the numbers don’t work for them” in the current market conditions, Clark says.
“And that’s why buying an investment property at today’s prices is a question mark. Not necessarily a great decision,” Clark says. “It may work out fine. It’s just more risky than it would’ve been in the past.
“So I would really think through the numbers on this purchase before you move forward.”
Securing a Down Payment: HELOC vs. 401(k) Loan vs. Home Equity Loan
Back to SJ’s original question.
SJ wondered whether to cover the additional $50,000 needed for the downpayment via a HELOC or by borrowing from a 401(k) account.
“I would say a third [option]. Go to a credit union,” Clark says. “And my favorite product for this is a five-year home equity loan.
“Use rent from your tenant to pay off that five-year home equity loan over the next 60 months. Because it has a fixed rate. The HELOC is a floating rate.
“There’s the possibility interest rates go down — I believe they’re going to go down — what if they don’t? What if they go the other way? And you have a floating rate on that money that you need to borrow for a down payment.”
Final Thoughts
Is a rental property worth it?
Many times, the answer is yes. That’s assuming home values aren’t inflated. And that you don’t have to do anything significant or risky in order to raise the capital for a down payment on the property.
However, with home values expected to grow more slowly in the next several years, Clark isn’t so sure now is the time to buy a rental property.
If you do it, he suggests making sure you can make enough money from rent to clear your monthly expenses including the mortgage, homeowners insurance, property taxes and maintenance.
