Monday, June 20, 2016

Oops, We Have a Mortgage Again

That's the title of our terrible Brittany Spears spoof. But it's true, kind of. After aggressively paying off the mortgage on our primary residence a mere three years after buying our first home, mostly thanks to Dave Ramsey and his crazy baby step number six, we're now in the process of a cash-out refi and tapping that equity, so we can end up right back where we started with a one hundred thousand dollar mortgage.

No one ever said we knew what we were doing with money.

Why would we do such a thing? Isn't being debt free just the bee's knees?

As with most of the big financial moves we make, there isn't one single and satisfying answer. Instead, we have are a few smaller answers that join up, like a Voltron made-of-dorky-financial-answers, and, together, help make good financial decisions and, you know, defend the universe.

Debt Free Ain't All It's Cracked Up to Be
I suppose debt freedom is supposed to feel something like financial nirvana but, if it ever was, it sure wore off quick. After paying off the mortgage back in 2013, we've regressed back to the emotional mean, or at least forgotten whatever having a mortgage and a monthly bill feels like.

For better or worse, there isn't an emotional desire to be debt free any longer.

Opportunity Costs
It's nice to avoid paying the interest rate (4.25%) on our old fifteen mortgage. But since the market historically performs better than that, especially over a 15 or 30 year mortgage period, there isn't a great logical reason to pay off a mortgage early since that typically will only increase your opportunity costs.

In short, paying off our mortgage early was not an optimal financial decision. But since those are sunk costs, gone forever with nothing to do about it, all we can do now is evaluate what's best going forward.

Luckily, the same analysis applies. If applying extra funds to investments instead of a mortgage payoff was a good strategy before, it also applies to getting a mortgage and investing the funds now (with one caveat that we'll get to later).

Money is Cheap
It doesn't hurt that the rate we locked in at is now even lower than that of our first mortgage, at 3.625%, and that's on a 30 year mortgage instead of a 15.

Now, there are definitely some upfront costs. Factor in the underwriting, appraisal, title insurance and other various fees that unfortunately come along with a mortgage, and we're looking at around three grand to borrow $100,000 of our own equity. Not great.

But, the money we invest should make back this three thousand in fairly short order. Certainly we should come out ahead over thirty years.

Arizona Property has Rebounded
When we purchased our home in 2010, we bought it for $132,000. We conservatively figure the house is worth $100,000 more now, somewhere around $230,000.

Depending on how comfortable you are with mental accounting, you could say that we're borrowing the $100,000 from the property's gains, rather than the $100,000 we used to pay off the original mortgage. While that sort of thinking is a shell game, it's a fun and somewhat comforting one for this homeowner to play.

Buying another House and, I suppose, Another Rental
The reason we're tapping this equity now is that we want to buy another house, a new primary residence, and to turn our current house into a rental property. We will try to start a family in the next year or two, and we'd like a house that would better suit us when we have a family (better school district, maybe something newer without lead paint, etc.). And, if we're being real, this first house was our starter house. We want a nicer kitchen and bathrooms, a little more space, and just a nicer home all around.

If we take out the loan now, we get a better rate than if we no longer live in the house and it's already a rental (by about a 1% difference in rate, since rentals get worse mortgage rates). This has a couple benefits for us. One, the rental will perform better if we have lower costs for the loan (coupled with the fact that we'll be local and can choose to be our own property managers, if we want to). Two, this also allows us to use some of the funds from the loan to serve as the down-payment for the next house. So, figure we will invest about $40,000 of the $100,000 borrowed, and use the remaining $60,000 as a down-payment. (I know this is typically not advisable or even allowed with some banks, but it's technically "our" money that we're accessing via the loan and, hey, the underwriter is already on board.)

The Bottom Line: We're Leveraging Up
After being anti-debt proponents for so long, we're going in the opposite direction and borrowing, both for our primary residence and for what will be our third rental property.

This has risks, as does all borrowing. Simply put, we are going to have four mortgages to pay, instead of the two we have now. To share some numbers, here is what our total debt will look like after we have all our loans:

Rental Property 1 (Indianapolis): $71,000, renting for $1,125/month
Rental Property 2 (Indianapolis): $64,000, renting for $1,000/month
Rental Property 3 (Scottsdale): $100,000, rent TBD (estimated between $1,100 and $1,300/month)
Primary Residence (probably Tempe): TBD, estimated between $240,000 and $280,000 ($300,000 to $350,000 purchase, with 20% down)

My thoughts on this debt falls into two buckets. For the rental properties, I'm completely fine with taking on debt when the numbers point to an income producing asset. Leverage makes the rentals more profitable and limits opportunity costs. We aim to limit the debt so that the monthly payments are so far below the monthly rent that we're able to save 20% of all rents just to save for future maintenance and vacancy, while still pulling good profits from each house. Adding a third rental will actually add to our income streams, bringing in another few hundred a month.

It's the next primary residence that I'm not quite as sure about, from a purely financial sense. We want a new house, without a doubt. The decision is in large part emotional or want based, since our current home is fine: it keeps the water off our heads, has three bedrooms and two bathrooms (though no suite) and is in a good neighborhood that doesn't even require us to lock the doors when we leave the house. We just want something nicer. A bigger kitchen with an island and fancy counters and cabinets made of solid wood, and a big old farm table in the dining room that we can play board games on.

But despite our genuine-but-first-world wants, I'm still not entirely sure how they fit into hitting financial independence in five years. Shamefully, I haven't run the numbers, because I know that buying an expensive house doesn't make reaching financial independence easier. It probably means working beyond our initial timeline so that we can pay off that new big mortgage.

An alternative might be to fix up our current home: putting in a new kitchen, renovating bathrooms, and maybe even an addition so we can have a big master with a suite. That has costs, too, but nowhere near an additional $300,000 or $350,000.

We've noticed some lifestyle creep in our lives in the past two years, like fancier groceries and more international vacations. But this new house would be a major deviation, as it would add a big honking four figure monthly expense to the budget, at least until we pay off the big honking six figure debt.

What do you think, readers? Are we foolish for leveraging up on our current property?

More importantly, is the loan for our current property potentially acceptable, but ought we reconsider buying a more expensive primary residence so close to early retirement?

Honest opinions are genuinely welcome. We are not seeking affirmation of our current plans but, instead, wise counsel from trusted readers. Thank you, as always, for reading.

*Photo is from Nick Kenrick at Flickr Creative Commons.


  1. Two things I don't understand. Why would you want to turn your first house into a rental. Isn't the whole refi plan to get the equity out to higher performing assets? Keeping the house as a rental eats up the tax free gains you have for a personal residence and the returns are probably better elsewhere. Why did you opt for 30 when you can easily get a 5/1 ARM for a % or more less? In 5 years you will have enough cover whatever mortgage you take.

    1. Hi Tim. Good questions there.

      The short answer for why we're keeping our house as a rental is that we like it and we want to. :) (Specifically, my wife really wants to keep our first home). But the more complicated answer is that our current rentals have each given us double digit returns so far, and that's with the cost of a property manager in another state. We can manage the property locally ourselves, so we anticipate higher returns. We'll see, of course. Plus, rental properties provide regular income with their own set of tax advantages (i.e. - depreciation), which is a nice balance to our stock and bond investments. And we can always decide to sell the house later if we so choose. We could potentially move back in to the house for a while, as well, if we were particularly worried about capital gains (or, depending on future rental opportunities, we could try for a 1031 exchange).

      As for why we didn't take a five year ARM, we're happy with the long term 3.625% rate rather than messing with teasers and adjustments for an extra percent off of a $100k loan. What will rates be in five years? If you know that, you're a lot smarter than I am. :) But since the plan is to keep the rental long term, we like the simplicity and long term low rate of a 30 year. Of course, many roads to mecca.

      If you're asking why we wouldn't just pay off the ARM at the end of five years, well, that's the same reason we didn't think paying off the mortgage early was a good decision: opportunity costs. And, depending on where the money was coming from, capital gain taxes. Since we wan to keep the rental long term, we also want to keep the mortgage long term.

    2. Just to add on, I hear what you're saying about the house not being an ideal rental. Even though, after the refi, we'll only have put less than $40k into the house (our original downpayment, plus closing fees x2), that doesn't tell the whole story. Since the house has appreciated, a sale is almost assuredly the best option since we'll get to tap all that equity, rather than just $100k.

      You're absolutely right: from an opportunity cost perspective, we're way better off selling.

      I can only say I've tried that argument, but sometimes what my wife wants is just the better option. :) And I can see her point. We can always sell our first home later, but can't get it back.

    3. Yea I get it just show her a picture of your current house and a picture of the one you could afford if you sold the one you are thinking of renting. The uncertainty of interest rates is exactly why I opt for ARMs right now. The break even point for the cost to refinance to a 30 year is about 2 years if I ever get worried about rates getting to a point that I don't want to be involved. Either way if the economy is strong enough to handle those rates my other assets will have appreciated that much more.

    4. I like the way you're thinking. Arbitrage is not something that comes easily to me.

      I suppose I'm still not sure of why the ARM is better long term, but I'm probably just missing something. If the 30 year rate is locked at 3.625% and, let's assume, only going up from here, and the ARM's savings of one percent is only 'in play' for a few years up front, isn't it possible that over the 30 years the ARM & the extra refinance strategy might come out behind?

      Will try your strategy with the photos. :)

  2. Hmm... well first thought, which has absolutely nothing to do with this post is: Good Lord you guys are experiencing serious end of the world weather down there!!! I trust you're staying cool and not considering anything stupid like going for a hike or bike ride in 120 degree weather.

    In terms of the house situation, well... it sounds like a trade off to me. Here are a few thoughts.

    Once I stopped working my perspective on things like vacations and home improvement changed dramatically. It's hard to underestimate the impact that free time has on one's psyche. I think you're sort of in a chicken and egg situation at the moment where you're trying to plan for day to day realities that are sort of difficult to conceive of right now. What will life feel like with kids? How will you feel about living space, renovations, etc once you don't have the pressure of a job to go to?

    I'm not saying that I don't think you should buy a new house right now, but I am saying that your priorities in a home could change dramatically and in ways that are difficult to imagine once you hit FIRE.

    When I was working, I spent much more time traveling around town than I currently do, so "stopping by" places like the bank or grocery store was easy and part of my routine. But once you're no longer out and about on a regular basis, you'll probably find that having those sorts of things closer to home is a priority. That's just one example, but trust me, your life will change in ways that are hard to imagine once you no longer have a job to go to.

    The other thing to consider is that "new" does not always equate to "quality" where homes are concerned. CatMan lives in a neighborhood that's experiencing a huge building boom. He's near one of the new light rail lines, so it's suddenly a very desirable neighborhood. The people next door had a small house on a big lot - they sold it to a developer who tore down the little house and put up two huge new McMansions. On the surface they look beautiful - and they sold for nearly a million dollars each, but he got to go in and see them being built and they basically used really cheap materials that will probably fall apart in a few years. So just beware... all that glitters is not gold in a new home.

    Anyhow, those are my thoughts. Hope you're staying safe and cool!

    1. Yeah, the weather is just not great right now. Broke a record yesterday, and was the fifth highest temperature on record here...ever. No bueno.

      I definitely hear you on the new not equaling quality. I think I'm just a little scared about lead paint, and the obvious problems that might cause the little one when he starts chewing on baseboards and door jambs. But I'm actually partial to homes built in the 1950s and 1960s. Maybe abatement is in our future.

      I hear what you're saying about our needs and attitudes changing, too. I just don't know how to deal with that now. I suppose the optimal approach might be to wait to buy until we're FI and have this family. We'd have to deal with the 1950s paint in our current house in the meantime, but maybe that'll be good, honestly.

    2. Ah, so CatMan is a Seattle-ite huh? Educated guess. I am as well. The Seattle area is booming and (famous last words) I really don't see it letting up for years. It is a perfect storm of international investors, Amazon taking over the world, Starbucks/Microsoft/Costco and other major HQ corporations operating at full employment. Also, it's cheaper than the Bay Area by far (and no income tax) so plenty of Bay Area institutions are building "satellite" presences in Seattle (because many tech folks in Seattle don't want to leave). It also has great schools all within (relatively) easy commuting distance. In fact, Bellevue is the only city in America with four public high schools in the Top 100.

      Related to today's post though, I'm a huge proponent of rental real estate in general, particularly once you're fully funding your retirement vehicles (401k's and such). More specifically, I believe in rental real estate in major metropolitan areas with great jobs and great job prospects moving out for a couple of decades (think to yourself, if you were graduating from college today with an in demand degree, which cities you would most likely move to, and be honest). And as I said in a different post, buying in good school districts is a great "protect your investment" location decision.

      So net net, I do a ton of BiggerPockets podcast listening these days, and I do believe in the TAX ADVANTAGED power of rental real estate investing, BUT pick your market carefully.

      I have no idea if I would be so enthusiastic about Arizona or not. I was in Vegas a couple of weeks back (I go every year to visit relatives) and thought to myself, "This city may be screwed in 30 years. Running out of water. Hotter earlier in the year. More hot in general. Etc." I don't think I would feel as comfortable owning real estate in the SW. But that's just my Emerald City paranoia coming through I imagine :-).

    3. Actually, CatMan and I are both in Denver, which is booming beyond belief right now. I do have to say, if I had bought four houses instead of one back in the early 1990s, I'd be rakin' in the dough!

      Question about owning rental properties (for anyone out there) - I know a handful of folks who have done it, and all of them have absolute horror stories about nightmare tenants who wouldn't pay the rent, literally tore the places apart and had to be forcibly evicted. Even in the best of circumstances there were your midnight plumbing disasters and a whole host of other maintenance issues. Frankly, it doesn't seem like a very "passive" way to earn income to me. Is there a secret to doing it successfully? Does using a property management company solve all of those problems? Just curious how people are making this work.

    4. Yes, my best friend is in Denver. I would say it falls into the handful of cities I think have a bright present and foreseeable future. I didn't realize it had new light rail stations as well.

      Passive is a tax treatment, not a measure of effort :-). That being said, the most important part of being a landlord (besides buying a smart property at the right price in the first place) is your tenant evaluation process (and reference vetting!). Maintenance issues are sort of on you in the first place (i.e., what quality is the place and how do you maintain it). It's not for everybody though. Getting the right tenant(s) is key.

    5. This comment has been removed by the author.

    6. Hey, Tin:

      We're definitely maxing out all retirement accounts and then some, though Mrs. DB40 doesn't have a retirement account yet since she's still in school, so we're definitely missing out on some tax advantages. I completely agree that selection of market matters.

      We bought this home in AZ in 2010, and the prices have risen to the point that we wouldn't be able to find a good rental property here now. But, our logic is that we purchases at the 2010 price of $132k, which makes a profit possible. Some mental accounting is involved, I think.

      We share some of your views on the region re: water. Though currently residential use is not even 10% of all water used, so there's quite a lot of slack in the overall system. Agriculture is taking the lion's share, and if things got to the point that residents were hurting for water, I'm sure adjustments could be made.

    7. Hi EcoCatLady,

      Funny you should mention that: we're going through eviction right now with one of our tenants in Indianapolis. They dutifully paid their rent for two years, agreed to re-up for another two years on a new lease...then went AWOL and simply moved out without notice.

      The property manager makes the process much easier than I think it would be otherwise, but its still takes up some mental space and leads to decision fatigue. Overall, I think it's a fairly mediocre deal to hire a property manager but with an out of state rental, it's just a necessity. Locally, we're going to try to manage this one ourselves and save 8% or 10% of rents, too.

  3. Love the title! Ha ha. Your sense of humour rocks :)

    Wow, you guys have 3 rental properties? Arizona properties must be really undervalued. If we ever tried that in Toronto...we'd be completely screwed.

    Just wondering, are you planning to do what Paula Pant from Afford Anything is doing? Real-estate investing?

    1. To be fair, both our current rentals are in Indianapolis. We bought them in 2014: one was just over $90k, one was just over $80k. So, yeah, cheap little rentals that throw us a couple hundred bucks a month. Nothing to get rich off of, but we sure do like the income aspect of them...kind of like a monthly dividend.

      The plan we're contemplating would turn our AZ home into a rental, while we move to another. As Tim rightly points out, this is probably suboptimal financially. But hey, it's our first home, so we have some emotions tied up in it. Both of us kind of like the idea of keeping it in the family.

      We are big fans of Paula Pant (I was even on a couple podcasts with her, which was, like, a small dream come true). As with all our financial mentors/examples, we try to borrow from her ideas and tactics.

  4. First congrats and all your progress so far. I have been following your blog for some time now and it inspires us to do more in pursuit of FIRE. My honest opinion is probably one you don't want to hear. We are at the other end of the spectrum. We've have three children, all still minors, and have upgraded our house. It is very nice and we love it. There in lies the problem. We love our big nice house and can't imagine leaving it to downsize. We have both said if we had to do it over again we would have stayed in a smaller house like our first one and just lived debt free. Paying off a much larger note is so much more difficult than our first house would have been. Honestly I am not sure we would follow our own advice because everyday you would be reminded that your house is still smaller and not as nice but as someone who has forever left on his current mortgage, I would think twice. Just my two cents. Best of luck and thanks for your posts.

    1. Thanks for the kind words, iFreebies. I'm so glad that our blog has some value for readers like you.

      I like your perspective! We very likely are just trying to manufacture happiness via a home purchase, which we know is likely to be temporary. Eventually, everything just regresses to "normal".

      I'm going to share your post with the missus and see if we should maybe just reconsider our current home.

  5. I can understand what you are doing, particularly if you have no other debt. I have often thought about the same thing with us. I like our house, but I believe that we will move to another home in a better school district in a couple of years. Our problem with that plan is student loan debt. That is what keeps me from going down that path. However, if that were gone I think I might follow a similar path even though I am not a handy person.

    1. I'm not (yet) a handy person either, jason. I think that's part of what's driving us to select a mostly-remodeled home, which is a bit more.

      For what it's worth, I think student loans are much better debt than house debt. Student loans have a positive ROI (higher starting salaries, higher wages, more resilience to recessions) are probably more dubious, except in the case of very certain rentals, and even then it's tricky.

  6. Hey, friend!! My only piece of advice would be that if you do make the leap, to buckle down big time for a couple of years and get that new mortgage paid off ASAP. Do you have a financial SHTF backup plan, say, for if one (or both) of your jobs went bye-bye or if the American economy hit the skids?

    1. That's really sound advice, Laurie.

      We do have a pretty healthy emergency fund and it would grow to account for our higher monthly costs. But our SHTF plan is usually to rent out a room to help defray the cost of the mortgage. In a worst-case scenario plan, we would access our investments that, mostly, are in taxable accounts.

      As for quickly paying off the mortgage, I think we have a rough plan to try to hit our retirement number (currently $1M) and then pay off the primary mortgage. Basically, the 1500 Days plan. :)

  7. I'm not debt averse if the money is going towards an investment so I think your plan is good. Leverage can be a good thing. I have to say that I'm always jealous of housing costs in low cost of living areas. Even the more expensive house would is considered inexpensive here. And your rental properties in Indy look good...I'm going to e-mail you for more details as I may be looking in that area in the future!

    1. Please email anytime! Would love to share our story, though it's not all positive, of course. :)

      I know what you mean about it being a low cost area. Perspective means a lot. To us, $350k sounds outrageously expensive now, since our last home here was $132k. But to someone in NYC like you, $350 still is crazy cheap, I'm sure.

  8. A 100K mortgage doesn't sound so bad! We still have a mortgage. We prepay it fairly fast and pay extra every month, but I plan on riding it out for another 9 years or so at this point. We small mortgages on our rentals too but that has never bothered me.

    1. Thanks, Holly. I'm less worried about the $100k mortgage on our current house than I'd be about the $240k+ mortgage on a second one. I'm thinking that latter piece is the real risk.

  9. I agree with Holly, a $100,000 mortgage isn't the worst thing you could do. At least you're adding to your already impressive rental property portfolio!

    1. True, more rentals are good. :) Though I think we'll hit the point of "enough" pretty soon with rentals, too.

  10. Hi DBF,

    First of all: Thanks for posting that video of VOLTRON!!!! :)

    I had a toy of that when I was about 3 years old and I never actually knew what the hell it was. Now I know!!!! Was that a popular cartoon in the states back in the day then as I don't ever remember seeing it over here!? Or maybe my memory is just rubbish.

    Anyway that has genuinely made my day. My mum still has the toy at hers in fact and my nephew still plays with it so now I can tell him what it is next time we're both round there... :)

    As for the house thing, it sounds like you are pretty much set on doing this and I'm definitely one for just doing what you feel is right so I would say go for it. I'm sure once you are in the next house you won't fall for the constant upgrade trap as you are far too savvy for that! Just gotta know when you "enough" is and if you think that is just one step up from what you currently have then have at it.

    I'm more than happy in our current house but only been here just under 2 years... come and ask me in 5 years time once TFS Jr is a tearing around the place and possibly with sibling in tow and then we'll see what my answer will be! We all know what the trade offs are being in the PF/FI crowd so we won't take these decisions to upgrade lightly, especially not as a default option which is what most people seem to do...


    1. Hi FIREstarter!

      So glad someone else was a fan of Voltron as a kid. I don't know how popular the show was with the country as a whole, but man, it was popular with my grade school classmates in the mid eighties. I remember my Voltron figurine to this days, with the broken wing and the scraped paint from me throwing it around my house and into the walls, convined it was actually flying...

      I don't know if we're set, honestly. I know it's suboptimal financially, so we may end up just renovating our house with some of those funds instead. A new kitchen and bathrooms done DIY may not cost us that much, and would make us feel a lot differently about the house.

  11. Lol, my sister and I used to watch Voltron after school. There wasn't much on TV in the 80's. I heard a lot of "wants" in your post. That's not necessarily bad. You do acknowledge that you might have to work a couple years past your goal date. I have one rental and every once in a while I think about getting another but I know it would put off my early retirement date even more. I'm 44 and hoped to semi-retire at 45 but now it is looking more like 47 if I want to do more on my "want" list. I've been thinking about refinancing or getting a HELOC for a new kitchen in my house before I sell it. I think I am too emotionally attached to it to rent it out. I'm a horrible landlord and learned my lesson the hard way. Property managers all the way for me. So, what am I trying to say...try to align your long term goals with your short term goals. And get tax advice on the rentals if you don't already know that stuff. It might make a difference.

    1. I hear you Daizy, and it's definitely a want driven decision right now. I think we may need to just tap the brakes and just see how we feel about the whole thing after a few months.

      Wants are fine, but they're not rational or even likely to give us more happiness in some cases.

  12. I would have raised cash for a year or two then buy the personal property, then again I know you want to have it now plus you will have in your mind all day now if you don't buy it. Personally, I bought a new home a year ago, and my previous is now rented to family members. I would wait a couple of years anyways to buy a property now, its seems like we are on top of the market right now. Either way you are doing it because you can and no one else is on your shoes.

    Another option would be to get 100k from your house and buy two other rentals instead of a primary residence. Then raise cash again and buy your primary residence, by then prices may be better who knows, whats happening in the markets may be a sign.. either way a 5% to 15% may occur soon as it always does every 7-10 yrs.

    1. I also suspect we may be in a housing bubble. Hard to know when it will pop, but I fear our friends in the great white north may help bring the needle to the bubble.

      I definitely don't think I'll be buying two more out-of-state rentals, given what's recently occurred with one of ours in Indianapolis. But that's a story for another day. If we go with another rental, I think it will have to be local. Given prices these days, that probably means our current house, which we purchased for a song back in 2010.

  13. Love it!! This is exactly how we acquired 30 rentals by the age of 30. I just started a blog on the adventures. Check it out!
    I will definitely be following your blog!