Making Changes at Home Can Be a Wise Investment
When it comes to getting a decent return on their investment dollars these days, for many people there’s no place like home.
Homeowners with money to invest and no desire to put it into financial markets have two strong options for boosting the investment in their houses: paying down their mortgage and improving the property.
And if you’re looking to sell your house, you may be able to use it to generate a long-term income stream at attractive returns.
Here’s a look at the risks and potential rewards of these three ideas:
Pay Down the Mortgage
Paying off your mortgage ahead of schedule is the easiest way to invest in your real estate, said Marc Eisenson, co-author of “Invest in Yourself: Six Secrets to a Rich Life.”
You can do this by following a formula that frees up extra cash to pay down the loan, or by using any discretionary income you have left at the end of the month to make higher payments on your loan, he said. “It is truly a self-directed investment,” Eisenson said. “You can invest a dollar, or you can invest $100, or $1,000. It’s completely up to you.”
The return on this investment can be as high as the interest rate on the loan: If the rate on the mortgage is 7%, that’s a 7% return on the principal you pay off.
For those who itemize deductions on their tax returns, the payoff is less because mortgage interest is tax-deductible. Still, the effective rate of return--ranging from about 4% to 6%, depending on your marginal tax rate--remains higher than yields on most high-quality fixed-income investments today.
“Just $25 a month will save you roughly $20,000 in interest on the typical 30-year mortgage,” Eisenson said. “That’s $20,000 that you can then use to pay for college or take a nice vacation.”
A big advantage to a self-directed pay-down plan is that you aren’t locked in. If the investment landscape improves, you can shift the extra dollars into higher-return alternatives.
By contrast, if you were to refinance your mortgage with a shorter-term loan--say, over 15 years--you might get a lower interest rate, but you’d be committed to a higher monthly payment regardless of what happens in the investment environment or in your personal financial life.
Making additional payments is as easy as adding $50 or $100 to your mortgage payment each month--or even just rounding the payment up. A person who has a $100,000 mortgage at 7%, for example, would pay $665 a month over 30 years. If that person could start paying $700 a month, the loan would be paid off about five years sooner and save some $23,000 in interest.
There is one potential downside to boosting your equity stake in your home: It can be difficult to convert that equity into cash when you need it, said Judith Martindale, a financial planner in San Luis Obispo. That’s why a lot of older people are cash poor and house rich.
The solution: Secure a home equity line of credit, which provides pre-approved borrowing power that can be tapped when you need it.
Improve the Property
Every home costs money to maintain. Beyond regular upkeep, many homeowners eventually entertain the idea of expensive remodeling or other improvements, with the goal of boosting the resale value of the property.
Many real estate agents advise clients planning to sell their homes soon to invest a few bucks on landscaping, painting or a thorough cleaning to get a higher price and faster sale.
“Realtors call it ‘staging’ a house for sale,” said Carl Adams, director of the seniors division at Dickson Realtors in La Canada Flintridge. “It can make a difference of many thousands of dollars in the sales price.”
But agents also said it’s sometimes hard to determine whether an inexpensive spruce-up made all the difference--or whether the house just hit the market at the right time.
More expensive remodeling or improvements--room additions, for example--can vary substantially in terms of how much resale value they will add to a home. There always will be some emotional payback from improving the house you live in, but experts caution homeowners to be careful about overestimating the kind of financial return they may earn on expensive projects.
For example, some “sweat-equity” projects do nothing to boost a home’s value and may even harm sale prices.
“You see people taking beautiful old Spanish houses and trying to turn them into 20th century modern homes,” Adams said. “It’s just a disaster.”
Projects that go largely unseen, such as replacing pipes with copper plumbing, rarely add more to the sale price than they cost, he said. That’s because buyers generally take good pipes and wiring for granted.
Even adding a pool, which can greatly improve livability, seldom increases a home’s sale price enough to make up for the often substantial cost, experts said.
If your goal is to boost the resale value of your home rather than simply make it more livable, Adams suggested consulting a real estate agent before undertaking a major project. These consultations generally are free--done to build goodwill among potential clients--and they can save homeowners from making costly mistakes.
Remodeling magazine does an annual survey of which remodeling projects return the most money. The survey prices 10 popular projects and then asks real estate agents in 60 U.S. cities to estimate what the projects would return in higher resale values.
In Los Angeles, for example, a minor kitchen remodel more than paid for itself, providing a return of about 15% on its $17,331 cost in one year, according to the magazine’s latest survey. But putting in a new sun room cost more than it boosted the sale price, the magazine found.
By and large, expensive projects don’t pay, beyond what they provide the homeowner in greater livability. In fact, adding a family room--a project that would cost about $57,000 in Los Angeles--is likely to boost the sale price by less than $50,000.
Carry Back a Mortgage
Adams, who works primarily with senior citizens who want to “trade down” to smaller, less expensive homes, has been encouraging some homeowners selling their houses to consider financing the sale themselves.
The real estate term for this process is called “carrying back paper”: In essence, you become the banker, providing financing to the person who buys your house.
Why? In the foothill neighborhoods where Adams works, many older folks are living in homes worth $750,000 or more, he said. The houses are long paid off and too big for elderly empty-nesters.
But a seller who gets $750,000 in cash is likely to owe capital gains taxes on at least a portion of the take. Then there’s the problem of finding somewhere to invest the money to get a decent return.
By agreeing instead to hold a mortgage from the buyer, the seller can get an annual interest return of 6.5% to 7%, secured by the house they may have lived in for decades. That could be a viable option in a market in which most other high-quality fixed-income investments are returning less than 5%, Adams said.
Moreover, by carrying the loan, you essentially are doing an installment sale. You still own the home; you simply are selling it to the new occupants over time.
That means you postpone the bulk of the tax bill from the sale. The seller owes taxes on only the portion of the gain received in any given year, Adams said. That’s likely to be a small amount when the sale is stretched over 10 or 15 years.
At the same time, buyers often like the arrangement because sellers rarely charge “points” or fees, which can make the process more cost-effective for both sides.
The big caveat: the risk of foreclosure. If the buyer stops paying on the loan, you’ll have to foreclose, which is an arduous legal process.
To reduce the risk of foreclosure, sellers should do three things: get a substantial down payment (at least 20% of the sale price); have the buyer fill out a loan application; and get a copy of his or her credit report.
A big down payment helps ensure that the seller gets a sizable chunk of cash up front. It also puts the buyer at risk of losing a significant sum if payments are missed and the seller forecloses.
Meanwhile, the loan application should list the buyer’s income and assets, which tells the seller whether the buyer has the ability to pay. The credit report tells you whether the buyer has a history of stiffing creditors.
“There are a lot of wealthy people who don’t have the desire to pay their bills,” Adams said. “You can’t just say that they’ve got a lot of money, so they’re good for it.”
The seller also needs to prepare home loan documents--just like a bank--that spell out the terms of the deal. Many sellers would benefit by having a real estate attorney involved in the process to review the transaction.
It’s a lot of work, Adams acknowledged. “But I don’t know where else you can go in today’s market and get a secured return of 6.5% to 7%.”
