Inherited House - Questions about Equity

[EleqTrizi'T]

Hello,

My wife and I just inherited her uncle's house. It's worth about $250,000 here in California...so it's a small house However, we're taking out a small home equity loan of $75,000 to pay for improvements. We actually are only going to need $50,000 of that dough, so we were thinking of just using the rest to pay the loan back. However, my neighbor stopped by and got me thinking....

He says we should pull out as much equity as possible, and roll it into investments (CD's, IRA's, etc). Since the interest on the mortgage would be 5.5-6%, we could make money on a higher interest investment. Plus, the taxes of the mortgage would be tax deductable, giving us even more profit.

His advice was to just to make sure we have investments that mature at the proper intervals so we never have to pay the mortgage out of wages. So we'd start off with a 3mo CD, a 6, 12, 24, etc.

It all sound too good to be true. Is it really that easy for me to make money off this inheritance? I don't need you guys to give me too many details, but if it is possible, tell me so I can get to a financial advisor ASAP. But don't forget the warnings of pitfuls that I might not know about.

I've never had this kind of money available... so when it comes to finance, I don't know what I don't know.

Thanks.

[NoSoup]

Well, with IRA funds, you wouldn't be paying the mortgage with those payments, as you are penalized substantially if you do anything with those funds unless specified exceptions prior to retirement.

Your neighbor, in theory, is correct - however, it is a lot more complex than he would make it seem.

With an equity line, it is likely that the rate is going to be variable, and if that is the case, it pretty much shoots down his plan right there. If it is a fixed rate, it makes it a bit more feasible, but you should consider talking with a tax advisor to see if it is beneficial to you.

Paying down the mortgage will result in a lower payment and more equity, basically. If you take out additional funds to invest, you want to make sure that the amount of the mortgage payment + tax benefits received is greater than the amount you would earn in interest - taxes applied for income and/or capital gains.

It would be extremely difficult to do in the short term, as I don't think you'll be able to find a short term (3 month) CD that has a rate anywhere near what you would need to get to even break even. In fact, I would actually be surprised if you find anything less than a 10 Year that would even allow you to break even - but keep in mind I live in Wisconsin, so the market may be different around here...

If you have a free and clear house, you may want to look to other options to gain income from the property. Fixing it up and selling it, for one. Or, you and your wife could possibly live in it. Another option you may want to take a look at is renting it out. In most cases, having a rental property will beat the pants off of any Certificate of Deposit you'll find in return.

If you are considering selling it right away though, you may want to consider if fixing it up is going to get you additional profit. Around here, at least, if you aren't able to do a substantial amount of work yourself, it is likely that you will not be getting an increase in value dollar for dollar the amount you put in.

Hope this helps - If you have any more questions, just let us know

[DDDDave]

First off.....congratulations......I always thought those stories of a rich uncle were BS....apparently not.

Do you live in this house? It does make a difference. If you do not live there then you can look at it as a cold, hard investment decision. If you do(or might) live there, you have to take in all the decisions regarding where you live...proximity to work, school, size of house, room for growth, neighborhood, etc.

As NoSoup was trying to say, you will not come out ahead borrowing money to reinvest in short term investments. Simplifying things greatly - borrow @ 6% - 1.5% mort. int. deduction = net 4.5% borrowing costs ; get 4% CD return - 1% income taxes = 3% income. That still works out to be only a net 'cost to borrow' of 1.5%. If you have a need for cash (start a business, buy an appreciating asset, college education) this house is a great source.

What it can also be is a great source of peace of mind. You say the house is worth $250,000. You could go to any bank or credit union and borrow say $75,000. You would not really need to 'qualify' for the mortgage as the Loan-to-value is low enough that they would basically just make you sign for it, with the house as collateral. Using the calcs. from above, the peace of mind of having $75,000 invested in a couple of accounts containing CD's and a reasonable stock/bond portfolio would cost you +/-$1,000./year. You would know that should anything happen, you could just sell some stock and you could raise cash quickly.

You need to remember that there will now be taxes and insurance on the property (whether you live there or not). You will want to be able to access some cash when these bills come due. If you do not want to go the way of a full-blown mortgage - then a home equity line-of-credit might be a more palatable option. You are approved for a loan up to a certain amount using your property as collateral. You start off at zero and the amount of the loan increases as you access the money. These accounts are usually accessed with what are essentially checks. It makes it very easy and quick to get to the money should a need arise. A lot of times these accounts are 'interest only' loans but the rate typically varies with the prime rate.

There is a ton of information available out there concerning these investments and strategies. Use it. It sounds like you are in a very enviable position. Don't makeany decision in a hurry.

Good Luck and again.....congrats.

[EleqTrizi'T]

Thanks for replying.

We do live in the house. The house is in an outstanding neighborhood. The school district really props up house prices where I live because the neighboring district is in financial ruin, yet ours is one of the best in the nation.

Basically, having the house allows us a total of $2600 in free cash every month, even after other investments, such as setting aside over $500 a month toward 401K at work.

I guess I have a lot of research to do. I'm doing my best to leave the Corvette at the dealer and plan responsibly.

[gar1976]

From a practical financial standpoint, I'd probably leave the house equity alone if you can. Never can tell when something might happen (lost job, illness, etc.) and you don't want to be caught in a position where you can't afford to make the mortgage payments because you need the CD income for a different reason now.

I see plenty of clients leveraged to the hilt - not having a mortgage payment is a huge step up and out from the middle class. Save what you would otherwise be sticking into a bank's profit and invest in your 401K or stock market. Or buy a rental property (du/triplex).

[Yakk]

You cannot get a guaranteed investment that will return more than a morgage costs, assuming the period and rate flexibility of both are equal. If you could, banks would buy that investment instead of lending you money.

You can use the lower interest rate from the extra equity to make leveraged investing more profitable. But it won't be risk free.

If you want liquidity, get a home equity line of credit (HELOC), and use it in case of emergency. If you have any debts, roll it into the HELOC, which will almost certainly have a lower interest rate, and move your payments on the debts into payments on the HELOC. If done properly, this can make you debt free very quickly.

I am not a professional, so take my advice with a grain of salt.