Net Worth Challenge

I received a good question from one of our readers and wanted to respond to it through a new post. (In reality, my response to the comment was getting lengthly and lended itself best for being it’s own post!) Thank you for your questions, Tony — you’ll find my answers below!

Tony said,

on March 22nd, 2007 at 3:24 pm

Congratulations on your purchase.

By the way, what is the state and general area of your property for the purchase price of $73,600, if you don’t mind me asking? Around my area, it’s closer to $500,000, ins @ almost $1000/yr (State Farm), prop taxes @ $6000+/yr.

One more question, what is “principal paydown� and how did you come about with it at $68?

Thanks for the congratulations note, Tony. My wife and I are excited — but VERY anxious to finish all the work. Painting has become quite the chore and is taking longer than I predicted.

Our home and our new rental property are located in the Midwest. The typical 3-bedroom, 2-bathroom single family home is around $160K to $180K. Of course, there are similar homes with lower prices (and higher prices) — it mainly depends on the area you’re looking at. But that range is typical for a nice home in a nice area.

Now ours was a lot less for two key reasons: (1) located in an outlying suburb and (2) its one half of a duplex building. The purchese price of our property was $92,000. We made a down-payment of $18,400 and took a loan for the remainder, which was $73,600.

The princial paydown refers to the amount of the bank loan that I am paying off each and every month. The mortgage payment I make to the bank includes two components: (1) interest and (2) principal. Now my payment is fixed, so the monthly mortage payment will always be $466. We can figured out the principal paydown amount using a couple different ways — one would be to create an amortization chart and another would be to use a simple math formula. The math formula is easier to talk about in this comments section, so I’ll discuss that one below.

First, I need to know the interest that will have accumulated by the time I make my first payment. I’ll use that information and add it to the loan amount to find out what my new loan amount is BEFORE I make my first payment to the bank.

73,600 — Beginning balance of bank loan
(+) 399 — Interest, calculated as: 73,600 * (.065 / 12)
—————-
(=) 73,999 — Owed to the bank the day I make my first payment

I’ll then take this number and subtract my fixed payment amount. This will give me the new loan amount AFTER my first payment is made.

73,999
(-) 466 — My fixed, payment amount.
—————-
(=) 73,533 — New amount that is owed to the bank AFTER I make my first payment.

The last step is to calculate how much the loan balance decreased. This is the “principal paydown”.

73,600 — loan amount BEFORE making payment
(-) 73,533 — loan amount AFTER making payment
—————-
(=) 67 — principal paydown

Now, another good question is, what does this number represent? When my wife and I purchased the property, it could be said that we fairly valued the property to be the same as our purchase price. (Yes, this is looking at it in simpler terms) So in this case, we believe the value of the property to be $92,000. Since we took out a loan with the bank, in essence we do not own the entire property yet. Instead, my wife and I only own $18,400 of the property —- which was the amount of money we paid as a down payment. This number is the equity we have in our home. The bank owns the remainder, which is $73,600.

As we make payments to the bank each and every month, slowly but surely our loan balance is going to drop. We are paying down the principal of that loan. After our first payment was made, the bank now only owns $73,533 of the property and we now own $18,467 of the property. So as time goes on, we’ll own more and more of the property as our “equity” in the home increases and the “loan balance” from the bank decreases.

This is probably a LONGER answer than you may have been looking for, but it’s a great refresher for many of us. The other thing to remember is that over time, the interest and principal portions of our fixed monthly payment will change. The amount of interest we are paying will slowly decrease and the amount of principal will increase. Our “principal paydown” numbers will continue to increase with each and every payment. Now how did I come up with the “principal paydown” amount from my previous “Numbers” post? I looked at the principal paydown numbers for an entire year and found the average. Over the course of a year our bank loan will decrease by $822 or, roughly $68 per month.

I hope this answered all your questions. It’s a good excercise for me to go back through the numbers and make sure I have been calculating everything correctly. Thanks for the great question. Let me know if I can clarify anything further. Perhaps I’ll upload an image of our amortization chart (done in Microsoft Excel) in the near future. It’s a great visual that is an alternative to running these calculations by hand.

I’m sorry it’s been a while since the last post. During the last two weeks I have been busy (yes, my wife isn’t that interested in the “tough work”) getting the property ready for rental. The items I’m taking care of are:

• Paint ceilings
• Paint walls (primer + regular coat)
• Paint doors
• Steam-clean carpet
• Replace air vent covers and air intake covers
• Replace all window blinds
• Replace thermostat
• Replace outlets and light switches
• Replace outlet and light switch cover plates
• Purchase refrigerator
• Clean, clean, clean!

It seems like a tall list — and it is! My wife and I knew the property needed some extensive repairs before it would be ready for rental. I’m pleased to report that I’ve made quite a bit of progress on my repairs, though. I’ve been busy painting all the ceilings and preparing the walls/trim for priming this weekend. Also, I purchased all the parts/items we needed from Lowe’s because of a nice Lowe’s 10% Off Coupon that is given to new/existing home purchasers.

Now that I have all the items and I’m well into the middle of my “to do” list, I’ll begin thinking about putting an advertisement in the newspaper and placing a sign in the front yard of the property. Basically, I need to start taking actions to get people calling me and get people walking through the property. This will be my first priority after paint is on the walls.

It’s official, my wife and I are now owner’s of a second rental property! We woke up early this morning to go down to our realtor’s office and sign all of those important papers. I am glad to report there were no “surprises” in the closing cost numbers. Our first purchase had a few items that we were not expecting, but this time everything went much more smoothly. Now that we’ve closed on the property, I have the keys and will be anxious to begin getting it ready for rental.

As I mentioned during our February Net Worth Update, I expect our expenses in March to increase considerably due to the closing costs associated with the home purchase and the materials I intend to purchase to clean, repair, and get the property ready for rental. The property needs a little work, to put it lightly, so hopefully these expenses won’t get too out of control during the month. The race is now on to get everything finished and find a renter for this property!

I just made my 2nd contribution into my Roth IRA this afternoon. I had planned on making the purchase during the last week of February, but didn’t get around to it during the hustle and bustle of preparing for the purchase of our new property.

I exchanged money from our money market account into my Roth IRA account to make the purchase. I plan on making the purchase for my wife’s account in the upcoming days. Both of us had planned on accelerating our purchases during the first part of the year. Up until last week that would have sounded like a great idea. With the recent performance of the stock market, however, it might make sense to spread out our purchases equally throughout the year.

One word comes to mind when looking at our net worth update from February —- ouch! My wife and I are heavily invested in the stock market (both in individual stocks and through mutual funds). This means that our portfolio and net worth will typically swing the direction that the overall market is going. In the case of last month, the market was hit HARD! I’m still pleased to see an increase in our net worth, but was a little disappointed in the performance during the last few days of February. I will not let it affect me too much because the market goes up and the market goes down.

The other highlights from February is my shifting of money between the taxable brokerage accounts and the cash & savings account. This shift is evident because of the LARGE increase in cash & savings. Most of the moves into the account took place during the last week in February. This is all in preparation for the closing on our additional rental property. Our closing date has been delayed a half-week due to some last minute complications that arose between the sellers sale of the old house and their purchase of their new house. The complications have been resolved and we’re on track to close this week. At that time the money in our cash & savings account will decreased dramatically because of the down-payment and closing costs that we expect to pay.

That’s about it for February. I’m anxious to see how the month of March plays out because of the home purchase. I expect to see our expenses rise considerably as we purchase cleaning supplies and other items that will be used in preparing the rental property for rental. Let’s hope it doesn’t get too out-of-hand.

I usually look at four numbers that make up the total monthly expense of a rental property: (1) mortgage payment, (2) property taxes, (3) home insurance, and (4) improvements/repairs. Note: all numbers below have been rounded up to the nearest dollar

1. Mortgage Payment — We are financing our property with a fixed-rate, 30-year loan. We intend to make a 20% down payment and will finance the remainder. The interest rate is 6.50% and there are no points to pay on the closing date. This means that our loan with the bank will be $73,600 and our monthly payments will amount to $466.

2. Property Taxes — The property has an assessed value that is higher than the contract sales price. While this may not typically mean much, in this case we have a good amount of evidence (sales price, appraisal, comparables in neighborhood) to appeal the assessed value from the county. I’ll talk about this process in the coming months as I prepare my appeal. For these purposes, however, I’ll assume that yearly property taxes will equal the amount paid last year, which was $1,400. This amounts to a monthly payment of $117. My wife and I do not have to escrow this payment, but each month we intend to add it to our money market account to earn interest before the property tax payment is due at the end of the year.

3. Home Insurance — I did not do much shopping around for home insurance on this property because of time issues and the rapid approach of the closing date. Therefore I purchased a policy from our regular homeowners and auto insurance company, which is State Farm Insurance. Our yearly premium is $379, which amounts to a monthly payment of $32. My wife and I do not have to escrow this payment, but each month we intend to add it to our money market account to earn interest before the homeowners insurance payment is due.

4. Improvements/Repairs — Even if the property is brand-new, there will still be periodic improvements and repairs that need to be made. I put aside money each month into an “improvements/repairsâ€? fund for my rental property. Through my own calculations I have determined the need for $77 a month into this fund.

Adding these four amounts together gives me a total monthly expense of $692. At the very, very least I will need to rent the property for this amount. I have every intention of listing it for a higher price and I believe the neighborhood can support a monthly rent of $830. At that rental amount, I would have a cash-flow of $138 per month. My cash-on-cash rate of return for the year would be 7.89%, assuming full rental throughout the year. If I included the principal paydown, which is the amount of the bank loan that gets paid off each month, my rate of return for the year would be 11.77%. Please note, I’m using my down-payment PLUS anticipated closing closes when determining these rates of return.

Cash-Flow Profit per Month:
$830 rent - $692 monthly payment = $138 cash-flow

Total Cash Investment:
$18,400 down payment + $2,600 closing costs = $21,000 cash investment

Cash-on-Cash Rate of Return:
($138 cash-flow x 12 months) / $21,000 cash investment = 7.89% return

Rate of Return, including Principal Paydown Numbers:
(($138 cash-flow + $68 monthly principal paydown) x 12 months) / $21,000 cash investment = 11.77% return

There are three key elements I’m leaving out of my calculations. The first is that I’m assuming full rental throughout the year. In reality, this will not always be true. To come up with more accurate numbers, I should assume a certain level of “vacancy” in the rental property. This would LOWER the rates of return listed above.

The second element is that I’m not taking into account potential appreciation of the rental property. The home should appreciate in value over time. Eventually, when my wife and I decide to sell the property, we will be able to “cash in” on that appreciated value. However, for our regular purposes of renting the property, this element does not affect us much. If we were to estimate a certain level of “appreciation value” in the property, this would INCREASE the rates of return listed above.

The third element is the effect on my wife and my income tax return.  Having a rental property gives us several benefits during tax-time that effectively lower the cost of having and running the property.  If I were to include these benefits in my calculations, this would INCREASE the rates of the return listed above.  However, as the rental property begins to generate positive income after all the expenses are taken care of (and yes, this includes depreciations since we’re talking about income tax returns), my wife and I will have to pay taxes on those profits.  If I were to include these benefits in my calculations, this would LOWER the reates of the return listed above.
Well, there you have it. Those are the base numbers for this rental property. As you can see it is difficult to get a definitive rate of return calculation without making some assumptions.  For this rental property and this neighborhood, I am making certain assumptions that I may not make with other properties — mainly my confidence in keeping it rented the entire year.  I’m sure I’ll have more discussions on this in the future, but for now, wish my wife and I luck as we go into our closing date for this new property!!!