I received an email from Jimmy last week about his financial situation and he's wondering what I would do if I were in his shoes. The basic idea is that Jimmy is relocating in the near future with TONS of equity in his existing home. Should he buy a house in the new area or rent and invest the equity?
Here are the details:
- We are both in our mid 30's.
- We have three young children
- We earn approx $100,000 p.a combined
- Primary Residence value: $609,000
- Mortgage: $245,000 (bi-monthly payments of $1600 per month)
- LOC available $80,000
- LOC debt (renos, car etc) on Primary: $50,000 ($250pm)
- LOC for deposit on rental: $47,250 (tax deduct) ($230pm ish)
- Rental House Value: $300,000
- LOC on rental (I managed to get it all on LOC): $141,000 (tax deduct)
- LOC available on Rental: $150,000
We are moving to a place that has equal house prices – we would have to seriously downsize to make money. Property is appreciating in the town we are moving to. So, my choices…
- Sell up, buy there and pay the costs attached to moving (realtor, tax, etc). Invest my credit lines into long term, dividend paying stocks etc
- Sell up, rent there and use all profit and rental house. My profit would look like:
- $609,000 (estimate)
- minus Outstanding Mort: $245,000
- minus non invested LOC: $50,000
- minus realtor fees:$20,000
- Profit: $294,000
- LOC on Rental: $150,000
- Amount to invest: $444,000
I have a non-registered account with Questrade where I do some small time swing trading and longer term fundamental investing.
I can rent for about the same as I pay on mortgage and other costs. The our plan would be to build capital and build our dream home in a few years time.
Do you think it is wise to rent and take a breather while we put this strategy into place or should we stick with buying and investing just the LOC of 150,000?
My 'gut' says that I can do better outside of property with this amount of money. I would look at good quality Income trusts (EIT.un, EIS.un, COS.un etc) paying 10% yield a year and also long term dividend aristocrats…
Looks like Jimmy is in pretty good financial shape. I like the fact that he's selling his house and using the equity to first pay down his non deductible line of credit. One of the biggest constraints that I can see from Jimmy's email is that he plans on buying his dream house in a few years.
Out of his alternatives, it's either take the profits, rent and invest with a large amount OR buy a house and invest with the smaller rental line of credit. How about getting the best of both worlds? What about buying a house and invest the larger amount? Yes, I'm talking about the Smith Manoeuvre.
If I were in this situation, I would first purchase a home in the new area IF the cost is equal to or less than the price that the old house was sold for to keep the mortgage payments approximately the same. So in Jimmy's case, I would buy a home in the new area if it's less than $600,000.
As Jimmy has mentioned above, he's interested in leveraging his portfolio which is what I would do also with the Smith Manoeuvre. However, note that leveraging is not for everyone and only those with a higher risk tolerance should even consider this strategy. If he decides to do the Smith Manoeuvre, he would need a readvanceable mortgage. A readvanceable mortgage would give you a mortgage and a HELOC that automatically increases it's credit limit with every mortgage payment.
Assuming that Jimmy wants to keep his mortgage payments to be approximately the same as before, his numbers would look like this:
- New Home Purchase: $550,000
- Down Payment: $294,000
- Mortgage Balance: $256,000
- HELOC limit: $550,000 x 80% – mortgage balance= $184,000
- LOC from rental: $150,000
- Total amount to invest: $334,000
So looking at the numbers, if Jimmy were to rent (at the same mortgage cost), he could invest the full $294,000 amount in a non-leveraged portfolio + the LOC from the rental. If he purchases, he could fully leverage his portfolio with $184,000 + the LOC from the rental. Of course, the HELOC credit limit would increase as he pays down the mortgage to a potential max of $440,000. However, reaching his amount is doubtful is he expects to move in 3 years.
Renting and investing the profits can be a good idea in some cases. However, the issue with renting and investing the profits in this scenario is that Jimmy intends to buy a house in 3 years anyways. In my opinion, 3 years is a pretty short time frame to be betting the markets not unless Jimmy intends to become a super star trader within that time. On another note, buying a house and hoping to sell it for a profit in 3 years has its own risk.
Overall, this is actually a pretty tough call. Here are the options as I see it:
- Conservative: Rent, place the profits into a money market fund for 3 years (3 years is too risky for the markets IMO), consider investing a portion of the rental LOC. In 3 years time, withdraw the profits and put it down on the dream home.
- Moderate Risk: Buy, get a readvanceable mortgage, use the HELOC to buy either strong long term stocks/ETF's. In 3 years time, sell your house, and transfer your HELOC to the new mortgage thus keeping your investments in tact.
- Heavy Risk: Rent, invest all profits and a portion of the rental LOC in the markets, sell investments in 3 years time and use proceeds towards down payment. At which time, you can start the Smith Manoeuvre.
No clear cut answer from me, the answer really depends on Jimmy's risk tolerance. If it were me, I would lean towards option number 2. What do you guys think?
Side note: If you invest in higher distribution investments, there is most likely a return of capital portion. If you borrow to invest and receive return of capital distributions, a portion of your deductible debt will be reduced IF you withdraw the distribution for use other than investing (ie. pay down the mortgage, vacation etc). Therefore, avoid withdrawing ROC distributions with leveraged investing.
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