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Reader Mail: Relocating with Lots of Equity in my Home

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…

  1. 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
  2. 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:

  1. 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.
  2. 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.
  3. 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. 

Disclaimer: The articles posted on Million Dollar Journey are the opinion of the author and should not be considered professional financial advice. Please consult a financial professional before making any major financial decisions.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 11 comments… add one }
  • Dunamis December 27, 2007, 5:23 am

    Great question and answer – very helpful… cheers!

  • Northerner December 27, 2007, 8:48 am

    MDJ, man you are up early. I’m visiting NL and got up at 5:15am this morning to make the Future Shop rush and you’re still out ahead!

    The only thing I wonder about this situation is how the assets were accumulated in the first place. With moderate income, the advice would be much difference if the majority of the equity came from increases in the real estate market versus mortgage payments.

    In this situation, I’d be assessing the current real estate climate in the area I’m moving, as well as the location of my future dream home. Being invested in the housing market may be a good idea, though it appears the rental unit could provide a solid hedge.

    Another thing to consider would be to sell the current home, pay off the non-deductable debt, and buy a home of almost equal value in the new location, keeping the payments the same, but the load of the current additional debt removed.

    With no current investments (none stated at least), I would not be jumping into today’s market with a large LOC leveraged investment in stocks. Leverage can be risky when you have the assets to cover, but in this case, the assets would be completely tied up in a home.

    Given that the money from the house sale, if not invested in another home, would be a short term investment (until the dream home is purchased, presumably in only a few years), I would be wary of putting that money in the market in a lump sum.

    Sorry if my thoughts seem jumbled, the 5:45am standing in line at Future Shop has frozen my brain.

    Cheers all.

  • FrugalTrader December 27, 2007, 10:02 am

    Northerner: I just got back from Futureshop myself.. $2500 later… :)

    Great comments!

  • CanadianDollars December 27, 2007, 11:25 am

    I agree with choice #2. It’s a good balance of yield and risk. I agree the reader is in very good financial shape!!

  • FourPillars December 27, 2007, 12:26 pm

    I’m not clear on his plan – does “sell up” mean he will sell both his primary and rental residence? or just the primary?

    For a family of five with $100k in salary, they have an unbelievable amount of debt & risk (in my opinion). Whatever he does he should try to avoid that much debt in the future – I don’t care if it’s deductible or not.

    Mike

  • Jimmy December 27, 2007, 3:05 pm

    Thanks for all your comments.

    I do not intend to sell the rental house. It’s worth in the region of $450K and so it has done well for me. It is fully rented out and I make a nice (small) profit from it.

    Mike – I am unclear what you mean by saying “Unbelievable amount of debt” .

    I have $675K in capital gain in real estate . My debt load is fully covered by long term rental and my mortgage payments ( we are good at budgeting!). Do you think that what I have done in the past was financially unwise? What do you suggest I do now?

    Also, the idea of buying again in three years would only happen if we were to rent and not buy now. If we were to buy now, I do not intend to move again with the next 5 – 10 years (too expensive).

    I appreciate all the advice I can get!

  • FourPillars December 27, 2007, 5:05 pm

    Hi Jimmy, I might have been exaggerating a bit when I used the word “unbelievable” but from what I can see you have about $483k in debt which is quite a bit. As you point out however you have a long term rental which helps a lot.

    There’s nothing wrong with leveraging for investment but you have to know what you are getting into. Things like interest rate risk, vacancy in the rental, possible unemployment can be harder to deal with if you have higher debt levels.

    It seems you have done quite well with your investments in the past. FT has suggested buying a house and leveraging that equity which is not a bad idea IF you are comfortable with more debt. I wouldn’t suggest a true SM since that entails maxing out the leverage from your primary residence – just leverage as much as you are comfortable with.

    As someone who has moved twice in the last three years, I totally agree about not wanting to move for a few years!

    I also agree with FT about investing short term money (three years) in high interest savings rather than equity markets.

    I don’t know what you should do in the future – it’s up to you if you want to rent for a few years (perfectly acceptable option) or not.

    Mike

    p.s. – FT – what did you buy????

  • Jimmy December 27, 2007, 5:53 pm

    I appreciate that, thanks Mike. I am not comfortable maxing out with leverage. I am thinking about long term, dividend paying ‘aristocrats’ more than anything else. I will then pay down my mortgage with these proceeds and reinvest with the corresponding increase in the LOC. I am in this for the long term and I am comfortable with the two mortgages I have. I think I am leaning towards buying and then investing a marginal amount in long term equities.

    Thanks for the comments…
    J

  • FrugalTrader December 27, 2007, 6:17 pm

    FP, I had to take advantage of the boxing day deals for appliances for the new place. So we picked up a new washer/dryer along with a new laptop.

  • just learnin' December 28, 2007, 6:34 am

    I think I still have to read about the SM a few more times before I get my head around it. I just received a copy of the Wealthy Barber in my stocking, so first things first.

    Having said that I just wanted to humbly offer a couple of useful links for anyone considering renting or buying. (This may not earth shattering news to everyone as I seem to be out of my league here, but perhaps it will be of help to someone.)

    http://www.smartmoney.com/home/living/index.cfm?story=rent

    http://www.getrichslowly.org/blog/2007/11/05/the-new-york-times-rent-vs-buy-calculator/

    Merry Christmas!

  • just learnin' December 28, 2007, 6:38 am

    (-: you’re going to be making good use of that washer and dryer with the baby on the way! Try to be patient while the bills go up.

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