Financing My First House Purchase

My first house purchase

Disclaimer: I’m not a financial expert or in place to give any financial or legal advice, I’m merely sharing my experience for others to get inspired.

When it comes to buying a house using a loan from a financial institution, the loan lords will ask you if you’re applying for a primary residence or an investment property. Or if you already have a primary residence that you own, a second home loan is an option too.

For a primary or secondary residence loan, the financial planning will be different than buying an investment property. If you plan to reside in the house for the entirety of the loan duration (10, 15, or 30 years) then paying off that loan as fast as possible will be the best long term plan in my opinion. Whether you decide to rent part of it out or not.

However, if you’re planning to buy an investment property, then profitability metrics are more important than paying off the debt faster, your tenants will help you with mortgage payments overtime so that’s taken care of.

Let’s get some terms defined first..

There are two metrics that I’ve used to analyze a rental properties before buying:

Capitalization Rate (or Cap Rate):

Cap Rate is a percentage that makes it easier for me to compare two or more properties. The higher the Cap Rate the better. In 2018, Denver area residential properties with cap rate 7% or higher are considered a great investment. Different time periods and/or different markets will have different cap rates. The cap rate is calculated by dividing the Net Operating Income (NOI) by the purchase price. The NOI is simply put your expected annual income from rent minus your expected annual expenses.

NOI = annual rental income – annual operating expenses

The net operating expenses include real estate property taxes as well as insurance annual cost.

Cap Rate = NOI / purchase price

You can see that that Cap Rate is tied to a time period, in this case it represents the first year of owning the potential house. Since my investment strategy is house hacking to eventually own the houses long term and converting all houses I buy in the future into rentals, I’m only going to consider the cap rate metric again on that same property when selling it and exchange it for a more lucrative investment (check out the 1031 Exchange process).

Cash-on-cash rate of return (or CoC return):

Cash on cash is a return on investment (ROI) metric or a percentage that I use to show how much is the expected rate of return based on how much cash I’m investing (down payment). This metric does not take taxes into account, so this is a pre-tax basis. It does however include the annual mortgage payments (principle and interest only) to the debt servicer (excluding taxes and insurance). The formula to calculate this metric is:

CoC Return = (NOI – annual mortgage payment) / down payment

This metric is also tied to a time period that’s typically one year. CoC return comes in handy when I’m trying to assess an investment by taking into account the debt paid that period. The higher the number the better the investment.

You do not have to consider both metrics when analyzing a property for a rental perspective, only one usually suffice in my opinion. I’ve used this sheet, that you can download for free from REICO, to do my rental property analysis. All the formulas are built-in and you just inser your inputs, like house purchase price, expected NOI, etc. Or you can use your own favorite one or make one yourself too if you want!

How I saved up for a down payment

As an employee of a big corporation in the U.S. I did have the option of participating in the Employee Stock Purchase Plan (or ESPP). The company that I work for offered it after being an employee with them for a number of years. The idea of an ESPP, is that the employee would contribute a percentage of their salary to this plan monthly starting at the offer date until the purchase date (typically 6 months). In this period, the percentage of your monthly salary will be stashed away until the end of the period or at the purchasing date. Your company will then purchase company stocks on your behalf at a discounted market rate (mine was 15% lower than the market price, which is typical).

At the end of the purchase date, you’ll have a bunch of company stocks in your brokage account ready for you to sell and make 15% profit right away. However! This is important. Those stocks are considered short-term stocks, which means they did not mature to long term stocks. Selling short-term stocks are taxed at ordinary income rate while long-term stocks are taxed at capital gain tax rate which for most cases at 15%. Your ordinary income is usually taxed at higher than 15% capital gain taxes (it depends on your income bracket).

In my opinion you should always keep short-term stocks until they mature to long-term and then sell them. It takes a full year for a baby short-term stock to mature to an adult long-term stock where you can then sell it off to the world!

In 2017, I’ve set aside a portion of my W-2 salary towards ESPP and some money was saved up in a high yield savings as well as some in stocks that I dabbled with to learn but I didn’t have a goal other than investing it somehow.

In 2018, I helped my landlord paint the front doors of the apartment complex she owned and I rented. We then became friends and talked about how to buy a multi-family apartment complex. She referred me to the real estate team that she works with and I went to all their free real estate courses that I can attend and learned as much online as I can. I also read many business books that helped me get into the mindset of an investor.

I’ve tightened on my spending for a year or two. Cooking and eating mostly at home, not really going out as much, no travel obviously. All in hopes to get to a decent amount of down-payment AND enough reserves for when shit hits the fan so to speak. That magical number for me was roughly $35,000. I came up with that based on the real estate market at the time and it’s based on the prices of houses I was looking to buy.

Let’s Talk Numbers and get into the weeds

In 2018, the goal for me was to get a house that’s in the lower 400k range given the Denver area market at the time. My rent was $950/month and I was making just a little over $80k as my W-2 salary. Since it was my first house, the Colorado Housing and Finance Authority CHFA had some loan options at the time that can accept a down-payment as low as 3% and some grants that do not require repayments. So I started researching for the options that work for me.

I learned from asking lenders that CHFA loans will not allow you to rent the house later or rent part of the house while living there even. So that’s not gonna work for me as a first-time house hacker. I then looked at conventional loans and hard money lenders (borrowing from rich people basically). But.. I didn’t want to pay an insane amount of interest that comes with hard money. Hard money lenders will look at a new investor as higher risk so they would offer me loans with higher interest rates at the time.

I decided to go with a conventional loan. I wanted to start simple and go with a 30-year fixed conventional loan with 5% down payment. This is a different way of looking at it compared to the recommended 20% down payment for buying a primary residence home and not a rental property. This is not my forever home, this is an investment.

The house I identified was listed for $400k and at the time buyers were offering 5k to 10k or so over the asking price. It was a good house with two entrances, two kitchens, updated already, and it had a nice big yard. Most importantly, the Cap rate was 7.1% and CoC Return of 15%. I liked those numbers. I also did not want to go into bidding wars with other buyers, so I offered $410k from the start. In hindsight, I may have been ok offering $400k or the asking price.

I was not happy about paying over asking for my first house, but fast forward four years, the house has appreciated in value and now worth roughly $600k. So there’s roughly $200k of equity in the house. House equity comes in handy in some interesting cases such as recasting or refinancing the loan as well as when you want to obviously sell the house. You can also “Tap into the Equity” of your house by applying for a Home Equity Line of Credit or HELOC or doing a Cash out Refinance or “Cash out Refi“. So that $10k over asking is now in the wash.

The down payment on that house came up to $20,500, where I’ve put $3000 as earnest money and $17,500 as my down payment. I saved up roughly $35k, so that left me with about $14,500 for reserves or emergency money. The reserves are roughly 2-3 months of mortgage payments. This covers things like vacancy or for expensive repairs (CapEx). Reserves are very important! My mortgage payments at the time were $2,460/month so I needed at least $7,920 (payments of 3 months).

Let’s stop and reflect here for a minute, I was paying $950/month rent for 1 bed/1bath apartment in downtown Denver and I decided to move to the suburbs in Arvada and live in a 6 bedroom 2 bath house and pay $2,460/month. That sounded insane to me at the time. My plan was to get tenants in the basement as soon as possible to help me out with the mortgage payments. So I did! I bought the house in November 2018 and had my first ever tenants in the basement in January 2019. Though, that process was not really smooth sailing. You can read more about it in my Establishing My First Rental post.