Q:We purchased a house six years ago and it’s worth about $700,000 today. We have a
$200,000 fixed-rate loan at 5.375 percent. We are now ready to move to an area that’s better for us. The houses are selling in the $800,000 range.
We are in a dilemma because we would like to keep our current residence and rent it out and watch it appreciate. We also are hesitant to sell because of the huge capital gains tax we would owe. The problem is that if we don’t cash in our equity by selling, we only have enough money for a 10 percent down payment, making the mortgage payment a stretch.
One lender advised us to refinance our current residence with a negative amortization loan and use the proceeds as a large down payment for the new house, allowing us to take a smaller loan when we buy. But some friends have told us that negative amortization loans are really risky.
Should we try this approach or is it best to sell and put the proceeds into the next house?
A: Let’s begin by evaluating the facts because it appears that you might not have a full understanding of them. Next, we’ll look at the potential benefits and risks associated with selling your current residence and keeping it.
If you decide to hold your property and rent it out, how are you so sure that you will “watch it appreciate”? Real estate has proven to be a good investment over the long term, but it is also true that the real estate market is emerging from a very long boom.
It’s not just possible, but probable that home prices will not increase over the next few years as much as they have in the last few years. Be careful of assuming that property values will always increase at annual double-digit rates.
Check with a qualified tax adviser on the capital gains issue. I’m no expert in these matters, but my understanding is that capital gains of up to $500,000 for a married couple bears no tax if the money is used to purchase another property to be used as a primary residence.
If you’re single, the amount drops to $250,000. It’s very important to seek professional advice on this issue.
If, indeed, you do keep your home and rent it out, it certainly may make sense to refinance your current loan and take some cash out to use as a down payment for the new house.
A large down payment will benefit in two ways: First, the mortgage terms could be better. Second, you will be better positioned to negotiate a favorable purchase price with a large down payment.
This brings up the issue that a 90 percent loan to purchase the new house would make the payment “a stretch.” If you finance 90 percent of $800,000, you are going to be $720,000 more in debt, regardless of whether the loans are secured solely by the new property or a combination of the two properties. The bottom line is that adding $720,000 in mortgage debt could be “a stretch,” indeed.
This brings us to negative amortization.
Your friends are partially right. A “neg-am” loan allows the borrower to make payments that are insufficient to cover the interest charged, increasing the balance each month. These loans are risky for folks who take out these loans for the sole purpose of purchasing a property that they cannot intrinsically afford.
However, contrary to what many think, a neg-am loan does not require that you make the lowest payment. There is always the choice of making a payment that covers the interest and curtails the principal.
But the real risk associated with a neg-am loan is that most carry monthly adjustable interest rates. There is very little or no interest-rate protection with neg-am loans.
I don’t have nearly enough information about your situation to make a firm recommendation, but I can tell you that now is not the time to take out a monthly adjustable mortgage rate, regardless of whether it carries a neg-am payment option. If you determine that the only way to afford both houses is with a neg-am payment, you are stretching yourself.
My advice: Understand the tax consequences of selling, if any. Research the rental issue. How much can you expect to rent the house for? Will the property be difficult to rent? Consult with a qualified real estate agent and fine tune a realistic price that you can expect if you sell.
The bottom line? Do your homework. The decision then will be easy to make.
• Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavagepmcmortgage.com).
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