Time to Get Real (Estate)

• Money: 0
• Commitment: 0
• Time: 1-2 hours

I'm sure you're getting bored by now. When are we going to talk about real estate?

Right now! In this lesson, you'll learn some core principles that help you understand rental property investing.

You should also listen to these two podcasts, which are fantastic for all real estate investors. You many not understand all of the lingo and some of the tips don't apply to newbies, but just listen and absorb what you can; there will not be a test. 

How Does It Work? 

I'll start very basic. To buy a property, most people spend money on a "Down Payment" and get a loan for the remaining cost of the house. The most common down payment is 20% of the price of the house. 

A house is for sale for $50,000. 

20% down payment would be $10,000.

You apply for a loan of $40,000 for the remaining cost.

Transferring property from one owner to another requires paperwork, fees, and of course, taxes. These extra expenses get lumped together and called "Closing Costs". You'll pay closing costs whenever you buy a property. There's no way around it! We often estimate that closing costs will be around 5% of the total cost of the property. 

(I've giving you basics here, but it's enough for now!)

Mortgage is Not a 4-letter Word

The type of loan used to buy property is called a "mortgage". You need to understand the "Interest Rate" and "Terms". 

You'll pay interest to the bank for the privilege of borrowing their money. The interest rate is based on a percentage of the total amount of the loan. Obviously, lower is better. Interest rates for property will vary from about 4 to 10%. 

The rate can be "Fixed" or "Variable". A fixed rate will not go up and your payment will be predictable. It's safe and easy to foresee the future payment with a fixed rate loan. 

A variable rate loan (or "adjustable rate" loan) can change rates over time. The rate may start off low, but could get higher (or lower) depending on what the larger American economy is doing. A variable rate loan typically starts off lower than a fixed-rate loan, but it's less predictable.

Term: A mortgage will have a time-period attached to it, ranging from 5 to 30 years.  The longer the time-period, the lower the monthly payments.

We recommend a 30-year, fixed-rate loan for your first project. This is a very common loan that many banks offer. 

But wait, 30 years sounds like forever! Don't panic! A 30 year loan does not mean you have to hang onto the property for 30 years. It doesn't mean you can't pay it off sooner. It just means that 30 years is the max amount of time you have to pay off the loan.

The advantage of the 30 year mortgage is a lower monthly payment. This is very helpful, especially in the beginning, when you are new and still learning. Over time, the rent you earn from the property generally increases but your mortgage payment will not, so your profit margin gets higher and higher (there's more to come on the power of mortgages, but let's move on).

I PITI the Fool

When you apply for a mortgage, the bank will calculate your monthly payment for you. Your payment will be made of 4 parts:

1. Principle: This portion of your payment starts to pay down the balance of your loan
2. Interest: I assume you know what interest is
3. Taxes: When you own property, you pay property taxes to the local government. The bank contacts the local authority and calculates your property taxes automatically
4. Insurance: You must have homeowners insurance! It's legally required and a good idea. You and the bank will get this set up later, but your insurance payment will be folded into your monthly loan payment. 

This is your PITI payment. It's is all very convenient because you only have to pay 1 bill per month and it's a fixed, predictable amount. The bank automatically sets this up for you. 

So there is the basic framework of how a typical mortgage works. The down-payment and PITI payment will be critically important in future lessons. 

Think Like a Business Person

Everything you read above would apply to a house that you're going to live in, or a house that you're going to rent to tenants. But now we're going to diverge. A house you'll live in is very different from a house you'll rent out. When you buy a house for yourself, you want the paint colors, the layout, and the neighborhood to match your tastes and lifestyle. These are physical and emotional aspects of the house that you can see and feel. 

A rental house is a business venture and it needs to make money. It doesn't matter how the house makes you feel. What might not be appealing to you could be perfect for someone else. But none of that matters if the house doesn't make money every month. How can you tell if a house will make money? That'll be next time!