Buying a home in America has not been this hard in a long time.
The barriers to entry are rising high, yet many people still place a premium on property. Surveys show nearly three-quarters (74%) of Americans still see homeownership as the most important pillar of the “American Dream,” ranking it above other economic achievements, such as career success, having a family, or college education.
As average wage earners seek out ways to invest in real estate with little or no money, unconventional approaches may give an edge. One so-called “stepping stone strategy” can provide a pathway forward to brave these tumultuous financial waters and cross the ford over into the realm of homeownership.
The principles of stone stepping are mirrored in strategies used by the wealthy, such as debt recycling and the “buy, borrow, die” strategy. Yet, with some adjustment, folks of more modest means can get their foot in the market and begin their property journey. Advisors share how best to apply such strategies to minimize the risks involved and get off the ground to begin building wealth.
One Step at A time
Simply put, the stepping stone strategy is a constant process of upgrading. Start by buying the best home one can afford. Then, once the homeowner has paid off enough of their mortgage, they can borrow against their existing equity to take out a second loan, and purchase a more expensive second home.
After moving into their newer home, they can rent out their first property and use the rental income toward gaining more equity in their second home. From that point, it may be possible to repeat the process to buy more homes again or to stop at the second home and live there simply.
Since the loan you will take out is leveraged, stepping to the next stone is all about building up equity.
“If you have a lot of equity in your first home, it may be worth it to refinance and use the equity to purchase your second home. However, if you don't have a lot of equity, it may be better to sell your first home and use the cash to purchase your second home,” says Jorey Bernstein, CEO of Bernstein Investment Consultants.
Equity is calculated simply by subtracting the outstanding amount of one's mortgage from the property's current market value. For example, if someone takes out a $200,000 mortgage for a $300,000 home and has paid off half of the mortgage ($100,000), their equity would be $200,000. If the home's value has appreciated by 20% over that time, however, ($360,000), then their equity would be $260,000. Equity level determines credit for a second loan. Often, a homeowner can borrow up to 80% of their available equity through a second loan under normal economic conditions.
“There are a few things you can do to turbocharge paying off your mortgage,” Bernstein adds. “Make extra payments each month, increase your monthly payment, refinance to a lower interest rate, and pay off your mortgage early.”
Someone's approach to this strategy is guided by which point on the opposite embankment they aim to reach.
“The implementation… depends greatly on your intended use of the properties,” says Steven Schoenberger JD, CFP, and Founder of Open Door Financial.
“If you are trying to buy your “dream home,” that is going to be a different approach than creating a portfolio of investment properties,” he adds.
“While every situation is different, a good rule of thumb is to establish an emergency reserve and then create an ideal cashflow to debt service ratio that will support your ultimate financial goals. Using these “buckets” together will provide a good guide for how to proceed in a prudent manner with new investments.”
There are some alternative strategies, too. One being “rentvesting.” In this scenario, “rentvesters” rent a place in their desired neighborhood, perhaps in the downtown of a bustling city, but also purchase an investment property in a more affordable locale, often in a suburban or rural area. This way, they can use the rental income earned from their investment property to up their inner city lifestyle and grow their wealth portfolio.
Another approach is “house flipping,” which can be particularly profitable if you have handy skills and an eye for selecting a promising fixer-upper. Even for those who can't afford the property outright, other alternatives exist, such as real estate crowdfunding.
However, as with all investment strategies, there are inherent risks to the stepping stone approach. Advisors warn that if you lose your footing and fall down between the stones, you could soon be “underwater.”
“One of the biggest risks of the stepping stone strategy is that you could end up underwater on your mortgage. This means you owe more on your mortgage than your home is worth. If you're forced to sell your home, you could lose money,” says Bernstein.
“Another risk of the stepping stone strategy is that you could have too much debt. If you take out a large loan to purchase your second home, you could struggle to make monthly payments.”
When deployed effectively, the stepping stone strategy gives buyers extra leverage to pursue their goals, whether it be achieving their homeownership dream or expanding into investment properties. In this way, it can be an excellent starter strategy for starting your real estate investment journey. As with many topics in personal finance, however, this strategy is no turn-key solution. Ultimately, how one gets started investing will depend greatly on their individual economic situation, macroeconomic factors at the time of purchase, local property market conditions, and a host of other specific factors.
This article was produced and syndicated by Wealth of Geeks.