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Dr. Don Taylor, CFA, Bankrate.com advice columnistNegative cash flow on a rental property

Dear Dr. Don,
I have a rental property in Florida that, due to increased insurance costs and tax increases, has my payments higher than my rents. The mortgage has 11 years remaining at 5.25 percent and I can't push the rent any higher than it is now. Should I refinance for 30 years, do a home equity line of credit (interest only) and pay off the existing loan or get a home equity loan and pay off the existing? I hate to get rid of a great investment.
-- Scott Strategic

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Dear Scott,
If the negative cash flow from the investment property isn't too painful, there's something to be said for looking at the cash outflow as an additional investment in the property and holding on to the existing mortgage.

For that to make sense, you have to expect the continued appreciation in the property value to be sufficient to justify that additional investment. If you feel that the property's potential rental income has capped out, that could signal some trouble ahead in property values, as well. It might be time to get rid of that great investment.

Refinancing to extend the mortgage term will reduce the monthly payment but result in you paying higher total interest expense over the longer term. The following hypothetical example shows the difference in interest expense but ignores the after-tax impact of mortgage interest deductions.

Example
  Existing mortgage Refinancing 30-yr. fixed Refinancing 5/1 interest-only ARM* Interest-only HELOC*
Loan amount
Loan term (years)
Interest rate
Monthly payment
Total interest
* Assumes interest rate stays constant over loan term with no principal reduction

Home equity lines of credit, or HELOC, and home equity loan rates have moved higher as the Fed has continued to raise its targeted federal funds rate. These loans are usually tied to the prime lending rate, which is currently 7.5 percent. The national average interest rate for a HELOC is 7.66 percent and is 7.56 percent for a home equity loan. Although you'll pay more in closing costs on a new first mortgage than you would on a home equity loan or line, it's a tough sell to move from 5.25 percent on your current mortgage to 7.5 percent on a second mortgage.

Property taxes and homeowners insurance aren't likely to move lower over time, so your negative cash flow issue is likely to grow over the years. I can't speak to what will happen to the appraised value of your Florida property over time, but it's hard to expect property values to continue to grow at recent rates.

There are too many open variables for me to do the math, but if you decide to keep the property, I'd suggest that you take out a HELOC to just finance the negative cash flow on the property rather than using it to pay off the existing mortgage or getting a new first mortgage. You've bought some time while keeping the great rate on the existing loan.

In your shoes, I'd run all this by my accountant.

I'd make sure that I had a read on the negative cash flow on an after-tax basis, a forecast of the expected return on equity if you hold the property long-term. While you're there, make sure to discuss the tax impact of selling now and also raise the possibility of a 1031 like-kind exchange to invest in a different property -- postponing all or part of the tax impact of selling this property.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "saving & investing" or "money."

Bankrate.com's corrections policy -- Posted: March 31, 2006
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