So you’ve probably heard that house hacking is a pretty cool strategy, and it really is. But what actually is house hacking and how does it work precisely?
In the most simplistic words, house hacking is renting out portions of your primary residence. So, that’s the place where you live in order to generate rental income and offset your own living expenses.
As a financial strategy, this is probably the most powerful way you can generate wealth early on in your life. Because it is so easy to do, it makes it a real no-brainer.
So how does it work in real life? You would usually go and buy a residential property, so that’s a one to four unit, and then rent out individual units or portions of it to other people, so you’re generating rental income and that will offset your own living expenses. In other words, it will help you make your mortgage payments. So in a way, you can say house hacking is harnessing other people’s earned income in order to offset your own living expenses.
I have been a real estate investor a lot longer than I have been a real estate agent. So as an investor, house hacking is really the obvious starting point for me to anybody who is interested in the world of real estate investing and passive income.
Before we get too much into details, I would like to take a second and clarify a very common misconception. Most people will think about their primary residence as their biggest asset, but the question, if it’s actually an asset or a liability is very debatable. I’m going to lean on the side of Robert Kiyosaki, who is the author of Rich Dad, Poor Dad, who says, if it puts money in your pocket, it is an asset. If it takes money out of your pocket, it is a liability.
If you follow that definition, your primary residence, which you’re typically not renting out is actually a liability, because you have to pay for it every month. An asset is going to put money in your pocket, and that’s the difference. So how big of a liability are we actually talking about here? For most Americans, that number is somewhere around 33 to 37% of their monthly income. To put this a little bit in a Milwaukee perspective, depending on which neighborhood you live, you might be talking about 10,000 to maybe $25,000 a year, so that is a significant amount of money.
If you were to try and save up between 10 and $25,000, you would have to do a lot of things. You can think about canceling your Netflix subscription, you can stop eating out, you can maybe stop driving a car and take your bicycle to work, but it will be a lot of effort and a lot of very frugal living to save up another 10 to $25,000. If you think that sounds painful, I agree with you. The beautiful thing about house hacking is that you can achieve your financial goals without those daily sacrifices. It’s just a matter of structuring it and setting it up correctly. You’re still living in a nice place, you’re still living in a nice neighborhood, and you can achieve your financial and your saving goals.
Now, if you think about what you can do in one year, think about what financial impact that will have on your life if you do this over three years, over five years, or even over 10 years. Let me illustrate the concept, and I’m going to use slightly simplified numbers.
So let’s say you’re currently renting an apartment and your rent is $1,250. You now decide you want to house hack and you go ahead and purchase a duplex for $250,000. Your monthly mortgage payment for the duplex is going to be about $1,500. That’s your PITI, your principal, interest taxes and insurance.
Now you go ahead and move into one side of the duplex and you rent out the other apartment and now you collect rent, let’s say 1,250 in rent. So with 1,250 in income and $1,500 in monthly mortgage payments, you are now paying for living on your side of the duplex $250 in living expenses. You’re in a nice duplex in a nice area. Now, if you want to take it to the next level, you can go ahead and rent out one of your bedrooms and let’s say, charge your roommate $500 for living with you. Now you have an additional $500 income, your total income is now 1,750, your total monthly expenses for your mortgage payment is 1,500. You are now cashflow positive by $250. You have now turned a liability into an asset because it’s putting cash flow into your pocket every month.
Now, before you were paying $1,250 in rent yourself now on the other hand, you receive $250 in positive cashflow, so that is a difference of $1,500 a month or $18,000 a year. So if you think this is pretty awesome, I certainly agree with you, but this is only the beginning. When we talk about investing in real estate, there’s really four major financial principles that are working in our favor.
So the first one is cash flow, the second one is appreciation, the third one is principal paid down and the fourth one is tax benefits.
We already spoke about cashflow. Appreciation comes in two flavors, forced appreciation and natural appreciation. Forced appreciation is if you remodel a place and you force the value up. Natural appreciation is if the whole marketplace goes up in value. Historically speaking, we have seen about 3.8% in appreciation in the US over a long-term average. Of course, appreciation is never for granted and the market can go up or even down. But long-term average is 3.8%, which comes down to about $9,500 on a $250,000 property.
So the next item is going to be principal pay down. No matter what you do to the property, or if the market goes up or down, you always have your principal pay down because your mortgage balance is decreasing every month as your tenant and you are making your payments, the principal is coming down. And that is usually somewhat in the magnitude of about 3% a year.
Now, mortgage principal pay down is a little slower in the beginning, and it’s faster later, but for simplicity’s sake, you can say it’s about on average 3% a year. Now the fourth item on our list is tax benefits. So as a property owner, you have certain tax benefits and tax write-offs that you do not have as a renter. You can deduct your property taxes, you can deduct your interest expenses, and you can deduct certain expenses on your property.
Of course, this is just a very high level simplified example just to illustrate the principle and mechanisms of house hacking. We have not included expenses for repairs and maintenance, for example. In the real world, that is certainly a consideration. But you can see when you tally up these four items, they provide a significant financial incentive for house hacking or real estate investing in general, and that is only in one year.
Now, consider the financial impact of this on your life if you let this run for two years, three years, five years, or even 10 years. And the best part is you’re not limited to one property, let’s say one duplex. With the conventional loan after one year, you can move out and buy another duplex and move into your new duplex. Now you have three units that are producing income and one unit that you’re occupying personally.
So your cashflow situation keeps improving as you keep adding properties to your portfolio. I’m doing this now long enough as a real estate agent that I have clients that are actually on their fourth or on the fifth duplex. And they often tell me the next property is going to be a single family, but then of course they keep buying another duplex.
So I think by now you can see how house hacking as a strategy can have potentially a huge beneficial impact over time on your financial future. But you’re probably wondering if this is all true, why is not everybody doing this? And this is certainly a good question. There are certain disadvantages to house hacking and house hacking is not a strategy for everybody. There are certain disadvantages to it, and this was just the first video. In the next video, we’re going to talk about the pros and cons of house hacking as a strategy.
And then in the following videos, we’re going to cover different types of duplexes, what to look for, different neighborhoods in Milwaukee that are more or less beneficial for our house hacking strategy, we’re going to cover different loan types and different financing strategies, and we’re going to talk about how to manage your house hack and everything you need to know about land lording.