As a homeowner, when you decide it’s time to move on — maybe you’re relocating, moving your growing family to a bigger house, or looking to downsize — you don’t always need to sell your current home in the process. Sometimes, buying a second home while renting out the first also makes sense.
Not only is it a great way to generate new income, there are plenty of other advantages. Let’s walk through the benefits of investing rather than selling, the implications of applying for a new mortgage when you’re already paying off another, and what goes into converting your first home to a rental property.
Renting out your house? Why not just sell?
It might seem easier just to sell your house if you’re moving, and in some cases, it might be. But there are significant advantages to keeping the two transactions separate. Here’s why you might want to consider buying a second home while renting out the first.
- New income stream. Will the amount you could get in rent every month cover the mortgage payment in addition to monthly condo fees or homeowner expenses (like insurance and repairs)? If so, leasing your home is a smart way to gain a new source of income.
- Are buyers scarce? If it’s a buyer’s market — when the supply of homes for sale outweighs the number of potential buyers — you may have more luck finding renters than buyers. Renters know that leases are year-to-year, so they’re often less picky about the squeaky door or smallish kitchen than can turn off a buyer. And if your home’s location rocks (near restaurants, universities, outdoor recreation — whatever’s the draw) you may have a renewable supply of tenants year after year.
- Are repairs needed? Could your home do with some updates? If so, renting out your house allows you to make little fixes over time. Then, when it’s a seller’s market, you may be able to list it for a higher price.
- Don’t discount tax breaks! You may be able to write-off some of your rental property ownership when you do your taxes. Partially or fully deductible expenses might include repair and maintenance costs, property management fees, realtor commissions, legal fees, and more. Tax laws differ by state and are subject to change, so make sure you speak with a tax professional if you’re serious about going the landlord route.
Taking out a second mortgage.
Buying a second home while renting out a house with a mortgage is entirely doable, but there are some small hurdles you’ll have to overcome
- Choosing the right home loan. The first step to getting started is to review your existing mortgage. If your lender allows renting (some don’t), you may have to wait a bit before a primary residence can become a rental property. Act too soon after taking out the initial mortgage and you may be facing a penalty. If your mortgage has clauses against reclassifying your residence as a rental property, you might look into taking out a home equity line of credit or refinancing to a loan that does allow it. Look into conventional mortgages, like Fannie Mae and Freddie Mac. These are usually not as strict on the types of properties you can use them for. However, they often will require higher credit scores and slightly more down payment.
- Speaking of down payments. In most cases, lenders will ask for a standard 20% down payment to fund the purchase of your second home. Smaller down payments may be allowed if you meet specific financial requirements, but a lower down payment might result in a less favorable interest rate, which could end up costing thousands over the life of the loan.
- Don’t forget about insurance. You’ll also want to dig into your homeowner’s insurance policy. The carrier may need to make changes if you plan to rent out your home and may require supplemental coverage or landlord insurance. Ask about how your annual rates may change.
Can you afford it?
Once you’ve determined whether or not it makes sense to convert your first home into a rental property, it’s time to crunch the numbers and see if you can actually afford that second home — or if you want the responsibility of handling two mortgages.
Keep these financial considerations in mind:
- Determine a reasonable rent. You want to take in more rent every month than you pay out in expenses, but you’ll need to be competitive with other local landlords. The best thing to do is to act like a renter and see how you compare. When you land on a number, take that figure, and then estimate the potential cash flow by subtracting the expenses you’ll still need to pay (mortgage, condo fees, insurance, property taxes, utilities, etc.)
- Vacancies happen. You want your home rental to generate a monthly income, but there may be times when the economy or the local job market makes that impossible. Or maybe you’ll need a vacant apartment while renovations or repairs are handled. Make sure you have several months of financial reserves you can fall back on to cover unexpected costs or a lack of tenants.
- Get pre-approved. Before you start shopping for a second property — the one that will be your new primary residence — be sure you get an upfront and underwritten pre-approval from a lender. Unlike a pre-qualification, a pre-approval spells out exactly how much you can borrow so you’re not shopping for homes out of your price range. On top of that, it also tells a seller that you’re a serious buyer and can be used as a negotiating tool.
Before you become a landlord
It’s a big decision, so we outlined six steps you’ll want to tackle before moving forward:
- Know the law: Every state has different rental laws. Besides being legally required to maintain a safe and habitable property, things like security deposits, property access, and end-of-lease notifications are also important. There are also federal housing safety and anti-discrimination laws you must know.
- Thoroughly screen applicants: You want to be able to trust the people you’re inviting to live in your home, so have them complete a real rental application upfront. Make sure you ask for personal and employment references.
- Create a lease agreement: A lease agreement, signed by both the owner and the tenant, is the best way to set expectations with renters and protect yourself in legal situations. There are many examples you can find online to help guide you through the process, but again, they vary by state. You’ll want to have a lawyer look them over.
- Consider a property manager: A good property manager can screen tenants and execute leases for you, but it comes with a price. However, if you’d rather not have to deal with getting estimates for repairs and common upkeep, it might be worth the cost. Plus, a property manager is the first line of defense when a renter has a complaint! Always a good thing.
- Rent auto-pay: If you haven’t been a renter in some time, here’s a newsflash: paying rent online is the way to go. Automatic payments eliminate the problems of bounced checks or rent getting lost in the mail, and they’re more manageable for the tenant, too.
- Keep records of everything: As a landlord, you’ll want to keep records of deposits, paid rent, maintenance receipts, and landlord-tenant communications. Not only is this smart for tax purposes, but these records will also help with any legal issues that may come up.
Ready to get started?
Buying a second home while renting out your first is not for everyone, but it can be a huge financial benefit if you’re successful. As always, this process is infinitely more straightforward when you discuss your situation with a pro. Contact a local loan officer in your area today if you’re ready to take the next step.