The Rental Property Easy Button
Many of us dream of owning a portfolio of rental properties. Acquiring a property and using other people’s money to pay off the mortgage while building equity and enjoying tax benefits is a proven path to wealth accumulation.
Unfortunately, would be landlords often hit a roadblock when looking to acquire their first rental property.
There are many low down payment options to get you into a primary residence with as little as 3% down (even 0% if you are a veteran or qualify for a down payment assistance program). Buying a rental property is an entirely different ballgame.
Since loans on non-owner occupied properties present a greater risk to the lender, larger down payments are required. Typically 20% is the minimum. While there are lower down options, most are not attractive after factoring in higher interest rates and/or mortgage insurance.
What if I told you there was an “Easy Button” for starting your real estate empire? Actually, there is. The first step involves buying your first home as a primary residence. The down payment riddle is much easier to solve as you can use any of the previously mentioned low down options to buy with just 3-5% down.
After a few years of principal reduction and price appreciation you will have built up some equity. You may even have been able to refinance and lower your payment by improving your rate and/or eliminating mortgage insurance.
Regardless of how you acquired your first home, you are now in a great position to acquire your next property as a primary residence. This allows you to benefit again from low down payment options while converting your previous residence to a rental.
Let’s take a look at the various loan programs available to you and how each will handle the conversion of your primary residence into an investment property.
In 2015, Fannie Mae eliminated their requirement that anyone converting their residence into a rental must have at least 25% equity in that property. Now anyone wanting to use conventional financing to buy a home while turning their residence into a rental can do so.
On the downside, they still require an executed lease and evidence of receipt of a security deposit or first month’s rent prior to closing escrow on the new home.
The reason is to prevent a buyer from providing a phony rental agreement to qualify for the loan. It’s a reasonable requirement but can require a little bit of coordination towards the close of escrow on the new home.
In addition to this rule, most lenders will require that the new property “makes sense” as a primary residence. In general, this means that the buyer is moving up to a home that is larger, in a nicer area or tangibly better in some aspect.
To see how this would play out in the real world, let’s look at a sample scenario.
Randy and Roberta Macias live in a nice entry level home valued at $300,000 with their twin daughters. Thanks to good timing, their home has appreciated over $90,000 since it was purchased in 2010 for $210,000.
At that time, Juan and Roberta were newlyweds and the 2 bedroom, 1 bath Craftsman style home fit their needs perfectly. Now, with a family of 4 they are busting at the seams and need more space, a better yard and a good school district for the girls who will be starting school in just over a year.
In a perfect world, Roberta would love to keep their current home and use it to accumulate equity to pay for college for the twins. The Macias can rent their current home for $1700 and 3 bedroom, 2 bath homes in the school district they want to move to sell for around $425,000. The current payment is $1400 after refinancing last year to eliminate their mortgage insurance.
When qualifying for a new conventional loan, we can use 75% of the rent to offset the total payment (principal, interest, taxes and insurance). So in this instance, we would take 75% of the $1700 ($1275) and deduct the monthly payment of $1400 ($1275 – $1400 = -$125).
In the real world, this property produces a $250 a month profit before ongoing maintenance expenses ($1650 rent minus $1400 PITI payment). The 75% calculation allows lenders to conservatively account for ongoing maintenance and expenses in addition to the mortgage payment and results in a -$162.50 for qualification purposes.
How is this negative amount handled? Just like any other payment, it is added to your liabilities when calculating the debt to income ratio. To an underwriter, this amount looks no different than a car payment or a student loan. Let’s look at how this impacts the Macias family.
Randy makes $3800 a month as a plumber and Roberta earns $4000 as a teacher, for a total household income of $7800 per month. They each have a car payment and Roberta is still working on paying off her student loans. In total they pay $795 a month.
With 5% down, the all in payment on a $425,000 home comes to $2,531 a month. This amounts to 32.5% of household income and is well within the limits of the conventional guidelines. Once we add the $795 per month in debts we have a total debt to income ratio of 42.6%. In most cases, the maximum DTI on a conventional loan is 45%, so we are good there but we also have to add the $125 rental loss to the debts. Thankfully, that takes us to 44.2% and the Macias family will qualify for the homes they are targeting.
- You will need to provide an executed lease and evidence of receipt of the security deposit
- Take 75% of the monthly rent and deduct the total monthly payment (principal, interest, taxes and insurance).
- If this is a negative number, count the amount as an additional monthly liability
- If this is a positive number, add it to your monthly income.
Next, let’s take a look at how this would work if you’re trying to buy your next home using an FHA loan. In most situations, FHA is the path of least resistance for buyers. FHA allows higher debt to income ratios and is more forgiving in regards to credit. Our scenario is one of the rare cases where FHA guidelines are more restrictive than conventional guidelines.
he FHA guidelines were revamped from top to bottom in October of 2015. There were a ton of changes, some for the better, some for the worse. The change in regards to conversion of a primary residence to a rental is one of the most puzzling and means FHA is not an option for many, if not most, people looking to keep their home as a rental.
To use FHA financing while keeping a departing residence, ALL of the following conditions must be met:
- Borrower must be relocating in an area more than 100 miles from departing residence.
- Borrower must have 25% equity in converting residence.
- A lease agreement for at least 1 year must be submitted.
- Evidence of the payment of the security deposit or first month’s rent must be submitted.
Bullets 3 and 4 mirror the conventional guidelines. Bullet 2 means FHA still requires the borrower to prove they have significant equity in their current home in order to use the rental income to qualify. The first bullet point is the one I take issue with.
FHA has always had a guideline prohibiting a borrower with an FHA loan from buying another home using an FHA loan (with a few limited exceptions). Now, FHA is saying they will not allow someone owning their residence to buy another home using FHA financing UNLESS it’s 100 miles or more away from their current residence.
For the vast majority of buyers, this means FHA is not an option if you want to keep your home as a rental.
- You MUST be moving at least 100 miles from the departing residence.
- You MUST have at least 25% equity in the departing residence.
- You need to provide an executed lease of a year or more and evidence you have received the deposit.
For anyone eligible, VA financing is hands down the best low down payment loan available. The rates are excellent, there is no monthly mortgage insurance and the guidelines are very friendly to the borrower. When it comes to keeping a property as a rental when buying a new home, VA delivers once again with very accommodating guidelines.
The guideline is so brief, and so clear, I’m going to quote the whole thing right here:
Use the prospective rental income only to offset the mortgage payment on the rental property and only if there is no indication that the property will be difficult to rent. This rental income may not be included in effective income.
Obtain a working knowledge of the local rental market. If there is no lease on the property, but the local rental market is very strong, the lender may still consider the prospective rental income for offset purposes.
In plain English, you can use the rental income to offset the payment on the departing residence, but you can’t add any of the rents to income. This is easier to understand when we look back at the example of the Macias family. If one (or both) of them was a veteran, we would simply take the $1700 a month of income, verify that it exceeds their $1400 PITI payment and wash it away for qualifying purposes.
Pay close attention to the last detail. In a strong rental market, lenders aren’t even required to document a lease agreement. In any case, a veteran does not need to document receipt of a deposit. Once again, an awesome, well deserved benefit for those who have served our country.
- Use the full rent as an offset to the mortgage payment.
- No requirement to document receipt of deposit.
Wrapping It All Up
Buying a new home and converting your current residence to a rental is possibly the easiest path to becoming a real estate investor. There are many options, and potential pitfalls, depending on your scenario and qualifications. Feel free to reach out if you’d like a no cost, no obligation analysis showing you exactly what’s possible!