Things to Consider When Renting Out Your Old Home to Buy a New Home
When most people buy a new home, they pay for most of it by selling their old home, if they can. This is the generally accepted approach, and most people do just fine this way. A few investment-savvy people, however, have found a different way to do it. Why not rent out your current home to help pay for your new one? It may not be a foolproof solution, but if done right, it can come with numerous benefits. Here are a few things you’ll want to know if you’re considering renting out one property to help pay for another.
First, let’s talk about the good that can come from this concept. Typically, the rent payment on a rental property can cover its existing mortgage payment with extra money left over for maintenance and additional cash flow. This means that if the new primary residence you’re buying is roughly the same value, the income from the rent can cover some of the new mortgage payment. Now, at first glance, some might point out that this isn’t very different from the original scenario, where the original house is sold to buy the new house, but the difference becomes apparent at the end of the mortgages, when the owner owns two properties free and clear instead of one. At that point, they can take advantage of the appreciation and sell the original property, pocketing the cash, or they can continue to rent it out, collecting a check every month. And while you wait, your tenant is paying down your mortgage creating a hedge against potential lack of expected appreciation. Compare that to an unpredictable stock market where investors typically depend on price appreciation.
Of course, as great as this deal seems, there are a few things you should consider before jumping in. For example, there are always risks associated with renting out real estate properties. At any point, a renter could leave or stop making payments. The property could be damaged, and while insurance will hopefully cover it, the rent checks will stop. This is always unfortunate, but it’s especially scary when you rely on the income to make your primary residence mortgage payment.
Luckily, many banks will often accept rental income when they do the calculations to determine if you are worthy of a mortgage loan. It’s not an ideal situation though. Although every bank is different, many will only count 70% of the rental income on the ledger. Also, you probably won’t find a bank that will consider the potential rental value of the property before a lease is signed and rent payments made. They’ll want to see records of consistent rental income, possibly over a long period. This is inconvenient because you’ll have to move out and find a consistent renter for the property before you can even apply for a mortgage on your new property. If you have enough income to cover both mortgages, it would be more convenient. A middle-ground option may be to take out a second mortgage on your current home to generate extra cash for the new home purchase. These are things you can discuss with a good mortgage broker (I can recommend a few).
The “in between” period
The period between moving out of the original property and moving into the new one can be longer than expected. You should have a plan that will support you for at least 4-6 months, if not a year. If you have money saved up, you could stay in an extended stay hotel, or rent another place month-to-month. If your financial position is strong enough to move directly from one home to another, you’ll need to factor in time for the move, preparing the old house, finding tenants, and collecting rent. (Also, be aware that any tenant security deposit funds should be treated as “other people’s money” and kept in a separate account. Do not spend the security deposit money thinking you’ll replenish it before they move out — that sets you up for trouble in a number of ways.)
Before you apply for any loan, you’ll be forced to give a lot of attention to your debt-to-income ratio. This is especially true when it comes to renting out a property to pay for another. The rental income will be very helpful in this ratio, but you’ll also probably need another strong source of income. It also helps to have few, if any, outstanding mortgages. To get your ratio, add all your require debt payments (mortgage, credit cards, auto loans, etc.) and divide by your gross income. So, if you have a $1200 mortgage, $100 credit card minimum payment, and a $200 auto loan, you’re monthly debt payment is $1300. If your job pays $4000/month, then your debt-to-income ratio is $1500/$4000 = 37.5%. In talking with your mortgage broker, you may find the 40% mark to be a key threshold; however, this can change and vary among lenders and borrowers.
Looking for more information related to buying a home? Please contact me. As a licensed Denver Realtor I am an expert when it comes to buying and selling homes, and am here to help you achieve your real estate goals.
And if you happen to be a current landlord investor or aspire to be one, as a real estate investor myself, I can help you think through real estate investment opportunities.