It’s no surprise that many property owners are considering the possibility of generating income by renting out their first home. A slowdown in home prices and sales makes selling less attractive, while rental prices for single-family homes increased 2.9 percent annually as of November 2018.
Growing demand for rentals is overtaking the demand for new homes, and you might be able to capitalize on the trend. If you want to know how to buy a second home and rent the first, however, you need to take a strategic approach. It’s a significant decision that demands research and preparation, with an informed understanding of real estate and your role as an investor.
As you move forward, you should set aside time to study the real estate industry in greater detail. Finances, maintenance, and property management become more complicated if you’re looking to rent out your home, and you’ll need to feel prepared before you dive in.See if you qualify to buy another home.
In this article:
- The pros and cons of renting your home
- Can you afford two homes?
- Our recommended mortgage lenders
- Loan requirements and HOA restrictions
- How to calculate rental rates
- Tax implications for renting your home
- Becoming a landlord
It’s best to have a firm grasp on the advantages and disadvantages of renting your home before you make your final decision. After all, it’s a significant commitment, and you need to consider everything it entails — both the good and the bad. Here are five of the benefits you’ll enjoy as an investor.
Pros of renting your home
- Stable and relatively predictable cash flow
- Considerable tax benefits on that cash flow
- Appreciation over your ownership
- Increased cash flow through inflation
- Complete control of your investment
Naturally, these aspects of real estate investment make it an appealing prospect. At the same time, investors have to show caution, as the real estate industry comes with certain risks and downsides which are critical to acknowledge.
Cons of renting your home
- Tenants who neglect the terms of the lease
- Failure to find tenants to occupy the rental
- Extended periods of vacancy and lost profit
- Higher-than-expected maintenance expenses
- Negative cash flow on the property
As you evaluate the pros and cons of renting your home, keep an optimistic outlook. Though risk is an inherent element of renting a property, you can mitigate many of the issues above if you take the proper precautions.
You need to feel secure in your financial situation before you start searching for properties. After all, having two mortgages and renting one home can be complicated. You’ll have to cover the mortgage of your first home, your second home, and maintenance and upkeep costs for both of them. It’s smart to crunch the numbers and see what you can reasonably manage.
First, determine whether your lender will allow you to convert your first home into a rental property. You should have a conversation with your lender before buying another home if you’re interested in renting out your first. In doing so, you can find out if they have any stipulations about your plans.
Then, there’s the financing. Because you’re not planning on occupying your second property, lenders may have stricter stipulations on a conventional loan. This is because you’re more likely to default on your second loan, so requirements may include having six months of liquid reserves, a 20% down payment, and a credit score well into the 700s.
Investment property loans have similarly strict requirements, thus making it critical to be financially prepared to put more money down for your purchase. Furthermore, interest rates tend to be higher than those on an owner-occupied loan, meaning you’ll be paying more over time.
It’s also critical to check the rules and regulations of your homeowners’ association, if applicable. It may have restrictions on the rental of properties under its jurisdiction. Some HOAs only allow a specific percentage or a certain number of homes in the neighborhood to classify as rentals, so look into the details.
Of course, you’ll earn an extra source of income through your rental payments, which will account for some of the costs described above. The rent you charge will depend on a range of factors like your neighborhood, property features, market rates, and more. Here’s a quick guide to some important rental math:
Calculate your mortgage expenses. You’ll need your down payment amount, interest rate, loan term, and PMI, if applicable to find out how much financing will cost you per month.
Calculate your estimated monthly expenses. Expenses should include repair costs and/or renovations, property taxes, and homeowner’s insurance.
Calculate 1% of your home’s appraised value. Many landlords charge between 0.8% and 1.1% of a home’s value for rent, although this will depend on market rates in your area.
Calculate market rates. Take a look at similar rentals in your area. What rates are they going for? It won’t be realistic to charge high rents if other homes with similar features are marked at lower rates.
It’s important to calculate your expected return on investment and cap rate to get a better idea of how much your rental rate will bring in each month. Ultimately, it’s crucial for your financing and property management costs not to outweigh the income brought in by renting out your second home.
Luckily for you, renting out a home has beneficial tax implications. Landlords can deduct many ordinary and necessary expenses from their tax return, including interest, maintenance, utilities, and insurance. Keeping good records will help you make the most of your rental income each year.
If you eventually decide to sell your rental property, however, you’ll have to pay taxes on your profit. The capital gains tax rate comes to 15% if you’re married, filing jointly with a taxable income between $77,201 and $479,000. The capital tax rate rises to 20% if your income is $479,000 or more.
That said, you have methods to prevent a tax hit when selling your rental property. You can pair the gain from the sale with a loss in another area of your investments, or take advantage of Section 1031 of the tax code by replacing your rental home with another investment property.
Assuming the role of a landlord comes with a unique set of responsibilities. It obligates you to make repairs, provide updates on proposed changes, maintain a good relationship with your tenant, and speak with them regularly. The transition from homeowner to landlord can prove difficult if you don’t prepare.
As an example, a tenant who refuses to follow the terms of the lease agreement will have to face repercussions. Are you willing to have that conversation and take action? When you’re a landlord, you’ll need to engage in conflict resolution and be willing to take legal action to mitigate your losses.
You’ll also be the point person for any home repairs, issues or questions, making yourself available to tenants. If the idea of being a proactive property manager doesn’t sound appealing, then you’ll have to prepare to spend more money for professional property management services, too.
Lastly, you have to consider the subject of homeowner’s insurance. It might not offer the coverage you want if you decide to rent out your home. You should seek landlord’s insurance instead, and more than that, encourage your tenants to purchase rental insurance to protect their belongings.
How to buy a second home and rent the first
Your first home is more than a place to live, but an opportunity to enter real estate investing. As long as you follow the suggestions above, the transition should feel natural. You can move forward with an informed understanding of how to buy a second home and rent the first.
As you continue, research the subject in greater detail if you still feel uncertain about the decision. Keep a positive outlook, and soon enough, you’ll enjoy the many benefits the real estate industry has to offer.See if you are eligible to rent your home and buy another.