RealtyTrac reports that February is one of the best times to buy a home. With mortgage rates continuing to inch up, the perfect time to invest in a second home as a source of rental income could be right now.
But buying a second home for investment is a big financial decision that can be intimidating without the proper knowledge. So to better prepare you to take the plunge in purchasing a rental property, we have put together some key factors to consider.
The 1% rule is a standard for determining if the investment property is a reasonable risk. According to Rocket Mortgage, for an investment property to be considered a success or an excellent financial investment, the monthly income should be equal to or greater than 1% of the home's sales price.
1. Can You Afford a Second Mortgage Payment?
Step one is to ensure you have the finances to afford an additional mortgage payment. A second home purchase is a big decision; in addition to the monthly mortgage payment, it's also essential to make sure you can afford any other debts that might come with buying a new home.
For example, can you pay to furnish it, and how much would you estimate for maintenance costs? You should also have some cash reserves if you struggle to find good tenants and the property isn't rented continuously. In addition, you'll want to plan for times when it needs to be unoccupied, and future repairs after long-term tenants vacate.
Your debt-to-income ratio comes into play here. Debt-to-Income (DTI) calculates all your debt to the amount of money you bring in. The max DTI for a conventional loan is 41% for an investment property. In fact, conventional Fannie Mae and Freddie Mac are the only types of loans you can use on investment properties.
Combining your DTI and credit score will determine if you are eligible for an additional mortgage and will determine your interest rate. For an investment property, the minimum credit score is 620. Still, you will need other compensating factors to qualify with the minimum score. It is also important to note that interest rates for second and investment properties are higher than for a first home or primary residence.
Your loan-to-value (LTV) is also a determining factor to consider. Investment properties require a minimum LTV of 80%, which means you must have enough funds to cover 20% of the purchase price and any additional closing costs.
2. How To Have a Second Home for Rent Without Committing Mortgage Fraud
A second property for rent is like a vacation property that you can rent out. According to the IRS, the property is rented out during the taxable year. Still, it is occupied for more than 14 days, or 10% of the days in which the property is rented.
Renting out a second home teeters on the line of mortgage fraud or not, so it is important to understand the difference between an investment property and a second house that you rent out.
Investment properties and second homes are qualified with different criteria; therefore, applying for one type of property while purchasing the other is considered mortgage fraud.
If your property does not meet the minimum requirements, it is considered an investment property. The best way to avoid fraudulent transactions is to talk to your mortgage lender to determine the type of property you want to purchase.
3. Type of Property and Financing
Once you have assessed your financial situation and determined that you can qualify for a mortgage loan, the next step is to decide which type of rental properties best fit your investment strategy. Would being a landlord and offering long-term rentals be the right decision, or would offering short-term rentals (like Airbnb) be a better option?
After choosing your preferred rental type, you must explore financing options to secure a second home mortgage. A popular option is to refinance your primary mortgage and use the equity as the down payment on your second home loan. 64% of buyers believe the cost of their primary home will increase in the next year.
Higher value equals more equity, allowing you to better use your current home to finance your second one. If you have enough equity in your current home for this option to make sense, the first step is to do a cash-out refinance on your current mortgage and convert the equity from your home into cash. Taking out a home equity loan on your first mortgage is another great way to withdraw a lump sum of equity from your property.
4. Location, Location, Location
Location is an obvious thing to consider, but it is especially vital when purchasing a second home to rent for extra income. It's a good idea to pick a property that is in a profitable area.
Looking at the demand and popular areas to buy helps ensure you earn enough rental income to cover the cost of a second home loan. In addition, the kind of rental property you want should determine the location you are looking for. For long-term rentals, cities or areas with a higher population are good examples of the correct location. For short-term rentals, tourist spots are the recommended location.
5. Landlord Requirements
Being a landlord is essentially a second full-time job. If you have decided to go with a long-term rental, then as the landlord, you need to be accessible at all times. In addition, it's beneficial for landlords to live nearby in case of emergency. Being a landlord doesn't stop with maintenance. They must also keep themselves up-to-date with rental laws, screen tenants, collect rent, and handle delinquent tenants.
A landlord may not be necessary for short-term rentals, whereas cleaning services, accounting, and maintenance are necessary. If you choose the Airbnb route, it is crucial to maintain a good customer rating which means you must keep up with the wear and tear on the house after each use.
Buying an investment property or a second home for rent is a big undertaking, but it is not impossible. It's essential to work closely with your lender to determine the right property type for your situation and ensure you qualify for the stricter requirements for investment properties before securing a loan.
This article was produced and syndicated by Wealth of Geeks.