Katey McKenna, Wealth of Geeks
RealtyTrac reports that February is one of the best times to buy a home, and 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. To better prepare you to take the plunge in purchasing a rental property, I have put together some key factors to consider.
The 1% rule is a standard some use when determining if the investment property is a good risk. According to an article from Rocket Mortgage, for an investment property to be considered a success or a good financial investment, the monthly income should be equal to or more than 1% of the home's sales price.
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1. Can you afford a second mortgage payment?
Step one is to make sure you have the finances in place to afford an additional mortgage payment. On top of the mortgage payment, it is also important to make sure that you can afford any other debts that might come with buying a new home. For example, can you pay to furnish it, and does it need any repairs? You should also have some financial reserves in case the home isn't rented continuously and when it needs to be unoccupied for repairs after long-term tenants vacate.
Your debt-to-income ratio comes into factor 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, on an investment home, conventional Fannie Mae and Freddie Mac are the only types of loans you can use.
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, but 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 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 need to have enough funds to cover 20% of the purchase price and any additional closing costs.
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2. How to have a second home for rent without committing mortgage fraud.
A second home for rent is like a vacation home that you can rent out. To the IRS, it is a property rented out during the taxable year but is occupied for more than 14 days or 10% of the number of 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 home that you rent out.
Investment properties and second homes are qualified with different criteria, and if you say you want one kind of property, but it really is the other, that is mortgage fraud. If your property does not meet the minimum requirements, it would be considered an investment property. It is important to talk to your lender about the kind of property to make sure you are not accidentally committing mortgage fraud.
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3. What kind of investment property type are you looking for, and how do you plan on financing it?
Once you have looked at your finances and determined that you can qualify, you should look at the kind of investment property you are looking for. To put this in other words, you need to figure out what kind of rental property you want: long-term or short-term rentals. Long-term rental involves more of a landlord position while short-term would be more like an Airbnb.
After choosing the rental type, you will want to investigate a financial plan that will help you purchase your investment property. The best option is to refinance your primary residence and use the equity to cover the down payment for your new property. 64% of buyers think that the cost of their current home will increase in the next year. Higher value equals more equity which allows you to use your current home better to finance your second one. If this is the route you want to go, you can do a cash-out refinance where you covert the equity from your home into cash, or you can take out a home equity loan that allows you to take out a lump sum loan.
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4. Location, Location, Location
Location seems like an obvious thing to consider, but it is actually vital to purchasing an investment property. You are buying a second home to rent as a form of income. If so, you will want to pick a property that is in a profitable area. Looking at the demand and popular areas to buy helps ensure that you will earn enough in rental income to cover the second mortgage cost. 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 right 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. It's beneficial for landlords to live nearby in case of emergency. Being a landlord doesn't just stop with maintenance. They are also required to keep up-to-date with rental laws, screen tenants, collect rent, and even possibly deal with delinquent renters.
For short-term rentals, the need for a landlord is slightly different. Cleaning services, accounting, and maintenance are needed for short-term rentals. If you choose the Airbnb route, it is important to keep a good customer rating which means you need to 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 to do. It is essential to work closely with your lender to determine the right property type for your situation. To wrap it up, make sure you qualify for the stricter rules for investment properties before proceeding with the loan.
