Considering a second home while renting out your first? It’s more achievable than you might think. Here’s your guide to making it happen and generating extra income. We’ll walk you through the benefits of owning a second home, how to buy one without selling your first, and how to step up as a landlord.
Author’s Personal Take
I started my real estate investing journey by buying a second home and renting out my first. And let me tell you, I had a lot to learn. When you become a landlord, there are a hundred and one thing you have to know to successfully generate rental income. It may seem scary and overwhelming at first, but do you homework and make sure you find quality tenants. That is the difference between a consisten stream of cash flow (income) and continuous headaches. Read this article about how to attract quality tenants. I also recommend setting up a separate business checking account right away so you can separate your rental finances and maxmimzie your tax deductions (on Baselane it takes only a few mins to create the bank account). Good luck!
Considering a second home while renting out your first? It’s more achievable than you might think. Here’s your guide to making it happen and generating extra income. We’ll walk you through the benefits of owning a second home, how to buy one without selling your first, and how to step up as a landlord.
The Benefits of Renting Your Home
By renting out your current home, you maximize your assets. Other benefits include:
- Generate passive income – Rental Income: Well-maintained properties in desirable areas can lead to positive cash flow, meaning you earn more than you spend. That’s additional income directly padding your bank account, while a renter is paying off your mortgage. The rent can supplement your regular income or act as a fallback.
- Tax Perks: Owning an investment property in the U.S. brings notable tax perks. You can deduct property taxes, mortgage interest, and depreciation costs. Plus, certain capital improvements further enhance property tax efficiency.
- Equity Growth: Your property’s value can appreciate over time, resulting in increased equity. Renting your property out not only provides you with rental income but may also increase its value over time.
- Manageable Debt: With the rent covering monthly payments, you can potentially offset some, if not all, of your mortgage loan.
The rewards are tempting, but there are challenges as well. Rent isn’t just about cashing in every month. Managing tenant relationships and upkeeping the property are also part of the landlord’s responsibilities. To ease this process, hire a property manager.
Define Your Second Home's Purpose
When thinking of buying a second home, ask yourself:
- Are you goign to rent out the first and live in the second home?
- What if the first home is vacant for a few months, do you have funds to pay both mortgages?
- Are you ready for the initial and ongoing costs?
- Any tax benefits from the first and/or the second home?
- Will the first home generate enough rental income to pay your monthly costs? (mortage, insurance, taxes, maintenance, utilities, etc.)
If you plan to live in your second new primary home, and plan to rent out the first one, make sure you can get financing. Mortgage lenders follow guidelines from major entities like Fannie Mae and Freddie Mac.
Second Home Criteria:
- Lenders view second homes as less risky, possibly qualifying you for lower interest rates.
- For at least half of the year, you must live in the house and use it for personal use.
- It should operate as a vacation home all year, with only one unit.
- While short-term rentals are permissible, property management companies cannot manage them.
- The property should be over 50 miles away from your primary residence to be classified as a vacation home.
Investment Property
You will need a higher down payment and interest rate if you’re buying another home as an investment – either to rent or to fix and flip.
- Lenders perceive these as riskier due to potential rental damages and missed payments.
- Proof of rental intention, like a rent schedule or lease agreement, might be needed.
- Usually, VA or FHA loans are not available for second homes or investment properties. However, with “house hacking,” you can utilize these loans for multifamily properties, renting out other units while occupying one as your main residence.
Always review your finances, budget wisely, and discuss with your family before taking the plunge.
NOTE:
Having a second home might not give you tax benefits. Even where it’s located, how much you earn, and how many days you rent it out matter. For instance, if you rent your second home for over 14 days annually, the IRS might see it as a rental property, and you could be taxed on that rental income.
How to Buy a Second Home and Rent the First: Step Guide
Purchasing a second home while renting out your first can be a rewarding venture. Following are the steps to guide you through this process seamlessly.
1. Assess Your Financial Situation
Before diving into the property market, understand your financial position. Here are a few tips to gauge if you’re ready:
- Credit Score: If you put down 25% or more on a second home, Fannie Mae sets a minimum credit score of 640. For a primary home, you need a 620 credit score. A strong credit score can lead to better loan terms. You can improve your score by paying off debts with high-interest rates.
- Monthly Mortgage Payments: Understand what you currently owe and how it impacts your finances. The minimum cash reserves for a second home mortgage are two to six months. Lenders want to ensure you can make monthly payments if you lose your job or have another financial hardship.
- Monthly Income vs. Expenses: Ensure a stable income ratio and enough financial reserves for potential additional expenses.
2. Calculate Rental Property Returns
Making sure your first home can fetch a good rental return is key. Here’s how:
- Estimate Monthly Rent: Check the rental market for similar types of properties in your area. Use Baselane’s free rental property calculator to estimate your second home’s monthly ROI and annual cash flow.
- Deduct Monthly Expenses: Don’t forget about property management fees, property taxes, maintenance costs, and potential vacancy periods (best to budget at least 5-7%). Repairs, property taxes, and insurance typically consume around half of rental income, according to the 50% Rule.
- Considerations for Renting Out Your First Home: Does the property have the potential to gain value? Long-term, will you enjoy this area? Is there any recreation nearby? Find a real estate agent who can tell you about the local housing market and amenities in the areas you’re considering.
3. Research Loans for a Second Home
Understand your financing options before buying a second home. The equity in your primary residence might be the key to funding your next purchase.
In conventional loans, down payments can be as low as 3%, but many lenders require 10% or more for second homes. A second home mortgage with less than 20% down may require private mortgage insurance (PMI). For a second home, borrowing equity from your primary residence may be the best option for avoiding PMI.
Using your first home to finance your second
If you’ve built substantial equity in your primary home, it can be a valuable asset to help fund your second property.
Two prominent financing options are:
- Cash-Out Refinance
During a cash-out refinance, you replace your existing mortgage with a new one, allowing you to access your home equity in cash. You may benefit from lower interest rates because it’s based on your primary home’s mortgage. With this method, you could borrow up to 85% of your first home’s value. However, associated closing costs and current interest rates can influence the total equity you can access. - Home Equity Loan or HELOC
Both are forms of second mortgages that use your primary residence as collateral. Home equity loans typically offer a fixed rate and are disbursed as a lump sum. In contrast, HELOCs have variable rates and provide flexibility for expenses over an extended period. With these methods, you might access up to 85%-90% of your home’s equity, possibly more than a cash-out refinance.
4. Get Quotes for Landlord Insurance
Ensure you’re covered for any unexpected situations and your projected insurance expesnses are accurate by getting a rental property insurance quote
- Property Damage: Coverage against natural calamities or tenant-induced damages.
- Liability Insurance: Protection against legal claims from tenants.
- Loss of Rent: If your property remains vacant for an extended period.
- Optional Covers: Depending on your location, you might want flood or earthquake insurance.
5. Set up Rental Property Bookkeeping
Financial tracking is a game-changer for landlords:
- Income and Expense Tracking: Record monthly rent, maintenance costs, and other expenses.
- Regular Reconciliations: Compare your book records with bank statements to ensure accuracy.
- Digital Tools: Consider digital rental property accounting software that offer automated rent tracking and categorization for your finances.
Final Thoughts
You might want to consider a second home due to the high demand for rental properties, but be sure to track your income and expenses! And for managing your rental property finances, consider Baselane. It’s tailor-made for landlords like you to keep track of the nitty-gritty and maximize profits.
Want to simplify your landlord process? Book a FREE demo with Baselane today!
