You’ve decided to move out of your home. For whatever reason, it’s time to move and you’ve laid out a plan as to what will happen next. The traditional move is to sell your old home and move into a new home. Depending on what your financial situation is, sometimes that home is a larger one, sometimes it’s smaller, and sometimes homeowners decide they want to be renters instead.
Sometimes, the plan is a bit more complicated — what if you decide to rent out your house for more than the cost of your current mortgage and buy a second home? You could actually pull off this “buy-new-home-rent-old-home” strategy, but to be successful, there are lots of angles and factors to consider first. Let’s take them one by one:
Great idea, but there are rules
Before you can begin to entertain the notion of renting out your current home and buying a second one, you need to review your current mortgage. Some mortgages don’t let you convert your residence into a rental without paying a penalty or refinancing into a more expensive, non-owner occupied loan.
Technically, you would be violating the terms of your loan, triggering what is commonly called an “acceleration clause,” forcing you to pay off your current loan. Other lenders might not let you rent your place until you’ve lived in it for a certain amount of time, so you need to read and understand the terms of your mortgage.
Your home might not be worth as much as you think
Real estate value not only comes down to location,, but also the type of residence you would be selling. Not all home assets are valued equally. “First off, if it’s a condo, appreciation for the unit will be below the general market,” said Kent Sorgenfrey, a Southern California-based mortgage lender.
The current market value of your home is important because it will influence how large a mortgage a new lender will grant you on your next property.
You might overestimate how much rent you’ll receive
Ideally, you would like to receive enough rent to cover your current mortgage, if not more. That way, you could apply the added income to the mortgage on your new or second home. Therefore, check with local property managers to find out what homes like yours are renting for. You might even advertise your home for rent to see whether you get any nibbles at your hoped-for price.
Don’t forget to account for all those rental expenses
Even if somebody pays you what you want, you don’t just get to stick all the rent in your pocket. As a landlord, you can expect expenses that come with owning and managing your rental. How much rent will you clear after deducting for insurance in the event the new tenants destroy your property? And don’t forget to account for property taxes, homeowner’s association dues, utilities and general maintenance as well.
If you’re smart, you also need to set aside money for an unexpected vacancy. Typically, you should set aside 10 percent, so if you were to charge $2,000 a month or $24,000 a year, you need to set aside $2,400.
Further, if you decide that you’re not cut out to be a landlord, figure on setting aside another 10 to 15 percent of your rent to hire a good property manager who will be responsible for screening tenants, running background checks, executing lease agreements and running down estimate repairs after a your tenant’s toilet starts overflowing in the middle of the night.
Not all rental income is treated equally
As you did when applying for your current mortgage, you will have to show your total income when applying for a new mortgage to help the lender determine your debt-to-income (DTI) ratio. Naturally, if it were up to you, you would like to include your after-expenses rental income as part of your total income to lower your DTI.
Your lender, however, might not count any of your rental income or might just count a portion of it. Your lender, for example, might first insist on seeing a signed year-long lease agreement on the old home.
“If you have no landlord experience, they may require that you be able to show rents on your 1040s to prove you’re actually receiving the money,” Sorgenfrey added. “That could take a while. It is far too easy to fake a rental agreement, and lenders know that.”
If a lender on a new mortgage does count the rental income, the lender might not give you full credit.
“Often, the best any lender will do is a rent credit for 75 percent of the actual rent income,” Sorgenfrey noted.
This 25 percent difference, of course, could mean that the actual rent, in the eyes of the lender, won’t even cover your mortgage on your current home.
If you’re underwater on your current home, you face another set of barriers:
Lenders, by nature, are not charitable institutions. If you owe more on your current mortgage than your home is worth, few new lenders, if any, would lend you money for a second home. The FHA, a major lender insurer, requires that the home you plan to make a rental has a loan-to-value (LTV) of 75 percent or less. To ensure value, you would likely be required to provide a current appraisal on the rental home.
There’s a big reason that lenders are so gun-shy when they don’t find enough equity in the home that you want to use as a rental. They’re afraid, as often happened in the Great Recession, you will dump the old home and let it go into foreclosure as soon as you’re handed the keys to your new home.
“Any underwriter — even if the applicants qualified for making two mortgage payments — would be concerned about the potential to ‘buy and bail’ given the fact they are upside down,” said Ted Rood, a national mortgage lender with MB Financial Bank in St. Louis, Mo. “The borrowers would probably be OK on a ‘buy and bail’ concern, if they brought in a really good letter of explanation and had a good credit history, but it would be more up to the underwriter’s discretion.”
The terms of your current loan also will undergo added scrutiny
If you have a current adjustable rate mortgage, a new lender won’t calculate what you owe based on your current rate, but what you could owe if your rate increases. In other words, if you’re paying 4 percent currently on your mortgage, but it adjusts to 8 percent, the lender will assume the worst-case scenario. According to your lender’s calculations — and only their figures count in the end — your $1,500 a month mortgage is a $3,000 a month mortgage, or double what you’re now paying.
This “difference” is vital because you’ll have to prove to your new lender you can afford two mortgages, the possible $3,000 one on your old home, and whatever your new mortgage payment will be. Calculate your possible mortgage payments using the handy MyBankTracker mortgage calculator for more scenarios.
The bottom line
You might have all kinds of reasons to rent out your current house and buy a new one. It can be a great strategy, but you’ll have to meet all kinds of conditions, most important, of which, is showing you have the means, resources, and income to support two mortgage payments.
If you don’t, you may have to defer your dream of renting your current residence. You might just have to sit tight in your current place until prices improve and you continue to pay down your mortgage to build more equity.
If you’re absolutely determined to move, you could sell or short sell (if your home is worth less than you owe) your house. A short sale, however, could trigger a tax liability. Also, the move is likely to screw up your credit score and that of your co-signer, if you have one.
There’s no harm, of course, in discussing your situation with a mortgage lender who should be able to tell you straight up, after running a few numbers, whether you can afford to buy a new home and keep the old one as a rental.
Inevitably, even the best idea or plan will, at some point, bump into reality. Sometimes, the obstacle will be small; other times it will be insurmountable. “If you’re too far underwater,” Sorgenfrey said, “you just might be stuck with your white elephant, and it could hang around your neck for quite a while.”
Peter is a staff writer at MyBankTracker.com who covers banking, personal finance, investing and homeownership.