Should You Rent Out Your Home to Buy Another?
Upgrading from a starter home to your dream home may seem daunting in today’s high-interest environment and unstable housing market. As a homeowner, however, you have a strategic advantage that may help you bridge the gap. Renting out your home, or even a few rooms, can be a great way to earn extra income to put toward the home you really want.
Before you begin, it’s essential to understand the process, as well as the benefits and downsides, of renting out your home to buy another property.
Should You Rent Out Your Home to Buy Another?
Deciding whether to rent out your home may depend on your circumstances. If you don’t have enough cash for the down payment, renting out your current home can help you generate income to add to your savings and apply to your down payment.
For example, your reason for wanting to move could be that your family is growing and you want more space or better local schools. These are both factors that could cause your new home to come with a higher price tag and require a bigger down payment.
Buying a home is one of the most important financial decisions you’ll make in your lifetime. It follows, then, that renting out your current home to purchase a second property is worth thoughtful consideration of the benefits and drawbacks of doing so.
Pros of Renting Out Your Home
The benefits of turning your home into a rental property are numerous and include the following:
Earn passive income: Renting your home may provide positive cash flow if the rent amount you receive exceeds your housing costs, including your mortgage, insurance, and maintenance. This additional income could help you afford a more expensive home. When projecting your potential income, many real estate investors recommend using the 50% rule as a general guideline. According to the rule, 50% of your gross rental income should be allocated to expenses and not be considered part of your profit.
Leverage a paid-off home: If you have substantial equity in your home, or, better yet, you own your home free and clear, you may be able to tap into your home’s equity. That could give you the cash needed for a down payment on a new home or even to purchase one outright.
Receive tax benefits: You can deduct some expenses from renting out your home. According to the IRS, if you collect rental income, you may deduct mortgage interest, property taxes, depreciation, repairs, and necessary operating expenses.
Build wealth: Since real estate prices have historically appreciated over time, you could continue to build equity in your current home and your new home. The FHFA (Federal Housing Finance Agency) House Price Index averaged 4.60% growth year-over-year from 1992 until 2023. It’s also possible your rental income will rise over time. According to an iPropertyManagement report, rental rates have increased at an average of 8.86% per year since 1980.
Potentially qualify for a larger loan: You can usually include rental income when you apply for a mortgage, but you must meet specific eligibility criteria. For example, Fannie Mae sets rental income guidelines stating you must establish that the rental income is likely to continue. Also, your rental property must be either a one- to four-unit investment property or a two- to four-unit principal residence where you live in one of the units.
Cons of Renting Out Your Home
Despite the potential benefits of renting out your home, there are also reasons you might choose not to take this route:
Hassle: The responsibility of having tenants and managing the property can make being a landlord a chore. Ask yourself if you’re comfortable dealing with tenants and handling repairs. Nuisances can range from late-night phone calls to fix a toilet to tenants who cause damage to your property or don’t pay rent. Outsourcing landlord duties to a property management company is one option, but that can cut your rental income by 8% to 12%.
Risk of becoming underwater on both mortgages: While building equity in two homes is possible, the opposite is also true. If property values drop, you could end up underwater on two mortgages. In this case, you could owe more on each mortgage than each home is worth.
Unpredictability in the rental market: As a landlord, you may go through periods when your property sits vacant or when tenants don’t pay rent. If you’re not prepared, you could face significant financial hardship that could limit your ability to make ends meet or take advantage of other financial opportunities.
Lack of liquidity: Generally, real estate is a long-term investment that is not the most liquid asset. That means your house can’t be quickly sold or liquidated if you need to access cash. If you suddenly need cash, you may be unable to sell your home quickly enough to address your hardship.
How to Rent Out Your Home to Buy Another
Before deciding to rent your home, do your due diligence to ensure the strategy makes financial sense. Start by calculating the costs of renting out your current home. Additionally, assess the local rental market, including the demand for rentals and the average rental rates for similar homes in your area. Weigh the pros and cons and consider your risk tolerance level.
If you decide to turn your current home into a rental property and buy another home to live in, here are the steps to make it happen:
Consult your insurance agent: Make sure you have enough liability coverage in case a tenant sustains an injury in your home. Consider getting landlord insurance that can help to protect you against costly repairs. Landlord insurance typically costs 15% to 20% more than homeowners insurance.
Get your home ready for a tenant: Make any repairs or improvements to your home to ensure it’s in good condition for new tenants. Before listing your property on the market, consider enlisting the services of a professional who can give it a deep clean.
Advertise your home for rent: As a landlord, you aim to get as many potential tenants as possible to see your rental listing. Listing your home on several online platforms and enlisting a local real estate agent to market your home are two ways to shine the brightest light on your rental opportunity.
Screen potential tenants: Review applications from potential tenants to ensure they have a solid rental history, no record of eviction or criminal activity, and adequate income to pay the rent. You must understand the local and state landlord-tenant laws and renters’ rights, including discrimination laws.
Sign a lease agreement: Once you find a qualified tenant, create a rental agreement that details the arrangement’s terms and conditions, including the rent amount, monthly due date, and other essential information. Have your tenant sign it when they agree to rent from you.
Apply for a new mortgage: With suitable tenants ready to move into your current home, it’s time to turn your attention to securing a mortgage loan for your new home. As mentioned, you may be able to include rental income when you apply for a new home loan, but confirm with your lender. Shop and compare mortgage loan offers with multiple lenders to find the most favorable rates and terms.
Alternatives to Affording Your Dream Home
It’s possible to afford your dream home without renting out your current house, but it may require a longer time frame. Consider these alternatives to help you purchase your dream home.
Shore up Your Credit File
Taking steps to improve your credit can boost your approval odds for a mortgage with low interest rates. Paying less in interest charges over the life of your mortgage makes your new home more affordable. A strong credit file can also help you qualify for a bigger loan that is necessary if you want to buy a more expensive home.
Save for a Large Down Payment
Making a larger down payment can help you qualify for a larger loan amount you may need to purchase your dream home. A larger down payment decreases your borrowing amount and your lender’s risk. As such, you might get a lower mortgage interest rate which could enable you to afford a more expensive property.
Aiming for a down payment of at least 20% could help you avoid private mortgage insurance (PMI) payments, saving you between 0.22% and 2.25% of your loan amount annually.
Increase Your Income
Boosting your income can not only help you save for a large down payment, but it’s also one of the most important factors lenders consider when you apply for a new home loan.
Increasing your income is one way of lowering your debt-to-income ratio (DTI), the percentage of your gross monthly income that goes towards paying your monthly debt obligations. Lenders typically prefer your DTI to be below 43%, but the lower, the better.
Perhaps the easiest way to raise your income is through your job. Volunteer for overtime or request a wage increase if your salary falls below the market rate for your position and experience. Taking on a second job or starting a side hustle are also excellent ways to raise your income.
Reduce Your Debt
The other way to lower your DTI is to reduce your debt. If possible, pay off any loans or credit card accounts with low balances. Even if you can’t pay off your credit cards, decreasing their balances will lower your credit utilization rate, which accounts for 30% of your credit score.
Optimize your efforts by following a debt repayment strategy such as the debt avalanche and debt snowball methods. While the debt avalanche method focuses on paying off high-interest debt first to save on interest charges, the debt snowball method focuses on paying off your smallest debt first to build momentum.
Should You Rent Your Home and Buy Another One?
Renting out your home and purchasing another property can deliver a wide range of benefits and downsides. Ultimately, the decision to follow this strategy is a personal one that will depend on how you feel about several important considerations, such as:
Could your rental rate provide positive cash flow, even after paying for ongoing repairs, maintenance, insurance, and other costs?
Do you want to be a landlord? If no, can you afford to hire a property management company to handle tenant issues?
Is the rental demand in your area strong enough to help avoid a long vacancy when a tenant moves out?
If you decide to follow this path, make sure your credit remains consistent throughout the mortgage process. Your lender will review your credit when you apply and could check it again closer to your closing date to make sure there have been no significant changes.
As such, it’s essential to monitor your credit, looking out for potential issues that could cause a problem with your loan approval. Consider signing up for Experian’s free credit monitoring service to access your FICO® Score☉, the score used by 90% of top lenders. You’ll also get your Experian credit report and real-time alerts to help you stay informed of any changes to your credit.
For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We are here to help you navigate the complexities of renting out your home and purchasing your dream home.
