Vail Daily column: Buying a rental property might be easier than you think
Many people think it would be great to own more real estate but think they can’t qualify for a mortgage loan for a rental property on top of their mortgage on their primary residence. In some cases that is certainly true, and no one should take on mortgage debt that they can’t comfortably handle.
Acquiring a rental property should entail asking yourself if you are cut out to be a landlord or not. Even with a good property management company there can be issues. Tenants are people, too, and they have their good months and not so good months, incur illnesses, job losses and family emergencies just like everyone does at some point. If the only way you can comfortably afford a rental property is by assuming it will carry itself all year every year, then perhaps being a landlord is not for you.
But if you have a financial cushion that can absorb occasionally missing a rent check coming in and the prospect of a new water heater or other home repair doesn’t send you into a cold sweat, then you might want to look further into how lenders qualify borrowers who are buying investment properties.
First, to get a decent rate on a mortgage loan for an investment property you will need to put 25 percent down. Loans for investment properties always are charged a higher rate, and if you don’t have 25 percent down, then you will get charged a really high rate. The minimum you can generally put down is 20 percent, but that extra 5 percent will generally lower your overall interest rate by about 1/2 to 3/4 percent.
So let’s say you found a condo to buy that would make a good rental for $550,000. The current tenant rents the property long-term for $2,300 per month, and you have $137,500 to put down and get a loan for $412,500. Today your rate on a 30-year fixed would be about 4.25 percent and your principal and interest would be $2,029.25. Let’s assume taxes and condo fees run $600 per month so your total monthly cost is about $2,629.25. Rental properties in resort areas like Vail seldom cash flow so you’re looking at, in a perfect world, a $329 per month net loss.
Assuming you need the rental income to qualify for the loan, here’s how the lender would look at this situation. First, they would ask you to have what is called an operating income analysis done as part of the appraisal. The appraiser would research comparable rents and work out a schedule predicting what maintenance costs might be incurred annually and allow for a vacancy factor and paying a management company their customary fee (even if you want to manage it yourself). They then arrive at an estimated net income before debt service.
As a rule of thumb, the income analysis reports I have seen lately seem to work out to a net income of about 75 percent of the gross income. So if the appraiser agrees the $2,300 is a fair market value rent chances are he will suggest that 75 percent of that amount be considered stable net income, or $1,725. The lender will then assume that you will show a negative cash flow of about $904.
The lender will then look at your other fixed monthly payments for your primary residence, car loan, minimum credit card payments and the like and add the $904 to the total. This means in terms of qualifying you will only need to qualify for an extra $904 per month versus the entire cost of ownership of $2,629 per month. Lenders use what is called a debt-to-income ratio to determine if you qualify or not. This is calculated by adding your monthly minimum payments and dividing by your gross pre-tax income. This ratio varies by lender and loan program, but generally a ratio in the mid forty percent will get you approved.
Let’s say your income is $12,500 per month and your house payment on your primary home is $2,500 per month. You have car payments of $600 per month and credit card payments of $200 per month. Currently your debt-to-income would be 27 percent because your $3,300 in monthly payments divided into your $12,500 per month equals 27 percent of your income going for your monthly payments.
So of you take on the rental property deficit of $904 per month your monthly obligations would go to $4,204 per month and dividing that into your monthly income equals 34 percent, which generally should get you approved.
If you were buying the property as a second home and did not plan to rent it out the lender would look at your current monthly payments and add to it the new mortgage payment, taxes and condo dues and divide that into your monthly income and in this case your DTI ratio would go to 47 percent, which is at best borderline to get an approval with.
And why, you may ask, would someone buy a property that doesn’t carry itself cash flow wise? The answers are many and people do it all the time. First, if you have a good tenant and a good property you may not incur a vacancy rate as the appraiser predicts. Your maintenance costs may be lower. There are also numerous tax breaks to owning rentals that will minimize your tax bill somewhat. You will also be paying down the principal balance over the years, in this example over five years about $37,000 in principal reduction will occur (about $624 per month). There is also the strong possibility that your property will appreciate in value.
Chris Neuswanger is a loan originator at Macro Financial Group in Avon and may be reached at 970-748-0342. He welcomes mortgage related inquiries from readers. His blog and a collection of his columns may be found at http://www.mtnmortgageguy.com.