Wondering how to build a passive income stream? That’s probably why you’re reading this blog. We all, to some extent, recognize the potential benefits of investing in rental property.
The modern form of real estate investing traces its roots all the way back to the 1800s, and it continues to prove itself as one of the best forms of passive income. In this blog, we’ll explore seven of the top benefits of investing in rental property, what to look for in a real estate property, and what to consider before investing.
How Do I Get a Mortgage for a Rental Property?
Before we dive into the benefits of investing in rental property, it’s important to understand some of the steps that go into applying for a mortgage for a rental property. We’ll cover some of the most important factors below, and give you some tips on how to improve your eligibility if you don’t meet the mortgage requirements for a rental property just yet.
Credit Score
In general, lenders are looking for a credit of 620 at a minimum. However, a score of 740 or higher, which is considered to be in the “very good” range, will help you secure better interest rates. This means more money in your pocket in the long run. It is important to keep in mind that actual qualifying factors will vary from institution to institution and mitigating circumstances are often part of the discussion.
If your credit score is currently under 620, try prioritizing paying off some debt to build up your credit score.
Down Payment
A conventional mortgage for a primary residence allows would-be homeowners to put down as little as 3%, depending on the specific lender and loan program. If you’re buying a house to live in, less than 20% down payment will require you to pay private mortgage insurance (PMI). This protects the lender from some financial loss if you default on the loan.
However, PMI doesn’t apply to mortgages on investment or rental properties. This means you should aim to make a larger down payment of at least 15% to 20% in order to finance a rental property. Some properties, such as multiunit investment properties, require at least 25% down.
Debt-to-Income Ratio (DTI)
Another major factor lenders consider is what’s called a debt-to-income ratio (DTI). This takes into consideration how much of your monthly gross income goes to debt. To qualify for a mortgage for a rental property, your DTI should ideally fall between 36% and 45%.
If you don’t have any existing rental properties, a lender may not count the potential income from the rental property you’re looking to purchase towards your current monthly gross income. If that’s the case, your ability to get a mortgage for a rental may rely on your personal income alone.
Savings
In addition to showing that you have sufficient income compared with your debt obligations, you’ll also need to show you have plenty of money in the bank to cover financial hiccups. It’s a good idea to have three to six months of reserves saved in a liquid bank account, including the full mortgage payment with principal, interest, taxes, and insurance.
Now that we’ve covered how to apply for a mortgage for a rental property, let’s explore seven of the top benefits of investing in rental property.
1. Passive Income
Real estate investing is often touted as one of the best types of passive income streams. Once you find the right property, buying a home for a rental investment is a great way to hedge against inflation and increase financial security.
For people looking to generate passive income on the side, diversify their investment portfolio, or even make money during retirement, a rental property is an attractive option. Income from rentals may also be taxed differently than income from employment, which can mean tax breaks and advantages come tax season.
Tip: It’s important to consider your cash flow options before investing in rental property. Be sure to consider all your expenses when it comes to renting out a property — don’t make any moves too quickly. Before you purchase a property, try to figure out how long it will take before your rental property starts generating passive income streams.
2. Increased Financial Security
It’s not uncommon for people to move temporarily for work. Some people may also inherit a family home they don’t want to sell for sentimental reasons.
Whatever the reason, a lot of homes can sit empty for months or years at a time. The trouble is vacant properties are expensive and more likely to attract vandals and squatters. Also, unnoticed maintenance issues can escalate into larger, much more costly issues if left to persist.
Tip: Keeping an eye on a house you don’t live in can be difficult, but renting out that property while you’re away could be a great option for you. It can help leave you with greater peace of mind knowing you have tenants in your home looking after it. It can also help you generate some more income if you’re stuck with more than one housing payment depending on your circumstances.
3. Diversification of Investments
If you’re already someone who prioritizes investing in the stock market and retirement funds, a rental property can help you diversify your portfolio. This in turn can help protect against risk, according to a recent report from BiggerPockets.
Tip: Try to take advantage of positive market swings and purchase in a buyer’s market whenever possible. Since this isn’t always possible, be sure to find a fair and honest lender who can help you get the loan you need.
4. Tax Benefits
One of the major benefits of real estate investing is the tax exemptions available for owners of a rental property. Rental income is not subject to self-employment tax, and rent-related expenses can be deducted by the Internal Revenue Service (IRS) under the following categories:
- Ordinary and necessary expenses
- Improvements
- Depreciation
This means you can deduct your insurance, interest on your mortgage, maintenance costs, and physical wear-and-tear on your property.
Depreciation may produce an insignificant loss, which in turn you may deduct against other income. In other words, you may achieve net positive cash flow from the rental income, but after calculating the expenses, still come out at a net loss for tax purposes. You should be aware that depreciation does reduce the cost basis of a property for calculating capital gains when you sell your property.
5. Property Value Appreciation
By renting out your property, you have the option of holding onto your asset in case it appreciates, allowing you to sell at the right time. Market factors will influence how much appreciation will occur. To find out what you can expect, research the appreciation potential of different neighborhoods and cities.
6. Flexibility to Sell
Another benefit of investing in rental property is the flexibility it gives you with buying and selling. Say that you are ready to move, but the market conditions aren’t optimal. A better option than selling for a loss would be to rent out your property until market conditions improve. Having your property rented out gives you the flexibility of selling when you are better positioned to make a profit.
7. Moving Options
Due to financial or other constraints, you may be unable to stay in your current home. In the event you need to temporarily relocate for work, it is nice to know you will have a place to live on your return. Before renting, be sure to check your local and state housing laws, and be respectful of any existing leases you have.
How to Spot a Great Rental Property
All of the benefits of investing in a rental property that we covered above won’t really matter if you don’t take the time to find and choose a property that makes sense for you. Below are a few factors to consider when wondering if owning a rental home is a good investment for you.
Location
Your location can have a significant impact on the price of the property, and the upkeep needed to maintain it. Be aware of the factors that tenants look for when evaluating potential rental properties. Great tenants appreciate schools, neighborhoods, grocery stores, parks within walking distance, and proximity to an active downtown or beautiful nature reserves.
Transportation
Public transportation and major highways make it easier to rent a property close to them. Most people don’t stay at home all day, and routes that help them get to work, shopping, and entertainment spots as soon as possible are a major perk.
Easy Parking
Parking off-street is a requirement for some rental properties in certain areas. Regardless, it’s a feature that usually attracts higher-quality tenants. In a city, you may have a harder time finding a parking garage, but the property may still have parking within five or six blocks of the home.
Utilities
If there are separate units in the building, it’s more convenient if each unit has a separate utility provider. Having a breakdown of these costs means you won’t have to worry about whether you’re charging renters fairly or shouldering the cost yourself.
What to Consider Before Purchasing a Home for Rental Property
Is owning a rental home a good investment? Absolutely. But it’s important to do your due diligence before diving in.
Getting into real estate investing is exciting. But like any major investment, it’s not without its fair share of difficulties and frustrations. Before putting your initial payment down and signing on the dotted line, below are a few factors to consider before buying a home as a rental investment.
Difficult Tenants
You could end up with tenants who aren’t ideal despite your diligence in the screening process. Some of these behaviors could include being needy and demanding, paying late, or simple things like forgetting to turn off the water.
In more severe cases, they could be destructive, in which case the depreciation allowance may be woefully inadequate. The standard lease form can, however, be customized to include a rider that details the rules regarding occupancy, pets, smoking, tenant insurance, and other aspects. A security deposit can also be helpful in this case.
Neighborhood Decline
The perfect scenario would be for your property to flourish among other well-cared-for residences in an area predicted to appreciate. This would result in a steadily increasing cash flow and stable operating costs. Nevertheless, neighborhoods can change, resulting in the possibility of your investment depreciating over time.
Just as you would pay attention to the local politics of your hometown, you should pay attention to the local politics in the areas you invest in. Try to understand the five to ten-year predictions of the areas your potential rental property could be, not just what’s a great deal in the here and now.
Upkeep
Even though a rental property is a great form of passive income, repairs of all kinds are still necessary from time to time. While an especially handy homeowner with a lot of spare time may be able to save a lot of money by performing the repairs themselves, contractor fees should be expected for the average real estate investor.
Need help qualifying for a loan for your rental property? Contact us today to see how we can help you.