Achieving financial security is only possible if you invest your money to let it grow. Your basic savings account won’t amount to much, CDs provide mediocre returns, and the stock market is risky. So what’s a person to do? Diversifying your investments is the key and investing in real estate is a great way to do it. If you’re thinking about adding real estate to your portfolio, check out this guide on buying a house to rent out.
Overview of buying your first rental property
Buying a house to rent out can be a great way to bring in more monthly cash flow. When you buy your first rental property, there is a lot to consider. The type of property, how you’ll find tenants, and how you’ll manage the property are just the tip of the iceberg.
Lenders look at rental properties differently than your primary residence. They usually want a larger down payment and charge higher interest rates on the mortgage to make up for the risk. You’re more likely to default on a home you don’t live in than the one you do, especially if you have financial trouble.
Before you buy a second home as a rental property, make sure you have the money saved for a down payment, a contingency plan if you lose your tenants and have to cover the mortgage payment and other housing costs yourself, and a plan to manage the property. Will you hire a property management company or do it yourself?
Is buying a house to rent out a good idea?
Any investment is a gamble. There’s an opportunity cost when you invest your money in anything, whether stocks, bonds, or real estate. You choose to invest your money in one investment, which means you can’t invest it in another.
There’s no guarantee that any investment will perform well. Real estate tends to be more consistent than the stock market, but it still has its risks. That’s why it’s important to make sure you have enough funds set aside should things go wrong.
When things go right in real estate investments, it can be a great way to supplement your income. Real estate typically appreciates, which means your investment grows over time. As you pay the mortgage down and the home appreciates, you increase your home equity or the money you’d get in hand if you sold the house today. Before you become a landlord, you should understand the good and bad sides.
Pros and cons of becoming a landlord
Landlords have a lot of responsibility on their shoulders, but it often pays off financially. Here’s what to think about when becoming a landlord.
Pros of buying a house to rent out
- You can write off many of the expenses of maintaining and repairing the home as business expenses.
- The net cash flow earned from your rent after expenses can supplement your retirement income or other financial goals.
- The rent collected can offset the mortgage, repair costs, and expenses to run the home while you earn the home’s appreciation.
- You don’t have to pay Social Security taxes on your rental income.
- Real estate isn’t as volatile as the stock market and often reacts opposite to the market, helping you diversify.
Cons of buying a house to rent out
- You never know what type of tenant you’re getting, if they’ll be destructive or if they’ll default on their rent.
- You must follow through on a lease even if you need to sell the house fast to liquidate your investment.
- It’s a lot of work maintaining and running a house. Anytime something goes wrong, you are responsible.
- If you invest long distance, you’ll have to pay a property management company which can be expensive.
- There’s no guarantee your investment will appreciate.
Buying a house to rent out (6 Key tips)
Buying a house to rent out is exciting and overwhelming at the same time. Before you buy your first rental property, use these tips.
1. Get to know the area
Don’t invest in a home without researching the area. When you buy a home, you invest in the neighborhood too. Do your research and find out the average rent in the area, the number of renters in the area, and if the home you’re thinking about buying is typical of what the local renter wants.
Just because you love a home and the area doesn’t mean renters agree. It doesn’t make sense to invest in a rental home in an area where most people buy houses rather than rent. Work with a local real estate agent to find out if it’s a good area to invest.
2. Decide if you want a fixer-upper or a move-in ready home
Investing in a home can look many ways. You can buy a home that’s ready for tenants right away or buy an undervalued property that needs some TLC before you rent it out. Before you look at homes, choose your strategy.
If you’re the fixer-upper type, you may save money buying an undervalued property, fixing it up yourself, and renting it out. You will not only earn the rental income, but the home should naturally appreciate with the home improvements. If you’d prefer to buy and rent right away, then buying a move-in-ready home is a better choice.
3. Know the market rent
You know what you’d like to charge for rent, but that doesn’t mean that’s what tenants in the area want to pay. You shouldn’t charge more than the average rent for the area, so do your due diligence before buying a home.
A licensed real estate agent or appraiser can help you learn about the area’s average rents. Work the numbers to determine if it makes sense to buy the home knowing how much rent you can charge. Is it enough to cover your monthly mortgage payments, 1/12th of the real estate taxes and home insurance, plus any costs to maintain or fix the home?
Leveraging a house-hacking approach? If you rent out rooms but plan to live in the house, you'll also need to determine if the rental income you'll earn is sufficient.
If not, you may want to look for a different home. Investing in a home that doesn’t allow high enough rents leaves you upside down from the start.
4. Pay off your debt first
Buying your first rental property is exciting but expensive too. As the landlord, everything falls on your shoulders. The hot water heater breaks - you’re responsible. The roof has issues - you must fix or replace it.
If you have a lot of consumer debt already, you may not have the extra funds to put aside for emergencies your rental home may have. Focus on paying your consumer debt down (or off) before investing in a home for more financial security.
5. Fix your credit
Securing financing for an investment home is a lot different than financing for the home you live in full-time. Lenders view investment financing as riskier, so they usually want borrowers with excellent credit and stable income.
At least a few months before you think about buying a house to rent out, pull your credit and make sure there’s nothing to fix. Look for things like:
- Late payments that you can bring current
- High credit lines you can pay down
- Collections you can settle
- Mistakes you can dispute with the credit bureau
6. Get legal help
There's a lot that rests on your shoulders as the landlord. Know your obligations and rights before buying your first rental property. Having a lawyer review your purchase, the rental agreement, and your strategy can help you determine if what you’re doing is worth it, legal, and beneficial for everyone involved.
The bottom line
Diversifying your portfolio helps diversify your risk when trying to create financial security. Buying a house to rent out can be a great way to create monthly cash flow, invest for the future, and hedge against the risk of investing entirely in the stock market or other risky investments.