Things to Know Before Buying a Second Home to Rent
Buying a second home to be used as a rental home is one of the best ways to invest your money and generate additional income. A rental property pays for itself in the long run and because it appreciates over time, you can sell it for a profit in the future.
But there are several things to think of before making that move. Other than finding a location where demand for rentals is high, you must be aware of how investment property financing works. An investment property mortgage is different from your primary mortgage.
And failure to understand the differences is why many would-be landlords fail to get mortgage approval. Mortgage requirements for a second home are tougher because borrowers are more likely to default on this type of mortgage than on their primary mortgage.
To protect themselves, lenders try to ensure that only borrowers with proven financial capacity can access investment property mortgages. They do this by imposing more difficult terms; as a way of screening out less qualified applicants.
Before you initiate the mortgage application process, here are things you need to know.
1. Your credit must be excellent
Credit score requirements for a principal mortgage are more flexible as lenders are willing to allow some wiggle room if your credit is not stellar. But for an investment property, lenders not only expect a high credit score, but they want to see an absence of defaults on the report. The minimum acceptable credit score is 680. However, you will get better terms if your score is higher.
2. Proof that you can afford a second home
Buying a second home means more debt obligations. Even though the rental is supposed to generate enough income to cover its monthly costs, this is not certain. This is because there will be periods when the home is vacant or tenants default on the rent. For these reasons, lenders want to be sure that you are in a financial position to absorb these shocks. They do this through:
- Proof of income
Lenders want proof that you have a steady job or a profitable business. They may ask to see a letter of employment (not older than 30 days), pay stubs, Notice of Assessment from the CRA, and possibly your tax returns. If you are self-employed or earn commissions, they may require proof of substantial income (for at least two years), along with some of the above, and proof of business registration.
- Your debt ratio
This is a measure of how much you earn and how much you owe, as well as the proportion of your monthly income that goes into servicing debts. The goal here is to measure how much stress your finances can endure. If you are loaded with debt, you may be unable to take on the added strain of a second mortgage. Debt ratios are calculated using the Gross Debt Service Ratio (GDS) and Total Debt Service (TDS) Ratio.
- Proof of down payment
Lenders want to see that you have enough money set aside to make the down payment on the home. They want to make sure this money is not borrowed. The money must have been in your bank account for at least the last three months. The typical down payment on an investment property is 20% of the purchase price of the home. This is how much you need to have in your bank account.
- Cash at hand
Additionally, you must have enough cash to cover six months of mortgage payments on your primary home and the rental property. This money must be in cash inside your checking account or held in financial instruments that are easily converted to cash. Furthermore, lenders want proof that you have enough cash to pay the closing costs on the mortgage and this is usually 1.5% of the purchase price of the home.
3. Down payment and interest
Factors that determine how much the bank will require in down payment are the number of units in the property and if the home is owner-occupied or not. Homes with 1-4 units are categorized as residential, while those with more than 4 units are commercial. Mortgage requirements for these two categories are very different. Our focus is on residential properties.
- Owner-occupied: Owner-occupied homes with 1-2 units attract a down payment of 5% (maximum loan-to-value of 95%). If a home has 1-4 units and the owner will live in one of the units, the down payment is 10% (maximum Loan-to-value is 90%).
- Non-owner occupied: Homes with 1- 4 units, where the owner is not going to live in the property, attract a down payment of 20% (the maximum loan-to-value is 80%).
- Interest rates: For investment properties, the interest rate is 0.50% to 0.75% higher than what you pay on your primary mortgage.
4. Amortization period
The amortization period on a rental property mortgage is determined by the down payment on the home. Whether a home is owner-occupied or does not influence on the amortization period. If the down payment is 20%, the amortization period will be 25 years. If the down payment is over 20%, the amortization period is 30-35 years.
There you have it. Things to know before buying a second rental home. For more information on rental properties, please visit https://www.leenanproperties.com/.