As a homeowner, you already know that owning property is a stellar way to build wealth over time. But if you’re interested in expanding your homeownership with a rental property, we’ve got some helpful tips that could help maximize your investment.
Buying a rental property isn’t the same as buying a home you plan to live in. When you apply for a mortgage on a rental property, your qualifying income is determined differently.
If you’re planning to buy a rental property, you might be able to use a portion of the rental income to help you qualify for your mortgage.
Future rental income—the money you expect to receive from tenants renting out your property—can be used as part of your qualifying income. In some cases, this rental income can be added to your employment income, increasing your buying power and helping you get the mortgage you need for your rental property.
Not everyone can benefit from this perk, though: it’s only available for buyers who currently own a home, or buyers who have previously rented out a property.
For more information about future rental income and how you can use it to maximize your rental investment, check out our resources below, then schedule a call with one of our loan experts:
- How will the lender determine the amount of future rental income for my investment property?
- How will my future rental income help me qualify for a rental property?
- Who can use future rental income from an investment property?
- Who cannot use future rental income from an investment property?
How will the lender determine the amount of future rental income for my investment property?
Your future rental income is determined by careful consideration of two factors: the current rental rate for the property, and the appraised rental value of the property.
If you’re buying a rental property, chances are it’s already rented when you apply for your mortgage. When you apply, make sure you provide the lender with a copy of the lease(s) already in place.
Your lender will use this information to help determine how much rent your property will bring in each month. While this won’t necessarily be the rental income they’ll use, it’s a helpful, real-world number for your lender to consider.
Once you’ve applied for your mortgage, the lender will also order an appraisal of the property. For this second part of your lender’s consideration, a third-party appraiser will research current rents of similar properties in your area, then determine the fair market rent value.
This market rent value represents the appraiser’s researched estimation of how much rent the property will bring in each month. This number may be higher or lower than the lease(s) currently in place, but it ultimately helps your lender understand how your property compares to others in the area.
With these two numbers for consideration, the lender will review both the current lease(s) and the market-rent appraisal, and use these numbers to determine your future rental income.
As they process your application, your lender will typically use the lesser rental rate in their calculations. This helps minimize the risk of the loan that your lender takes on. But these numbers are only used for the mortgage approval; you do not have to rent the property at the rate your lender uses for your loan.
Once approved, you determine how much you’d like to rent the property for each month.
How will my future rental income help me qualify for a rental property?
While some borrowers can utilize future rental income to qualify for a mortgage, it’s not as simple as including the total amount to be collected each month as income.
There are costs associated with the property that your lender will need to account for to approve the loan. To do this, your lender will adjust the rental income amount to allow for the expenses and losses that happen with any rental property.
Because different property types carry different potential costs, lenders base their future rental income calculations on the type of property you’re buying:
For investment properties, future rental income is calculated by adjusting the monthly rent collected for vacancies, loss, maintenance, and management expenses.
- $Monthly rental income X 75% = $Adjusted rental income
Then, the lender subtracts the monthly housing payment for the property from the adjusted rental income to get the qualifying rental income. Your housing payment includes the monthly loan payment (including principal and interest), property taxes, homeowner’s insurance, and any homeowner’s association dues.
- $Adjusted rental income - Housing Expense = Qualifying rental income.
Joan wants to buy her second rental property: a 3-unit building she plans to rent out. Based on similar units in her area, she plans to rent each unit for $1,800 per month, or $5,400 total. Based on her mortgage estimate, her monthly housing payment would be $3,200.
To find her adjusted rental income amount, Joan’s lender modifies the total rental income to account for costs and potential losses:
- $5,400 x 75% = $4,050
Then, to calculate her monthly qualifying rental income, the lender subtracts the monthly housing payment from the adjusted rental income:
- $4,050 - $3,200 = $850
In Joan’s case, the net rental income is greater than the monthly housing payment. And because Joan has been a landlord for more than a year, the lender will add this $850 to her total monthly income, helping her qualify for the loan.
Who can use future rental income from an investment property?
If you already own a home, you can make sure of the future rental income from your investment property to qualify for your mortgage.
Lenders want their borrowers to repay. If you’re a homeowner with a demonstrated record of on-time payments, and if you’re a landlord with experience managing a property, you’re much more likely to continue succeeding as a homeowner and landlord than someone without this experience. This is why lenders privilege these borrowers: they have a proven record of repayment.
If you’re a current homeowner, lenders will offset the investment property’s future housing payment with a portion of the future rental income:
- $Monthly rental income X 75% = $Net rental income
- $Net rental income - Monthly housing payment = monthly qualifying rental loss
If the adjusted rental income is more than the housing payment, the investment property has a positive cash flow. The lender will include the income amount as an addition to the income on your application.
If the adjusted rental income is less than the housing payment, the investment property has a negative cash flow. The lender will then include the amount of the loss as a monthly expense.
Even if the future rental income on your property doesn’t result in a positive cash flow, including this income cancels out some of the housing payments and reduces the loss. This still makes it easier overall to qualify for a new loan.
Revisiting our earlier example, if Joan’s second rental property were a 2-unit building with the same monthly housing cost ($3,200 per month), she wouldn’t make a profit when factoring in the future rental income.
Joan can still use the future rental income because she’s been a landlord before. At $1,800 per unit, her property would bring in $3,600 per month. Adjusting for costs and potential losses, her net rental income would be $2,700 per month.
- $3,600 x 75% = $2,700
Then, the lender subtracts the monthly housing payment from her net rental income:
- $2,700 - $3,200 = -$500
Because the monthly housing payment is more than the adjusted rental income, Joan’s property has a negative cash flow.
Even with the negative cash flow, Joan can still use the future rental income to help her qualify for the mortgage. As long as her employment income makes up for the loss, she can buy the property now and fix it up, enabling her to collect more rent over time.
If you have experience as a landlord, make sure to provide your lender with a copy of your most recent federal income tax return. This will serve as proof that you have the experience necessary to benefit from future rental income on your mortgage application.
Plus, if you’ve been a landlord for at least a year and the rental income is more than your total housing payment, lenders will add excess rental income to your qualifying income, boosting your buying power even more.
Who cannot use future rental income from an investment property?
Unfortunately, first-time buyers are out of luck when it comes to rental properties. Since you don’t have a track record as a homeowner or landlord, lenders will require you to qualify for the full housing payment based on your employment income alone.
Without future rental income added to your application, it’s much more difficult to get a mortgage for your investment property:
If Joan was interested in buying an investment property as her first home purchase, she wouldn’t be able to use the future rental income to qualify for the loan.
This means that Joan’s employment income is the only income her lender will consider when approving her loan. She would have to make enough money to cover the $3,200 monthly housing payment on top of her usual monthly expenses and debts.
For most buyers, then, it’s not possible to qualify for a rental property without first owning or renting out another home. The required income is too high without future rental income factored in.
There is, however, a workaround if you’re interested in purchasing a multi-unit property as your first home. Buying a 2- to 4- unit home that you plan to live in will allow you to factor in future rental income as a first-time homebuyer.
Because you’ll live in the home, the property isn’t considered an investment property like it would be if you rented out all the units. For more information about buying a multi-family home as a first-time homebuyer, check out our resources here.
In the case of rental properties, every borrower’s situation is different. Your lender will calculate your qualifying income based on your unique circumstance, and so it’s best to work closely with your lender.
At NewCastle, we’re proud to offer a boutique, innovative approach to the homebuying process. Schedule a call with one of our loan experts to discuss your options, or start your application and close on your investment property in record time.