Investing in real estate to build wealth is a legitimate path for people who want to accumulate more assets. However, many people may find this investing strategy out of reach because of their current financial state. If you’ve got higher debt or lower income, there are still ways you can become a homeowner and build equity in your property.
The concept of house hacking means purchasing a 2-4 unit property and occupying one of the units. Another variation of this approach involves owning a single-family home and renting out the rooms to roommates.
The idea is that the cash from your rental income will cover or exceed the mortgage cost. You can live for “free” and potentially clear a profit after paying your mortgage and other expenses. It’s a totally legitimate way of building wealth.
You’ll still want to borrow responsibly and have cash reserves for emergencies, so it’s not an easy-peasy solution that requires no planning or income. However, it’s not impossible to go this route either. If you think you may be interested in using the house hacking approach to build wealth, here are some things to consider.
How Much House Can You Afford?
First, you’ll want to know how much mortgage you can really afford. Yes, you’ll have a renter to help carry your mortgage, but depending on your loan type the bank may or may not consider that income or only consider a portion of in the underwriting process.
One way to buffer against the risk of having cash flow problems (fixing a furnace or roof isn’t cheap,) is to stay well under the maximum amount of mortgage you can afford. Pretend you won’t have a renter and that your income is slightly lower than it actually is- this is a good, affordable, mortgage amount.
But just so you are aware of what the bank looks at in their underwriting process for home loans, let’s examine some debt-to-income (DTI) ratios banks consider for home lending.
First, they’ll calculate what’s called a front-end ratio to make sure borrowers have an affordable mortgage payment. The front-end ratio means the mortgage payment (principal, interest, taxes & insurance) as a percentage of the borrower’s gross monthly income.
To put that in perspective, let’s say you earn $5,000 a month before taxes. If your potential mortgage payment will be $3,500, your front-end ratio is $1,900/$5,000, or 38%. The bank standard for this ratio is no more than 28% for borrowers, but can be as high as 31% in some cases.
This isn’t the only consideration when it comes to your DTI. There’s also a back-end ratio. The back-end ratio includes all mandatory monthly debt payments (including car payments, credit card payments, student loan payments, etc.) The rule of thumb is that a borrower’s back-end ratio should be no more than 36% of their gross monthly income, including their mortgage payment.
Let’s say your total debt obligations, including your mortgage, come in at $2,000. Divide that number by your gross income of $5,000. The back-end ratio comes out to be 40%.
In this example, the borrower’s DTI is higher than what lenders like to see. You can either find a less expensive property, increase your income or decrease the amount of debt you. This will improve your DTI ratios and the likelihood of being able to finance your rental property.
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Fix Your Finances
Improving your credit score and saving up for a down payment is a great way to reduce your monthly loan payment to help your rental unit turn a profit. Since you’ll be occupying one unit, you’ll want to get the most out of your rental unit(s.)
This will come down to managing monthly costs that include the principal amount of your mortgage, interest, taxes and insurance.) You’ll want to keep this payment low in order to keep more of your rental payment in your pocket.
Of course, you’ll want the best deal on your home with an affordable property. However, the affordability factor can be affected by your interest rate which is influenced by your credit score. A lower credit score can raise your interest rate along with your monthly payment considerably.
Using this Loans Savings Calculator by myFico, you can see the difference your credit score makes for a 30 year fixed rate mortgage on a home that costs $150,000. I used the state of Illinois in this calculation:
Another thing you can do is save for a down payment to decrease monthly payments. This means your principal loan balance will be lower as well as your monthly payment. Most lenders require 20% down and some may go as low at 10% or 5%.As you can see, your credit score makes a huge difference in your annual percentage rate (APR), monthly payment and total amount of interest you’ll pay over the life of your loan.
If you opt for an FHA loan, you’ll only need 3.5% down on your purchase. Keep in mind, for any home loans with less than 20% down, you’ll have to pay something called private mortgage insurance or PMI. This can tack on another 0.20%-1.50% to your total loan amount. (The PMI rate is 1.75% for FHA loans)
Have a Business Outlook
Although house hacking sounds like a casual endeavor, you’ve got to be mindful of the real deal: you’ll be a landlord. If you don’t understand the implications of this, make sure you seriously consider what you’ll be getting yourself into.
Landlording is not only a business, it’s a serious one. As a business owner, you’ll be taking calculated risks, so you’ll need to calculate your risk exposure and protect yourself from financial mishaps.
Ideally, you’ll have access to cash reserves so that major repairs don’t break you as a landlord. This is called capital expenditures or CapEx. Some recommendations suggest saving 20%-30% of rental income for CapEx while other methods entail making a list of large expenses and breaking them up over their lifetime.
For example, a $10,000 roof could last 20 years. Over 20 years or 240 months, this roof repair could be broken down to a savings requirement of about $42 per month. To get the most accurate CapEx number, you’ll want to make a list of all the large repairs you could face as a homeowner. There are many, so you’ll want to be thorough. There are a number of rental calculators and resources that can guide you on how to estimate realistic figures for CapEx.
This number doesn’t include regular maintenance on your property: lawn care, cleaning, fix up minor wear and tear. Don’t forget to account for vacancy rates, marketing your property to potential renters and then screening them thoroughly. A bad tenant can cost you tons of money down the road.
As you can see, house hacking expenses can add up quickly and it can become difficult to turn a profit on a monthly basis. However, the beauty of this strategy is that even if your monthly profit is not large, you are still building equity and increasing your asset base. And that’s the entire point of this discussion: house hacking to build wealth.
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