Written by: Derek Melvin
We get asked a lot of questions when it comes to home selling, especially when it comes to the sell vs. rent dilemma. How to buy a second home and rent the first? Should I sell my house or rent it? Is buying a house a good investment? Can I buy my second home with no money down? These are all excellent questions.
Owning rental properties can be an excellent way to generate passive income for physicians. The more passive income you have, the less you will need to work, or the less you will need to withdraw from other investment accounts in retirement.
Not many people have the ability to keep their existing home as a rental and still afford to buy a new home, so it is a moot point. Many of the doctors we work with are in a unique position though. They might be going from a residency income to an attending level income and can afford a much larger house payment. Also, physician mortgage loans, also called doctor loans, enable doctors to purchase a new home with as little as 0% down. This can make the option of turning the starter home into a rental property a much more realistic option.
Today I want to dive into the pros and cons of selling your existing home versus turning it into a rental.
For this blog post, we are focusing in on the pros and cons of selling your home versus keeping it as a rental property. With this scenario, you are buying a new primary residence and keeping your old home as a rental property.
With that said, there are special home loans for doctors. For more information about home loans for doctors and the benefits of using a physician mortgage, view our blog post, Mortgage Loans for Doctors – Do Doctors Get Better Rates?.
Should I Sell My House or Rent It?
Before we get into numbers of whether it will be worth it, I want to know if someone wants to own a rental property. If not, then the answer is easy; sell. We’ll go with the assumption today that you have an interest in owning a rental property. Whether it be for portfolio diversification, passive income, or whatever reason is appealing to you.
Also, a couple easy questions to ask yourself are:
- Can you afford the next house if you keep this one and turn it into a rental?
- If you turn it into a rental, can you rent it for a profit?
Can You Afford to Buy the Next House if You Keep This One?
Another assumption we will make in this blog post is that you are moving to a new house either way. That decision has already been made. Maybe you are taking a job in another city. Maybe you are a doctor who recently entered practice and have an expanding family and need more space. Can you afford to buy the next house without selling your current home?
There are two main factors here: the down payment and the monthly cost of the mortgage(s). We’ll start with the down payment.
Can You Afford the Down Payment?
If you have enough cash for a 20% down payment, you can skip ahead. If you don’t have that much cash on hand, you have a couple options in getting approved for a mortgage on the new house.
As mentioned before, some banks who offer doctor loan programs will give a mortgage to physicians or dentists without the customary 20% down payment. This is great, as it lowers a hurdle required to buy a house. Some lenders will go as low as 0% down (only closing costs required), although most will require 5-10% down, depending on the loan amount. Still, 10% is less than 20%. On a $1M home, that makes a big difference.
Depending on the property you are looking at though, 20% down may be required if you are in a competitive marketplace, such as the Bay Area currently. Some banks will not lend with less than 20% down for certain condos or co-ops. It often depends on how many units are owner-occupied.
Let’s assume you only need 5-10% for a down payment with a doctor loan. You will also need money for closing costs, moving expenses, and reserves. The bank will not let you completely drain your bank account for the down payment. They typically require around 4 months of mortgage payments in reserves after the down payment and closing costs. If you do not have enough cash on hand for those expenses, you may need to sell your home in order to buy the next one – or, start saving up.
The other factor is mortgage payments on both properties.
Can you afford the mortgage payments?
The assumption with a rental property is that you will have renters in the property paying you rent that will cover the mortgage payment on that property. Well, a bank typically wants to see two years of consistent rental income before they will make that same assumption. This means, you have to be able to afford the payments on both properties in order to qualify for a loan on the new house. Let me explain further.
While there are some exceptions, to qualify for a mortgage, you typically cannot have more than 43% of your income going towards debt payments. If you do we have some bigger issues to discuss, but that’s a topic for another day. Here is how this comes into play.
If your mortgage payment on the current home is $1,500/month. You have car loans totaling $1,200/month. You have student loan payments of $2,000/month (some lenders will ignore student loan payments for doctors, which is insane to me). And your minimum credit card payments total $300/month. Those add up to $5,000/month in debt payments.
If your monthly income is $15,000/month ($180,000/year), the maximum mortgage payment a bank will offer without selling your current home is $1,450. That would be a step down from your current home.
If you earn $20,000/month, you can qualify for a new mortgage of $3,600. Depending on the homes you are looking at in your desired area, that may or may not be enough.
If that limits your options to homes you dislike, the answer is easy, you need to sell the current home (or the cars) if you want to buy your desired new home.
Is a Rental Home a Good Investment?
If we determine that you can buy the new house you want without any issues, then the first thing I want to know is whether your current home can be rented for a profit. Said another way, will the expected rental income be greater than the costs of owning the rental property?
Call me crazy, but I like rental properties that make money. I’m not as excited about owning a rental property that loses money.
Talk to some real estate agents and property management companies to get an idea of what they think you could realistically rent your home for. You can also do some searching online yourself to see what similar properties are renting for. These would be places such as Zillow or Redfin.
Let’s pretend your mortgage payment, plus property taxes, insurance, HOA dues (if applicable), management fees (if using a property manager) along with some estimated annual maintenance costs average $2,000/month. If you can rent the property for $2,500/month, then that is a profitable rental property!
If you can realistically rent the property for $1,500/month, and it costs you $2,000/month, then that is not a profitable rental property. That rental property is losing you money. Not good. But what about property appreciation over time, or tax deductions?
Sure, we can dive deep into the numbers to look at more specific estimates, but all we’re really doing is looking for ways to justify holding onto a property that will lose us money. Claiming a depreciation expense on the property to reduce your tax liability is great. But if the property is losing $6,000 a year, you are spending $6,000 to maybe save $1,500 in taxes.
I would rather pay $1,500 in taxes and not lose $6,000.
Do You Want to Be a Landlord? Potentially Long-Distance?
Assuming the property can be rented for a profit, you need to decide if owning a rental property is appealing to you. You know what it’s like to be a homeowner. Think of all the headaches you have had to deal with owning the home you live in. Now pretend you have to deal with those headaches, along with the headaches that your neighbor’s house creates. Not as fun when you don’t call the property your home.
That being said, if you’re making money, the headaches may be worth it. Some of them could be alleviated by a property management company, so you only have to deal with major issues. This can be especially helpful if the rental property is in a different location than your primary residence.
When you ask, should I sell my home or turn it into a rental, first ask yourself if you want to be a landlord. Does owning a rental property appeal to you? It can be a great way to generate passive income for doctors, but it can also create some frustration for you. If you are OK with that, then go for it!
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Disclosures:
Any examples are hypothetical and are for illustrative purposes only. Consult with a tax professional for tax implications pertaining to your specific circumstances.
