Most of us have a limited income and need to make budget choices, so what about having your neighbors pay part or all of your mortgage expenses? You must know three things before deciding if this is a good financial path for you.
- What is a primary residence, and why is this important?
Primary residence is defined as any property of up to four units. When you ask for a Primary Residence loan, whether you are buying a house, condo, or multifamily, it means you intend to live in the home for at least twelve months. If you live there for the majority of the year and can prove it, it’s your Primary Residence.
This distinction is essential to understand, as loans for Primary Residence have better terms than investment property loans. The down payment is the cash the buyer pays upfront in a real estate transaction, and they are defined as a percentage of the purchase price. You can get Primary Residence loans with much less down payment, compared to investment loans, in some cases as low as 3%, 3.5%, or 5%, based on other criteria (There are owner-occupied loans with no money down). In an investment property loan, you often are required to have a minimum of 25% down payment. It is a significant difference; for many, the down payment amount will define whether you can buy the property.
- Budget and mortgage qualifications
Knowing that you can live in one unit and rent the other units, how much will you actually spend out of pocket on your mortgage? Consult with your realtor about the rents in the area, and considering the income, vacancies, and other expenses, what is the balance?
With your lender, inquire about your mortgage options, check how your lender will calculate the rent income, and be aware that different mortgage plans will require different qualifications. Your Lender will run a credit check; you will need to have a certain credit score, qualified income, an acceptable Debt-to-Income (DTI) ratio, and more. The DTI is calculated by dividing all your monthly minimum debt expenses by your gross income. For this reason, it is crucial to understand your options in considering the rental income when qualifying for a mortgage. It can vary from one lender to the other.
The property can be vacant, meaning most lenders will not include your future income in your income calculations, often resulting in a high DTI, higher than required to qualify. Some lenders will accept a signed lease to include the income, and often they will consider 75% of the income to cover future vacancies. In the market, you can find multi-family with tenants living in the building. All you need is one vacant unit for you to move in. In this case, will your lender accept the current tenant income to calculate your DTI?
- The magic of numbers
Previously, you calculated the income and expenses. Did you take into consideration the taxes? Theoretically, how much is left if you need to pay taxes on every dollar you earn from the rental income? I said theoretically because here comes the magic of numbers, the tax benefits you get from owning a property and renting the other units. The primary residence definition was for mortgage purposes. For tax purposes, the units you rent, which can be one to three units, pending if you bought a duplex, triplex, or quadruplex, will benefit from depreciation, which is a reduction in the value of an asset over time due to wear and tear. The property’s actual market value can increase, but you only calculate the property’s depreciation as a loss for tax purposes. That, and other tax deductions such as property taxes, mortgage interest, and more, will make all the difference. These benefits are very significant, as they can result in meaningful savings. At the end of the day, you want to keep more money in your pocket.
Let’s check an example of depreciation; If you bought a duplex for $500,000, you need to divide how much from this amount is the value of the land and how much is the property’s value. Often, you use the 80%-20% proportion. We calculate 80% of the purchase to find the structure value; in this case, it is $400,000. You live in one unit, so you will use half of the building cost amount to calculate the depreciation of the rental unit. The rental unit can be depreciated over 27.5 years; we divide $200,000/by 27.5 years = $7,272 a year. This amount can be depreciated against your income yearly for the next 27.5 years. With the other tax benefits, your balance for tax purposes can show a loss when your true balance is a surplus. Consult with your accountant. Get his help to navigate thru the magic of the numbers.