How to Buy a Second Home and Rent The First: 7 Essential Steps

Laura Olson
Aug 16, 2023

Depending on when you bought your home, you might have locked in a historically low interest rate on your primary residence. Now you’re looking to get a new home—but instead of selling your current residence, you’re thinking about turning it into a rental

Buying a second home and converting your first home into a rental property is one of the most common ways people become landlords. While this can be a great path to building wealth, it's essential to understand the complex factors involved.

This guide gives you a comprehensive understanding of each critical step towards owning two properties and renting one of them out. From assessing your financial situation to finding the right property management company, we'll cover everything you need to know.

Step 1: Assess Your Finances

Buying a second home and becoming a landlord can be a good investment, but only if you have stable finances to support both mortgage payments. 

Reviewing your financial situation is essential to avoid taking on too much debt. If used recklessly, debt can lead to bankruptcy or foreclosure, potentially resulting in the loss of your property if the mortgage payments become unmanageable. While renting out your first home can mitigate some of that risk, you need to ensure that any interruption in your rental income will not leave you unable to make payments to your lender(s).

Evaluating your finances ensures you understand your income, expenses, and debts. This information gives you an idea of how much you can afford to spend on a second home without stretching yourself too thin financially. Moreover, it helps determine if you can handle additional expenses, including maintenance and repairs, property taxes, and insurance.

Here are a few tips to help you determine if you're financially ready to take on a second mortgage: 

  • Calculate your debt-to-income ratio (DTI). This is your debt compared to your monthly income. Lenders use this ratio to determine if you're a good candidate for a loan. Zillow recommends you have a ratio of 36% or less to get a mortgage.
  • Consider your existing debt. How much outstanding debt do you have? It's important to factor in your monthly payments when considering whether you can afford to take on a second mortgage. Consider paying down higher-interest debt before applying for a second mortgage.
  • Review your budget. Look closely at your current expenses and see if there's room to cut back. Are you comfortable with the additional cost of owning a second property and potentially making do with less in exchange for owning investment real estate?
  • Have a solid emergency fund. It's vital to have a financial cushion to fall back on in case of unexpected expenses. Experts recommend having three to six months' worth of living expenses saved in the event that things don't go as planned with your rental. That should include six months of mortgage payments on the rental property, just in case.

Step 2: Run Your Numbers

Before deciding to make your current home a rental, you need to run the numbers and determine if doing so will offer you a sufficient return on investment (ROI). By evaluating your property's potential cash flow, you can make an informed decision on whether or not renting out your first home is the best move.

To calculate your property's cash flow, follow these steps:

  1. Determine your monthly rental income. Research comparable properties in your area for an idea of what you can charge for rent. You’ll also want to consider how much you can reasonably increase that rent year-over-year to keep up with changing economic factors.
  1. Calculate your monthly expenses. List all the costs associated with owning and maintaining a rental property. These expenses may include mortgage payments, property taxes, insurance, property management fees, maintenance, and repairs. Make sure to factor in vacancy rates, as you may not always have a tenant occupying your property.
  1. Subtract your expenses from your rental income. This gives you an estimate of your property's monthly cash flow. If the result is positive, your property will likely generate profit as a rental. If it's negative, you may need to reconsider your options.

For example, your research indicates you can charge $2,000 monthly for rent. Your current monthly mortgage payment is $1,200, property taxes are $200, insurance is $100, and you allocate $200 for maintenance and repairs. You also need to account for a vacancy rate, say 5%, which equals $100 ($2,000 x 0.05). 

Your total monthly expenses come to $1,800 ($1,200 + $200 + $100 + $200 + $100).

In this scenario, your estimated monthly cash flow would be $200 ($2,000 – $1,900). This positive cash flow indicates that your property has the potential to be profitable.

This is a simplified example; your specific situation may be more complex. It's always a good idea to consult a real estate professional or financial advisor when evaluating your property's rental potential.

Step 3: Get a Down Payment for a New House

Here are some strategies to help you accumulate the necessary funds for your new home's down payment: 

  • Savings: The most straightforward method is to save money over time. Set up a separate savings account for your down payment and contribute regularly. Automating your savings by scheduling recurring transfers from your checking account can make this process easier.
  • Cash-out Refinancing: With this option, you refinance your existing mortgage for more than you owe. The difference between the two amounts is given to you in cash, which you can apply toward purchasing a second home.
  • Gift Funds: If you have family members or friends willing to help, they can gift you money toward your down payment. Be aware that lenders may require documentation proving the funds are a gift, not a loan.
  • Down payment assistance programs: Many local and state governments and nonprofit organizations offer assistance programs to help eligible homebuyers with down payments. These programs may provide grants or low-interest loans to cover a portion of your down payment.
  • Sell assets: If you own valuable items, such as stocks, bonds, or even a vehicle, consider selling them to generate funds for your down payment. Be sure to weigh the pros and cons of liquidating these assets and consult a financial advisor if necessary.

Remember, the larger your down payment, the lower your monthly mortgage payment will be, and the less interest you'll pay over the life of the loan. Take the time to explore all your options and choose the best strategy for your financial situation.

person putting numbers into a calculator on a desk with paperwork and a laptop

Step 4: Research Loans for a Second Home

Loans for a second home differ from loans for a primary residence. While some requirements might be similar, there are notable differences.

Lenders usually apply stricter guidelines for second home loans than primary residence loans. They require a higher credit score, more substantial down payments, and proof that you have significant cash reserves to cover the cost of owning a second home.

Interest rates for second home loans may be higher, and there may be additional requirements, such as a minimum amount of time that the borrower must reside in the home if they are not renting it out.

When researching loans for a second home, it's crucial to take the time to compare various loan options. Here are some financing options to consider:

  • Home Equity Loan: This type of loan allows you to borrow against the equity you have in your first home to purchase a second home. Interest rates are typically fixed, and the loan has a fixed term and monthly payments.
  • Home Equity Line of Credit: Like a home equity loan, you borrow against the equity in your first home to purchase a second home. However, a home equity line of credit is a revolving line of credit you can use as needed, and it often comes with a variable interest rate.
  • Conventional Loans: This option is commonly used for buying a second home. These loans often require a down payment of at least 10% and come as either fixed-rate or adjustable-rate mortgages.
  • Portfolio Lender: Portfolio lenders hold the loans they issue instead of selling them to investors, which means they have more flexibility in their lending criteria. They may offer loans to borrowers who don't qualify for traditional loans due to factors such as income or credit history.
  • Private Lender: Private lenders are individuals or companies that lend money to borrowers, often for a higher interest rate than traditional loans. Private loans can be a good choice for people who don't qualify for other loan options and need a quick funding source.

Step 5: Get Quotes for Landlord Insurance

When transitioning your primary residence into a rental property, purchasing landlord insurance is essential rather than relying on regular homeowners insurance. Homeowners insurance is primarily for the homeowner staying in a home they own, and won’t cover your rental property appropriately. 

If you rent out your old primary residence and something happens to the tenants or the property your claim may be denied under homeowners insurance.

Landlord insurance provides coverage for three primary areas:

  • Property damage coverage addresses the costs of damages caused by natural disasters, accidents, or tenants.
  • Loss of rental income coverage reimburses landlords if the property becomes unlivable due to a covered event.
  • Liability protection coverage shields landlords from potential financial damages if a tenant or guest becomes injured on the rental property.

Additional coverage options are also available to tailor a policy to your unique needs as a landlord, such as flood insurance or sewer backup coverage.

Step 6: Decide on Self-Management vs. Professional Management

The primary responsibilities of managing a rental property include advertising the property, screening tenants, drafting leases, collecting rent, keeping track of income and expenses, and maintaining the property.

You have two options for property management: self-management or professional property management. Self-managing can be a good option for small property owners with the time, resources, and experience to handle all property management aspects. However, it can also be challenging, time-consuming, and stressful.

Professional property management offers benefits such as reduced stress and time requirements for the landlord. Management companies handle many responsibilities of managing rental properties and have the resources and expertise to do so effectively.

However, hiring a professional property management company also has a higher price tag. Property managers generally collect a fee of 8%–12% of the gross monthly rental income. 

Therefore, you need to weigh the pros and cons of self-management versus professional management and choose the option aligned with your goals and financial situation.

Step 7: Other Important Issues to Consider

Before turning your first home into a rental property, remember it may not necessarily make a good investment. Factors such as rental demand, location, and market evaluation should be considered to determine your property's potential profitability. 

You may also need significant renovations or repairs to make your property attractive to renters, which can adversely impact your initial profit.

In addition, be aware of the legal issues of being a landlord. You must understand and comply with local and state landlord-tenant and fair housing laws. Not complying with these laws can lead to significant legal and financial consequences.

Owning a rental property can also come with unanticipated expenses. When creating a budget, consider repairs, maintenance costs, capital reserves, and possible periods of extended vacancy. Underestimating expenses or overestimating income is a common mistake even the most experienced real estate investors can make.

Rental property owners also have specific tax reporting obligations. One is the requirement to report rental income on your tax return each year. Rental income is taxed at your regular income tax rate, but you may also be eligible for tax deductions to reduce your taxable income. 

Lastly, consider utilizing digital landlord tools to manage your property efficiently. These tools include online rent payment options, maintenance software, and budgeting apps. These resources can help you stay organized and make managing your rental property less stressful and potentially more profitable.

Wrapping Up

Buying a second home and turning your first home into a rental property can be a smart investment and a significant source of income. 

However, it’s essential to assess your finances realistically, select the right loan for your second home, choose the best way to manage your new rental, and invest in a good landlord insurance policy instead of relying on homeowners insurance.

Obie is an online insurance provider that can help you find the most suitable coverage for your rental property and ensure you get the best policy with the best rates. You'll receive  customize quote in minutes, making it easy to purchase the right policy for your unique situation.

To get started, enter your property address in Obie’s quick quote system.