Computing a current homeowner’s rental income from a departing residence is fraught with twists and turns, and I’ve tried to post a complete view of the rules without turning this into Tolstoys’ “War and Peace.”
A Definition of a “departing residence” is a currently occupied home that an owner will move out of – usually in concurrence with purchasing their next home.
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Homeowners who rent out their (departing) residence may not want to sell their current home for various reasons (inflation hedge; rental income – future retirement income; soft market; deferral of taxes into retirement age).
Departing residences is critical in determining the purchase price for their next home program:
(1) The rental income from a departing place is calculated into the buyer’s “DTI (Debt to Income” ratios.”
(2) There are two calculations to determine DTI
(3) The first is a “front end” debt ratio. If a buyer’s income is 10k a month and their TOTAL for the next home (PITI + any HOA) is $2500, their front-end debt ratio is 25%.
(4) The “back end” ratio is calculated departing residence with any net negative rent is then calculated into the back-end ratio with ALL ancillary monthly debts.
Ancillary debts include (primary) housing expenses, personal loans, credit cards, student loans, car payments, etc., which may also consist of a departing residence’s negative rent.
If a homeowner rents out a departing home with a negative rent ($$) and has any other ancillary debt, it will be very difficult to purchase their next home.
How “Net” Rental Income is Calculated:
Lenders only use 75% of the gross rent for “income” for the purposes of qualify to for their next home.
For example: If homeowner rents out their departing residence for $2,000 per month and their total departing housing payment (principal, interest, taxes, insurance, HOA) is $2000 per month, they will have a negative cash flow of $500.
NOTE #1: VA loans are an exception, as they allow the departing owner applicants to use 100% of the rental income from the departing residence.
NOTE #2: FHA Buyers with no “landlord history do not receive any rental credit from a 3rd unit (tri-plex) or 4th unit (four-plex).
The “FHA 100 Mile Rule” for Departing Owners
An Opportunity for 2 Commission Checks
Many homeowners begin shopping for their next home before ascertaining all the lending rules, which (in the case of FHA) are VERY obscure.
“The 100 Rule Simply States”:
Homeowners wanting to purchase their next home with an FHA loan MUST relocate 100 (+) miles from the current home property to use the rental income from their departing residence to qualify for their next one.
For example, The Jones family currently lives in Long Beach (123 Main St.) in a home secured by any type of loan conventional loan.
If Jones wants to buy a “move up” home in Huntington Beach (and rent out their Long Beach home), they cannot use the rental income from the Long Beach home IF the NEXT home is to be purchased with FHA financing.
OR hey will have to qualify for the HB home with both house payments and no rental income (which will be unlikely)!
OR, Purchase their next home with financing other than an FHA loan
OR They must sell the Long Beach home. That’s the FHA rule, and you take that (literally) to the bank. Both commission checks!!
Proving a Departing Residence Is Rented:
Homeowners must “prove” their departing residence is actually rented out BEFORE they qualify for their new loan by:
Provide a fully executed lease, a copy of the first month’s rent, the security deposit, and proof that the first check was deposited into the home owner’s account.
Equity Cushions Prevent Strategic Defaults
After the 2008 meltdown, lenders began requiring proof that buyers have at least a 25% equity cushion in their “departing residence” before using the rental income from that residence to qualify for their new loan
Strategic Defaults in a Declining Market:
Once Bitten Twice Shy
From 2007 – 2010 (before the equity cushion rule was instituted by all lenders), it was relatively common for the departing owner to buy another home (at a bottom dollar price), “literally” within walking distance of their departing residence, collect rents from the departing residence while letting it fall into foreclosure.
On a side note: Strategic default also disrupted the lives of unsuspecting renters. To add insult to injury, the foreclosing lender then had to pay the current renter “cash for keys” so the renter moved out and did not damage the residence.
Equity Requirements, NOW are typically 25-30%
For example, if a home is worth $1 million, and the loan against it is $900,000, there is only a 10% equity cushion. Hence “the owner” will NOT be able to use “rental income” derived from their departing residence.”
FHA requires a 25% equity cushion, but if applicants have no landlord experience, 30% is standard.
Jumbo loans also require equity cushions of 25% to 30%, and the same 75% gross rent rule will be used for qualifying purposes.
Fannie/ Freddie is the most flexible regarding departing residence equity position (25% max) requirements. Still, borrowers should always check with their MLO’s lenders to verify any additional “equity cushion” and/or “landlord experience”.
Reserves for Each Rental Property
Each owner of a departing residence must have six months of liquid reserves for EACH of their rental properties. If a departing residence’s total PITI is $2500 monthly an owner needs $15k in liquid reserves.
If the owner has multiple properties, the owners will ALL need to have 6 months’ liquid reserves for each property, which can put quite a strain on a (the soon-to-be landlord’s) bank account.
Cash Reserves for the Next Property
FHA and VA typically require no reserves at closing for the next home. Fannie and Freddie will typically require three months of liquid reserves.
If the next home requires “jumbo financing”, then that lender will require 12 months of liquid reserves for their next property. An expensive proposal.