Lending Rules for Renting Your Home to Buy Another

Homeowners frequently consider renting their current residence to facilitate the purchase of a new one. This path can present challenges when seeking a new mortgage, as lenders evaluate financial capacity differently for a primary residence versus an investment property. Understanding the specific lending rules and criteria is essential for navigating this process successfully. This article demystifies the considerations involved when transitioning from owner-occupant to landlord while pursuing a new home loan.

Assessing Rental Income for Qualification

Lenders evaluate the income generated from a rental property to determine its impact on a borrower’s ability to qualify for a new mortgage. This assessment involves specific calculations to account for potential expenses and vacancies. A common approach is the “75% rule,” where only a portion of the gross rental income is considered. For instance, if a property rents for $1,000 per month, a lender might only count $750 as effective income. This percentage helps offset anticipated costs such as maintenance, property management fees, and periods when the property might be vacant.

The method for verifying rental income depends on whether the property has an established rental history or is new to being a rental. For properties with a history of being rented, lenders typically require IRS Schedule E from recent tax returns. This form details income and expenses from rental real estate, providing a documented history of profitability. Lenders may average income over one or two years from this schedule.

If the property is newly converted to a rental, or if tax returns do not reflect current rental activity, lenders rely on a fully executed lease agreement. In these cases, an appraisal with a “rent schedule” or “comparable rent analysis” is often necessary to establish the market rent for the property. This analysis provides an independent estimate of the property’s earning potential. When using a lease agreement, lenders typically count 75% of the gross rent to account for potential landlord expenses and vacancy risks.

Lender Requirements for Property and Borrower

Lenders consider several other factors related to the property itself and the borrower’s financial standing. A significant distinction is the occupancy status of both the existing home and the new home being purchased. A primary residence typically receives more favorable interest rates and loan terms compared to an investment property due to perceived lower risk. When converting a primary residence to a rental, borrowers must inform their mortgage provider, as the original loan terms were based on owner-occupancy.

The existing mortgage payment on the home being rented out directly impacts the borrower’s debt-to-income (DTI) ratio. The DTI ratio is a crucial metric that compares total monthly debt payments to gross monthly income, indicating a borrower’s capacity to manage additional debt. Lenders add the new mortgage payment to the borrower’s total monthly obligations. The qualifying rental income, as calculated by the lender, can help offset the existing mortgage payment. For example, if a rental property has a $1,000 mortgage payment and generates $750 in qualifying rental income, only $250 of that mortgage payment would count towards the borrower’s total monthly debts.

Lenders typically look for a DTI ratio below certain thresholds, often around 43-45% for conventional loans, though some may accept up to 50% for certain programs or strong borrowers. A lower DTI indicates more disposable income available to cover financial obligations. The ability of the rental income to effectively offset the prior mortgage payment is therefore a significant factor in maintaining an acceptable DTI for the new home purchase.

Lenders also commonly require borrowers to have liquid reserves, which are funds readily convertible to cash. These reserves provide a financial cushion to cover mortgage payments and other expenses. The amount of reserves required varies based on the property type and loan program. For primary residences, lenders may require two to six months of principal, interest, taxes, and insurance (PITI) payments. Investment properties generally require more substantial reserves, often six months or more of PITI payments. Acceptable reserve sources include checking and savings accounts, stocks, bonds, certificates of deposit, and the cash value of vested life insurance policies.

Required Documentation and Loan Program Specifics

Securing a mortgage when renting out a current home to buy another involves submitting specific documentation to verify income, property status, and financial stability. A fully executed lease agreement for the property being rented out is a primary document. This agreement outlines the rental terms and the amount of rent to be received. Lenders may also request proof of security deposit receipt and evidence of the first month’s rent payment to confirm the lease’s validity.

For properties with an established rental history, borrowers must typically provide IRS Schedule E from their most recent tax returns. This form reports income and expenses from rental real estate. If the property is newly rented, an appraisal report that includes a comparable rent analysis or rent schedule (such as Fannie Mae Form 1007 for single-family or Form 1025 for multi-unit properties) is often required to establish the market rent for the property. Bank statements showing consistent rent deposits, especially if seasoning of rental income is required, may also be requested.

Conventional Loans

Conventional loans, backed by entities like Fannie Mae and Freddie Mac, are widely used and have specific guidelines for this scenario. Both Fannie Mae and Freddie Mac generally allow a borrower to use 75% of the gross monthly rent from a departing primary residence to offset the existing mortgage payment. This reduction helps improve the borrower’s debt-to-income ratio. Conventional loans typically require reserves, often two months for owner-occupied properties and six months for investment properties.

FHA Loans

FHA loans are primarily designed for owner-occupied properties. While generally not intended for investment properties, there are limited scenarios where they may apply, such as owner-occupied multi-unit properties where one unit is rented out. If a borrower has an existing FHA-financed home and wishes to rent it out while buying a new primary residence, specific rules apply, often requiring the borrower to have met initial occupancy requirements for the existing FHA loan.

VA Loans

VA loans are a benefit for eligible service members and veterans, primarily for purchasing a primary residence. Veterans can rent out a previously VA-financed home after meeting initial occupancy requirements, typically living in the home for at least 12 months. For a new VA loan, the primary purpose must be owner-occupancy. Rental income from the existing property may be considered to offset that property’s mortgage payment.

Jumbo Loans

Jumbo loans, which are for loan amounts exceeding conventional loan limits, often have more stringent requirements. While they may consider rental income from investment properties, they generally apply the 75% rule to the gross rental income. Jumbo loans typically demand higher credit scores, lower debt-to-income ratios, and more substantial liquid reserves, often ranging from six to twelve months of mortgage payments.