What do you do if you’re underwater on your investment property mortgage?

I have been there. Most likely, many who bought during the infamous real estate bubble have been there, too. In 2009, I thought the bubble had burst and prices dropped as much as they would. How wrong was I? I bought an investment property and quickly became underwater on it. I was drowning on that mortgage, and I didn’t know what to do. However, I had options, and so do you.

Let’s take a look at some baseline numbers to determine your best move.

Are you making a monthly profit?

The first thing you will want to do is look at the month-to-month profitability of the property. While a rental unit might not have equity, it might have profitability each month. To determine the profit you make each month, add up your mortgage, monthly taxes, monthly insurance premium, and anything else you pay. Then, subtract this number from the rental income you make on that property.

(monthly PITI, maintenance, 10% to reserves) – Rental income = Profit

Related:  How to set the perfect rent price for your rental properties

Questions to ask yourself

1. Are you in the positive?

If so, hold out on selling. If you are making a profit, it makes sense to hold the mortgage and wait for the value to increase to build equity.

2. Are you breaking even?

If you are breaking even, it might be a good idea to hold the mortgage. Each year, you pay down the principal a bit more. Your rent check each month brings you closer and closer to the surface. Unless you truly don’t enjoy being a landlord, or it is more work than you can handle at this time in your life, keep it in your portfolio.

3. Are you in the negative?

Did your calculations show that you were in the negative? That doesn’t necessarily warrant selling. Can you foresee an eventual turnaround? Real estate historically increases in value as time goes by.

What if I have a negative cash flow/loss?

For my property that was underwater, I was making negative cash flow the entire time I owned it, but I could afford to cover that cost. I covered the negative cash flow for nine years, knowing that the market would turn around, and it did. Earlier this year, I sold it at a profit. While it didn’t make sense for me to hold it as a rental because my mortgage was too high to ever have a positive cash flow from rent, it did make sense to hold until I could sell for a profit. My renters helped me pay down my mortgage and I made a little money in the end.

Look at your scenario and ask yourself these questions:

1. Can you afford a negative cash flow?
2. Will your property ever regain its value?
3. Do you have consistent renters that help pay down your mortgage balance?

If you answered “Yes” to these questions, it makes sense to hold the property. However, if you answered “No,” it might be time to look at your options.

Related:  When to sell a rental property?

What are your options to sell an underwater property?

When you have an underwater property that you have decided to unload, you have three options:

1. Short sale

To sell a property with a short sale, the owner needs to negotiate with their lender to accept a lower payoff than the balance. An owner or their Realtor can call the lender and speak with the real estate short sale or work out department to begin the negotiation process. Once you have found a purchaser, the lender needs to approve the purchase price and might decline to pay certain added items such as inspections. After the lender approves the purchase price, you can request they do not report this to credit reporting agencies, and they may or may not comply with your wishes.

2. Foreclosure

While no one wants to go through a foreclosure, sometimes choices are limited. When starting a foreclosure, the first step is defaulting on the loan. After 30 days, a lender sends a notice of default. This likely comes after they have reached out trying to change the loan payments to work with your financial situation. After 90 days of being in default, the owner gets a notice of sale. The last step is selling the property at auction.

3. Sell + pay loan balance

You can avoid short sales and foreclosures if you have cash on hand. The last option for homeowners is to sell the property for what it is worth and bring a certified cashier’s check to the closing for the shortfall. While it is not ideal to pay to get out of the mortgage, it keeps your credit intact.

Conclusion

Investment properties with underwater mortgages can make an owner feel helpless and stuck. However, there are options. In my situation, my property was underwater for about five years. I was losing money each month, but it was a manageable amount. I chose to wait it out, and eventually I sold for a profit. But each person’s financial situation is different. Look at yours to determine what the best move is for your lifestyle.

You’ve made the decision to convert the home in which you live, in other words, your primary residence, to a rental house.

Maybe you’re moving, or maybe you figure you can make some good money, collecting that all-important cash flow, by making your home your rental property. Whatever the reason for the change, congratulations on your decision!

But you can’t just move out and declare your home a rental. There are some things you need to do first. Find out what they are.

You need to take care of some business before you can turn your primary home into a rental property.

You might need to wait if you have a mortgage

Do you have a mortgage on your home? If so, you generally need to live in the home for at least 12 months before converting it into a rental. Why? Certain perks are associated with buying a primary residence as opposed to investment property.

You often get a lower interest rate and can put down less of a down payment when the mortgage loan is for your primary home versus a vacation home or an investment property.

If you say you’ll live in the house but you really are buying it as investment property, you are committing mortgage fraud. The penalty? Your lender could call in the loan immediately upon finding out. And that will probably lead to foreclosure.

Read your loan paperwork or call your lender to find out the waiting rules that apply to your loan. After you’ve lived in the home for the required time for your mortgage, you’re free to turn your primary residence to rental property.

Find out whether you can get another mortgage

When you move from your primary home, you might want to buy another home to live in. If that’s the case, find out whether you’ll qualify for another mortgage before you rent out your current home.

Your lender might consider the rental income you’ll get, but they might not. Either way, get the ball rolling by talking with a mortgage lender before you make any moves.

Check with your homeowners association

If your home is in a neighborhood governed by an HOA, you need to find out whether there are any restrictions regarding renting out your house. Some HOAs have no restrictions, some allow only a certain percentage or a certain number of homes in the neighborhood to be rentals, and some ban the practice altogether.

Change your homeowners insurance policy

Insurance policies for primary homes differ from insurance policies for rental properties. “In my experience, the insurance classification is really the biggest issue when converting a primary home to a rental property,” says Lucas Hall, Landlordology’s founder and Head of Industry Relations at Cozy.

And Lucas makes a great point. Why? If you need to file an insurance claim after you convert your home to a rental, but your policy has not been changed to a landlord policy, your insurer could deny your claim. “New landlords need to make sure they change the policy from a homeowner occupied policy to a landlord’s policy,” says Lucas.

Related:

• The 6 Most Important Clauses in a Landlord Insurance Policy
• Carry Adequate Insurance
• Umbrella Insurance: can it replace an LLC?

Learn about tax changes

It’s best to consult a tax professional both for your rental property and for your primary residence. But you shouldn’t be totally in the dark about taxes. Here’s what you need to know.

The bad news (regarding taxes) is that if you make money, that money is taxable income, so you should figure out how that might change your tax rate.

But here’s some good news. Once you have rental property, you get to take these deductions for rental property expenses:

• Utilities (if you pay them)
• Homeowners association fees
• Landlord insurance policy
• Repairs you make to the house
• Property taxes
• Mortgage interest

Related: Top 15 tax deductions for landlords

Ask your tax advisor or find out from your local municipality about the homestead exemption you probably have on your current home. You are allowed to have that only on your primary residence, so find out what you need to do when you wish to convert your home to a rental.

Ready your property

Look at the competition. Are the rental homes in your area upgraded? If they are and your home isn’t, you should consider putting some money into your home to help ensure you’ll get renters and at market rate.

A new coat of neutral paint throughout the house and nice landscaping in front are good starts. You might want to then make a list of all the improvements you’d like to make and get them done gradually. At the very least, make sure your home is well-maintained and that everything is in working order.

Related: Top 10 Amenities Renters Can’t Resist

Learn how to be a landlord

Once you rent out your home … hello, you’re a landlord. Many of us, myself included, learned the business by jumping in headfirst. But, you are apt to make costly mistakes this way. I know I did.

Related: 5 Unexpected Traits of a Profitable Landlord

But lucky you: If you happened to find this site, browse around. We are here to help you along the way with informative articles, a comprehensive state law section, and a toolbox with tons of resources to help landlords succeed.

Recently, I went down a residential mortgage rabbit hole.

I’ve been considering buying a vacation rental. With dreams of beachfront cottages and wooded cabins, I went online to research financing options. There were so many. True to myself, I obsessively researched it until the idea of a vacation rental gave me chills.

The amount of money we would have needed for a loan was too low for a traditional mortgage. I wasn’t aware that mortgages had minimums. I also wasn’t aware of the myriad of other stipulations with investment mortgages.

Securing financing for an investment property is more difficult than for your primary home. You need to prove that you can not only afford your mortgage but, if the property isn’t rented, you can afford the second mortgage as well. In addition, the down payment needs to be higher than with your home at a minimum of 20%. No small feat.

Here are the seven mortgage options for investment properties.

7 investment property mortgage options

1. Hard money loans

Hard money loans can be approved quickly and without too many hoops to jump, but they come at a risk. They are funded by investors who provide the loan based on the property and collateral. Hard money lenders generally lend with collateral to back up the landlord’s ability to pay. The loans are short-term (less than five years) and have high interest rates.

Pros: These loans can be funded quickly with fewer requirements than traditional loans. They are used mostly for fix-and-flip investors who will have the property for less than a year, sell it, and pay it off.

Cons: Hard money loans are expensive with high interest rates and origination fees. If your flip doesn’t work out as planned, a hard money loan could get very expensive and you risk losing your collateral.

Related: Top 10 reasons real estate investors use hard money loans

2. Conventional loans

Conventional loans are slightly less risky than other options; however, you need to be financially secure to be approved for an investment property. Loan requirements are more strict than with a primary home, and more money is needed up-front.

Pros: A conventional loan will have a better interest rate than a hard money loan. You can have a 30-year loan, so if you plan on keeping the property as a long-term rental, you have time to pay it off. Last, it’s backed by a bank, making the loan more secure.

Cons: The loan requirements are difficult to meet. Mortgage insurance is not available for second homes or investment properties, so a minimum of 20% needs to be put down on the property. In addition, if you need rental income to meet the debt-to-income ratio, you will have needed two years or more of property management experience (with a Freddie Mac backed loan). Last, the interest rate is higher on a second home.

Related: Pros and cons of making extra payments on your mortgage

3. HELOC

A HELOC—home equity line of credit—is when an investor takes equity out of their primary residence as a line of credit to purchase another property. You can use this line of credit for five to 10 years, depending on your lender, and you have 10 to 20 years to pay it off.

Pros: Using a HELOC loan for buying an investment property has a quick approval process, and you have a long period to pay it back.

Cons: The issue with HELOCs is that you are taking equity from your primary residence to buy an investment, and that is always a risk. The interest rate can vary, just like with a credit card, so payments will not be the same every year. If you are a Dave Ramsey fan, you know that he would say using a HELOC to buy an investment property is “dumb.” If you do not pay close attention to your finances, using a HELOC can be risky and your debt can get out of control.

Related:  6 ways to buy your first investment property for $1,000 or less

4. FHA loan

Many first time homebuyers know FHA loans well. They are federally backed loans that require only a 3.5% interest rate and a less restrictive approval process. For example, you can use a gift as a down payment. However, they come with extra stipulations, such as not using the home as a rental property.  So, why is it on this list?

Pros: FHA loans have low-interest rates, have extra funding available for renovations, and are less restrictive on the down payment.

Cons: You need to occupy the residence. That’s a big con. An FHA loan cannot be used for an investment property. However, it can be used for multi-unit properties. You can use an FHA loan to finance a three-flat, live in one unit, and rent the other two. That’s exactly how I financed my investment property.

5. VA loan

Veteran loans started in 1944 with the G.I. Bill of Rights. A VA loan is a home loan with no down payment. VA loans are available to vets whose service met a certain requirement. Like, FHA loans, VA loans cannot directly be used for investment properties, but there is a way around that.

Pros: VA loans can be used on properties with up to four units. If you want to use a VA loan to finance a rental property, you must occupy one of the units. The benefits of VA loans are no down payment, no PMI, eased debt-to-income requirements, and they are flexible.

Cons: There is a VA funding fee that is used to continue funding the VA loan program. You cannot buy a rental property that you do not occupy. It is difficult to qualify.

6. Cash-out refinance

A cash-out refinance is when you leverage the equity of a property you already own to purchase another. Let’s say your primary residence has $100,000 of equity in it. As long as you leave 20% equity in the property, you can refinance and take the cash out to invest in another property.

Pros: If your property has the equity, it is a quick process to get approved. You pay the interest rate of your primary residence, avoiding the high interest that comes with an investment property.

Cons: You start your mortgage over again. You might end up with a higher interest rate on your primary home than before. Without enough cash in your reserves, you might not be able to qualify for a refinance.

7. Seller financing

Seller financing, also known as private money mortgage, is financing supplied by the seller of the property. The financing can be for the down payment, whole mortgage, or both. Seller financing is popular among property investors and can benefit both the buyer and seller. Sellers can finance in two ways.

1) The buyer signs a contract to pay off the loan over a certain period of time, and the seller provides a deed of trust that lets them foreclose on the buyer if the buyer fails to pay, but also gives the buyer the right to sell. 2) The second option is a land contract where the seller keeps the deed until the loan is paid off. This option is less popular than the first because the buyer does not have the right to sell or refinance until the loan is paid off.

Pros: The approval process is fast. The closing fees are low. Down payment is flexible. The seller has pros as well. A motivated seller can finance the sale of their property. They have fewer tax implications. The promissory note can be sold to another investor if they need cash. The property can be sold “as-is” easier.

Cons: The seller needs to have the mortgage free and clear for a seller financing option to work. The interest rate is usually higher than with a standard loan. The seller needs to be willing to take the risk of holding a loan. Not all sellers will want to be responsible for financing.

Related: How to do a seller-financing deal

Conclusion

There are many ways to finance an investment property, but they each option has its quirks. When making an investment, look at all your options for financing. Making the wrong decision can cause you to go broke, but making the right decision can make you rich.

After my trip down the rabbit hole, I have an idea of which route is best for me. What’s right for your investment strategy?