Converting a Primary Residence into a Second Home or Investment Property

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You may not be familiar with the term “buy and bail” but lenders are. And if you’re not familiar you may be very surprised when a lender denies your loan when you try to convert your primary, current residence into a second home or rental.  That is, unless you stumbled upon this blog.  First let’s talk about conventional loans (those backed by Fannie Mae and Freddie Mac.)

If you are applying for a conventional loan, the guidelines are as follows:

Borrowers who currently own their own home typically have three (3) options when they decide to purchase a new Primary residence. They can …

  • sell the current residence and payoff the outstanding mortgage,
  • convert the property to a second home assuming the borrower can qualify with both the existing and new mortgage payments, or
  • convert the property to an investment property and provide documentation that they will rent the property and use the income to offset the mortgage payment.

In order to ensure that borrowers have sufficient equity and/or reserves to support both the existing financing and the new mortgage being originated, the following guidelines are required for qualifying borrowers purchasing a new Primary residence when the current Primary residence is pending sale or they are converting their existing Primary residence to a second home or investment property.

Current Primary Residence is pending sale but will not be sold (closed) prior to the new transaction:

  • Both the current and the proposed mortgage payments must be used to qualify the borrower for the new transaction.
  • Six (6) months of PITI for both properties is required to be in reserves. Reduced reserves may be considered of no less than 2 months for both properties if there is documented equity of at least 30 % in the existing property. Valuation can be derived from an appraisal, automated valuation model (AVM), or Broker Price Opinion (BPO) minus outstanding liens. Valuation is subject to underwriter approval. Reserve requirements for loans submitted are dictated by the automated underwriting findings and will replace the requirement listed above.
  • The current principal residence’s PITI will not be required to qualify the borrower as long as the reserve requirements above are met and an executed sales contract for the current residence is provided and confirmation that any financing contingencies have been cleared.

Conversion of Primary Residence to a Second Home

  • Both the current and the proposed mortgage payments must be used to qualify the borrower for the new transaction; and
  • Six (6) months of PITI for both properties is required to be in reserves. Reduced reserves may be considered of no less than 2 months for both properties if there is documented equity of at least 30 percent in the existing property. Valuation can be derived from an appraisal, automated valuation model (AVM), or Broker Price Opinion (BPO) minus outstanding liens. Valuation is subject to underwriter approval.

Conversion of Primary Residence to an Investment Property

  • Both the current and the proposed mortgage payments must be used to qualify the borrower for the new transaction: and
  • Six (6) months of PITI for both properties is required to be in reserves unless otherwise dictated by automated underwriting findings.

Up to 75% of the rental income may to be used to offset the mortgage payment in qualifying if there is documented equity of at least 30 percent in the existing property. Valuation can be derived from an appraisal, AVM, or BPO minus outstanding liens. Valuation is subject to underwriter approval. If the 30 percent equity in the property cannot be documented, rental income may not be used to offset the mortgage payment.

  • a copy of the fully executed lease agreement; and
  • the receipt of a security deposit from the tenant and deposit into the borrower’s account.

If you are applying for an FHA loan however, the guidelines are similar but slightly different in significant ways.  Also, keep in mind, there are  few exceptions to using FHA financing when you already have an FHA loan.  Here are the guidelines:

The main difference with FHA is that they don’t have specific cash reserve requirements in the same way as conventional loans.  In this way, FHA is more lenient.  Rental income on the property being vacated, reduced by the appropriate vacancy factor as determined by the jurisdictional FHA Homeownership Center (see http://www.hud.gov/offices/hsg/sfh/ref/sfh2-21u.cfm) may be considered in the underwriting analysis under the following circumstances:

Rental income:

  • Relocations: The homebuyer is relocating with a new employer, or being transferred by the current employer to an area not within reasonable and locally recognized commuting distance.  A properly executed lease agreement (i.e., a lease signed by the homebuyer and the lessee) of at least one year’s duration after the loan is closed is required.  FHA recommends that underwriters also obtain evidence of the security deposit and/or evidence the first month’s rent was paid to the homeowner.
  • Sufficient Equity in Vacated Property:  The homebuyer has a loan-to-value ratio of 75 percent or less, as determined by either a current (no more than six months old) residential appraisal or by comparing the unpaid principal balance to the original sales price of the property.  The appraisal, in addition to using forms Fannie Mae1004/Freddie Mac 70, may be an exterior-only appraisal using form Fannie Mae/Freddie Mac 2055, and for condominium units, form Fannie Mae1075/Freddie Mac 466.

Here is a link to FHA’s Mortgagee Letter 08-25 that originally outlined these requirements: http://portal.hud.gov/hudportal/documents/huddoc?id=08-25ml.doc.

I’m providing these guidelines as reference.  They are by no means a replacement for a good loan officer who can help structure a loan that is right for you without hours of internet research!

Charles Dailey – Branch Manager, Loan Officer, Certified Military Housing Specialist – CA DOC, MN DOC & WI DFI

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Comments 25

  1. Lorena

    What if the primary residence is being converted into an Investment property for the long term goal of doing a 1031 Exchange. We have a property that is worth a significant amount of money and will give us enough to purchase 2 homes in another area. We would like to rent it out and then eventually use it for a 1031 exchange. NO money is owned on the home. No loan is needed.

    Is there a quick way to accomplish this? How long must the home be rented out before it qualifies for a 1031 exchange? I’ve heard that one payment technically makes it an investment property and I’ve heard six months and 12 months.

    I appreciate any helpful information.

  2. Sako

    4-5 years ago my wife purchased her parents home in her name. 2 years later they leased a car in her name. Now that we’re married and moved out, we are in a pickle when it comes to purchasing a home for ourselves. The parents refuse to move and/or sell the house and the car lease (which they are paying) has 10months left on it. Existing house has a 300k balance left on the loan, house valued at about 400k. I do not have 20% for a new house, maybe 10-15% for a down payment and no other debt. What are my options in buying a house for us? She makes significantly more than me, and we want to put new house in her name.

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      Charles Dailey

      Isn’t family fun! 🙂 You’re actually not as trapped as you think you are. The lease, if it has fewer than 10 payments left on it at the time of your application, would not be factored into your debt to income ratio (this would increase your purchasing capacity by decreasing your debt to income ratio). Depending on how she “bought” the home, that may or may not be included in the debt to income ratio either. If she “rents” it to her parents and claims the rent on her Schedule E of her tax returns, that would be at least a partial offset of the liability. If she co-signed on the loan for them but they make the payments and you can document that they’ve made the payments on time for 12 months or more, then it can be excluded from the debt to income ratio. If you don’t have 20 percent down but want to get away from monthly mortgage insurance, you should use Single Premium Financed Private Mortgage Insurance (http://www.iloanhomemortgage.com/monthly-private-mortgage-insurance-it-doesnt-make-any-sense/). This way, you wouldn’t have a higher rate and wouldn’t have monthly mortgage insurance and it would increase your purchasing power. You can do this with as little as 5.045% down. Lastly, if you use Single Premium Financed Private Mortgage Insurance on a conventional loan for your purchase (at least if you did it with me), you’d have the ability to re-cast your mortgage when you finally sell the other home. This is complicated but it’s all explained here: http://activerain.com/blogsview/3781839/plan-your-home-purchase-using-a-mortgage-recast. If you used this method with 5-10% down, you’d also have the required reserves to carry two properties.

      If you’re in CA, I’m licensed there and would be happy to help. If you want me to get your pre-approval under way, here’s the place to start: http://www.iloanhomemortgage.com/charles-d-dailey/#charles-welcome.

  3. Ryan

    I own a 2 unit investment property that I have lived in for 6 years and I am purchasing a primary residence. I am closing in 6 days. I was pre-qualified for a loan and I was just informed by the lender that I do not have the 6 months reserves to cover both the investment property and the new primary home. I did not know nor was I previously informed that I needed 6 months reserve for the investment property as well as the new primary property! I have a lease for the unit I live in and they will be taking occupancy in 2 weeks! Any thoughts or information that can help me in this situation?

  4. Jon

    Thanks for the advice. I have a question. I am trying to purchase another home and rent out my existing primary FHA loaned residence. However, as it was explained to me, if buying a 2nd home through a conventional loan, the 2nd property must be a certain distance away (i think 50 miles) from my current primary residence. However, if I refinanced my current primary residence as an Investment property, could I be approved for another primary residence through FHA and avoid the distance rule…assuming I have 6 months reserves and income to cover both PITI?

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  5. Praveen T

    Thanks Charles. If I understand, I still am eligible for HARP refi for my current home as a rental property, correct?. I am assuming I can do this HARP refi only after closing on my new home then. Correct?. I am not looking for any cash out. The new home is not 100 miles away from the current home. As for property being on water, I am not certain how do you define it is or not. But the current TLTV is 90%. PS Note, my lender has done pre-qual and confirmed eligibility for new home based on our income. They indicated the same as you did that rental income would not be treated as income for loan as it would be less than 2 years.

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  6. clark from New Jersey

    Charles – wish I had read this 3 months ago.

    I just refinanced my townhouse and closed. (primary)

    I would like to rent out the townhouse and buy a house.

    The lender doesn’t want to touch this for 6 months.

    Do I have any realistic options, or do I need to wait 6 months?

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      Charles Dailey

      I’m not sure I understand why waiting 6 months would make any difference at all. If you have the required reserves and adequate qualifying income and an intention to occupy the property you’re buying within 60 days of closing, I don’t see that the hold up would be. Am I missing something?

      1. clark from New Jersey

        I don’t think you are missing anything? Not sure why WF would not want to finance other then they are being ultraconservative? The fact is that the consultant sent me a prequal letter, but when he went back to the underwriters for the official prequal, they balked.

        What do you think would be the best strategy in this case. Should I refinance both the townhouse and the new house all under one umbrella mortgage and get the townhouse listed as a investment mortgage?

        PS – I am married FYI. Let me know if this is something we should discuss by phone.

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          1. Praveen T

            Charles – I am in somewhat similar situation above. I have a current primary residence for which interest rate is locked in for 6 more years and then will be adjusted. I now have a ratified contract for a new home that i’m buying to be delivered in May’13. While I was trying to get my current primary residence refinanced, I was told that I will not qualify for refi as a primary residence in lieu of the ratified contract on another house as primary residence. I was not told by my realtor or lenders I spoke prior to signing the new contract about this issue. Now my question is, what options do I’ve to refi for my current primary residence before I move to my new home. PS Note, the current primary residence does not have much equity. Appreciate your advise.

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              Charles Dailey

              There’s a couple variables here that concern what you’d be doing with the home you currently have. If it’s to be a rental property, the you could try to see if it’s eligible for a HARP refinance as a non-owner occupied property. In this case, you couldn’t take cash out. If it is to be a second home, you could refinance it that way (though if there’s little equity, there likely wouldn’t be a way to get any cash out). The burden of proof that a home will in fact be a second home is very high due to many people making false claims about that in the past. If the property is on water or will be far away from the new home (say for instance the new home is near work and the old house is near relatives and they are 100 miles from one another), then it may work. This is hard to prove though so usually they are treated as investment properties in underwriting. The other problem with properties being treated as investment properties in underwriting is that you can’t claim the rental income unless you can document the rental income and that you’ve had history as a landlord. This is also tough.

  7. gabriel

    Thanks, great information!
    I’m in this situation but I have a question. We are going with a conventional loan for the purchase of a second house that we will use as principal and plan to rent out our current house but we wont have time to have a executed lease agreement by the time we get an answer if we are getting the new house (short sale so we are waiting on seller’s bank) and time of closing (again short sale so they give 30-45days. So what are our options?
    Will just listing our house for sale work and meet the guidelines?

    We are qualify with both house’s PITI and will have 6months reserve for both houses after closing.

    Thanks!

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      Charles Dailey

      Let’s hope that I understand your question correctly here. Assuming that you don’t have a document-able 30% equity position in your current home, you’ll need 6 months of PITI in reserves for both places but it sounds like you’re good there. If you are qualifying with both PITI’s then it doesn’t matter at all whether or not the property you’re retaining as a rental is rented. You neither need your property listed nor do you need an executed lease. If you have the reserves and the income to qualify with both payments, you’re done.

      1. gabriel

        Hey never thought of checking back here.Thanks for your reply, yes you perfectly understood my question even though it was a mess :). Yes,we have reserve and income to qualify with both PITI and I was just “worried” about what the status of our current home will need to be when we apply for the loan on the new home (wont have time to find tenants since we are purchasing a short sale that we don’t even know if its approved yet and once/if it is approved, we will only have like 30days to close)and banks are weary about ppl who buy and bail.
        We want to do the right thing and rent our house that it slightly upside down for a couple years until it is at market value.

        So from your answer, it look like I should be good! (getting different info from different lenders.I had to find on my own that I needed 6+6months PITI after closing for ex. Lenders had no trouble preapproving us but never told us about this “detail” 🙂 )

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          1. Garth

            Charles – I think I got a good understanding with this article and your comments. I have a primary that I’m looking to convert into a Rental. I have the signed lease and deposit. The rent amount will cover all costs mortgage,taxes,interest. I have no prior Property Mgt. experience. I have been presented the opportunity to buy a new primary but have low cash reserves and currently don’t have the PITI covered. I could have the PITI covered in 6-10 months with a hard savings plan. What are the best options to consider?

            My thoughts are to, Refinance my current primary as an non-occupied Income property, which is currently a standard 30 fixed loan non-FHA, and apply for a new loan under FHA due to low cash reserves currently. Will the rental income be considered as income for this?

            Or – Refinance both homes under one mortgage? – same question will the rental income be considered as income when looking at finances.

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