Which First...Personal Residence or Rental?

First, thanks to Steve for the inspiration for this topic.

 I'm glad you're thinking ahead to make sure you know what you're getting into. The last thing you want to do is go out and buy a home, whether it's a personal residence or rental first, and then find out you just put yourself in a position where you can't do the other. I took a slightly different spin on the question, but I think I'll get the basis of it answered.

First, let's cover the basic differences between owner occupied loans and non-owner occupied loans. With conventional financing, you have a few different options on the personal residence side. You might be able to qualify for a low down payment program and put down as little as about 3% of the purchase price, or even zero down if you live in an area where the properties may qualify for USDA financing. Keep in mind that with either of these options, likely you will be paying mortgage insurance in addition to your typical principle, interest, taxes and insurance (PITI). If you can put a significant amount down, you might be better off going with a 20% down program without the mortgage insurance.

On the non-owner occupied side, you'll see a big difference in down payment requirements, as well as a difference in rates. Typically you'll need 15-20% down to purchase a home that will be a rental property. You'll also see slightly higher rates. This is a reflection of the lenders perceived risk in this type of loan. The more "skin in the game" you have, the less likely you'll default on the loan. The nice thing about these loans, is often you can use a portion of the rents to help qualify for the loan. For a new purchase, you might be able to get 75% of the rent counted as part of your income to help qualify. Once you have 2 years tax returns operating the home as a rental property, you can then use the actual income of the property to qualify for additional loans.

One strategy to consider is actually buying your personal residence first, and converting it into a rental property later. The benefit is that you get the low down and lower interest rate terms of an owner occupied property, even once you convert it to a rental. Check your loan terms to see if it states that you must live in the home for a specified period of time first. Make sure you do your calculations first as well, as when you go to purchase another property in a couple years you will likely have to be able to qualify for both the existing mortgage payment as well as the new one you're attempting to get. This may not be the case if you have gained some equity in the property, but be prepared for it just in case, especially since there's no telling what loan programs will be available 2 years down the road. Something you might even consider doing that could help with this is buying a 2-4 unit residential building. For 2-4 units, you can still get residential financing, and you then have additional units paying for your mortgage that you can use as income to help qualify for both the initial loan, as well as another loan later. If the rent of the other unit(s) covers, or at least almost covers the mortgage (or better yet the building cash flows), you're golden in a couple years and you won't have to worry about trying to qualify for both the current building and an additional one.

The other benefit with buying a future rental as a owner occupied home first is that, if you use a low down payment program for the initial purchase, you're using more leverage on the property. If you buy it as a rental first, you are putting more of your own money in, and you can't get that money back out unless the property and rents go up in value enough to be able to refinance later. As a rental property, with conventional programs, even when you refinance you will be required to keep a larger portion of equity in the property. With a low down owner occupied loan, you have less of your own money in the property, and more of other people's money in the property. As long as it still cash flows with the higher leverage, that allows you to use your own money for other investments.

Now, there's one wild card I want to throw in the mix here, and that is seller financing. A lot has changed with this since Dodd-Frank went into effect, but seller financing can be and still is done on a regular basis. There are a ton of benefits to negotiating seller financing. You're negotiating directly with the seller, so there is a lot more flexibility to the terms that can be created versus the "our way or the highway", "take it or leave it" banks. The other great thing is that, if you create seller financing on a rental property, that loan is not on your credit report so it most likely will not count against you and hurt your ability to qualify for a conventional loan. Why not go out and find a rental property that you can buy with seller terms, and also go buy your personal residence? "Why in the world would", you may ask, "would a seller finance the sale of their property?". Well that, my friend, is an entire topic by itself and for a separate post at a later day (I guess I just figured out the topic for my next post).

One final disclaimer; conventional financing terms, programs and criteria change on what seems like a daily basis. Make sure you're connected and build a relationship with an experience, knowledgeable mortgage broker who stays up on the latest changes and can help create a game plan for you based on your specific situation. Lastly, make sure you make a plan, as it sounds like you are, but then act on it. Don't overanalyze all the different potential scenarios. Be smart, come up with an action plan that makes sense, and then go out and make it happen.

Simon Sinek: How Great Leaders Inspire Action

WSJ.com: Commercial Real Estate