Ok, so you have made up your mind about investing in a rental property. Investing in real estate generally offers investors a lot of advantages ranging from steady income, help from somebody else to pay down your mortgage debt, the ability to use leverage, as well as attractive appreciation potential.
Real estate can be a good investment if you buy for the long-term. Of course, house flippers and renovators can also make a profit, but the rental business follows other rules than a short-minded speculation focusing on a quick dollar.
If you want to invest in a rental property, especially if you are a first time real estate investor, there are a couple of basic investing principles that should prevent you from jumping into a couple of potentially expensive minefields.
1. Down payment
When you are investing in a rental property, you likely will need to approach a lender who will come up with the majority of the financing. Ultimately, that's their job: They will provide a loan to you which then will be secured by the house you purchase with the loan proceeds. Professionals also call this process collateralization.
During the financial crisis many lenders offered loans that didn't require any down payments (we all saw how that turned out). But, the more money you can put down from the get-go, the lower the mortgage payments are going to be.
Generally speaking, if you can part with some cash for a down payment, you could see a lower mortgage rate.
I would always advocate for a down payment in the 20% neighborhood (if not more) as it signals to the lender that you approach your property investment as a serious business and that you are unlikely to walk away from the mortgage.
2. Long-term financing
Some lenders will offer extremely low mortgage rates, so-called teaser rates, which will later significantly adjust. Consequently, your mortgage payments might shoot up to unaffordable levels if you take out such a adjustable rate mortgage (also called ARMs).
ARMs caused a lot of problems during the financial crisis as many home owners couldn't deal with the 'reset' mortgage rate and a wave of foreclosures followed as a result.
When it comes to investing in a rental property, it is always a good idea to take out a mortgage with a long duration. A 30-year fixed-rate mortgage is especially suitable for investors as they will benefit from fixed monthly mortgage payments and have better planning security. Adjustable-rate mortgage will adjust any time interest rates move and are more of a speculative character.
3. Know your numbers
When you buy a rental property you should have a rough estimate as to what the property's income is. If it is an unoccupied property, talk to neighbors or real estate agents to find out.
Understand that you will incur maintenance expenses, which will depend on the size and the location of your property and which will affect your return on investment.
Once you have a solid grip on the expected rental income and property related expenses (maintenance, insurance, taxes), make sure that the net amount covers your mortgage payments.
Even though you might calculate a low initial return on investment, understand that real estate really is a long-term investment. Owning a debt-free rental property when you retire and being able to access steady income that supplements other investments is a great way of preparing for retirement.
Obviously, if you buy a rental property, the asset must be attractive to prospective renters. Neighborhoods that are clean and safe are always a good bet for a rental property.
The same goes for properties that are located in centers of economic activity and provide access to critical infrastructure such as shopping centers, schools, hospitals and entertainment venues.
5. Screen your tenant
This is probably one of the most important pieces of advice there is. In order to avoid some serious trouble with your new tenants, run a couple of background checks.
Get a few references and talk with prior landlords to see if your applicant is as creditworthy as he or she claims to be. There is nothing worse than putting a tenant into your new property who will then not make his contractual payments.
The Foolish bottom line
If you follow these fairly conservative guidelines when it comes to investing in a rental property, you will have already mitigated a lot of risk that naturally comes with such an endeavor.
If you conservatively finance your investment project, rely on long-term financing and do your due diligence in terms of local market economics and the backgrounds of your prospective tenants, you will be well prepared for whatever is coming your way.
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