House hacking: The cheaper alternative
Obviously, the capital requirement can be a major barrier to entry for would-be real estate investors. That’s where house hacking comes in.
House hacking refers to the concept of buying a home with extra units or extra space, living in part of the home, and renting out the rest. For example, if you buy a triplex and live in one unit while renting out the other two, it can be considered a house hack. House hacking could also mean buying a large single-family house and renting the extra bedrooms to roommates, just to name one other possible scenario.
This can be a great way to dip your toes into real estate investing, as you can learn the basics of things like property management in a hands-on manner.
In fact, my first real estate investment was a house-hacking situation. In 2011, I was living in a very expensive real estate market (Key West, Florida), but there was an abundance of smaller duplexes for sale at the time. I ended up buying a duplex with a two-bedroom unit on one side (where I lived) and a one-bedroom unit on the other side, which I rented out to help cover the mortgage.
Why house hacking requires less capital
Here’s the key point: If you live in a home, even a home with several living units, it is still considered a primary residence. This generally results in lower mortgage rates and lower lending fees, and may even get you favorable property tax treatment. And for the purposes of our discussion, the down payment requirements for primary residence mortgages can be much lower than for investment properties.
Most primary residence mortgages can be originated on single-family homes as well as two- to four-unit multifamily properties. (Note: Anything with more than four units is generally considered to be commercial in nature and is ineligible for residential mortgages.)
Conventional loans can be made with down payments as low as 3% to 5%, depending on the property and the borrower’s qualifications. If your credit score is on the lower end of the spectrum, you could still obtain an FHA mortgage for your primary residence with as little as 3.5% down. FHA loans aren’t the cheapest or quickest but can be a great option for homebuyers without stellar credit. If you’re a veteran or are an active-duty military member, you may even be able to obtain a primary residence VA mortgage with no down payment at all.
An example of how house hacking can be a lucrative investment
To illustrate how this could work, consider this example. You buy a quadruplex (four-unit property) for $300,000, move into one unit, and rent the other three units out for $750 each ($2,250 total) per month.
You obtain a conventional mortgage with 5% down, so based on a 4% interest rate, you’ll have a monthly $1,361 mortgage payment (principal and interest), and we’ll say that including property taxes and insurance, you pay $1,800 per month to your mortgage company.
Not only does the rent you collect completely cover your mortgage payment, but you’re generating $450 per month in income. And over time, your tenants are paying down your loan and building equity for you.
Are you a good candidate for house hacking?
There are a few things to consider before you think about a house-hacking situation of your own.
For one thing, you must live in the property. If you obtain a mortgage on a primary residence and you don’t move in after closing, it could constitute mortgage fraud. You don’t necessarily have to stay forever, but most lenders have certain time requirements before you can move out of a property financed as your primary residence, so be sure you know the rules.
Also, you need to be willing to share your space. If you want a property that’s entirely your own, house hacking is probably not the way to go.
There are also some big potential downsides you must be willing to deal with. For example, cash flow in investment properties can be rather unpredictable. In our example, the property produces a positive cash flow of $450 per month -- but only if all three of the other units are occupied and nothing major goes wrong. Vacancies and unexpected maintenance expenses can quickly erase your income.
Furthermore, it can be a headache to live right next to your tenants. If you own a rental property you don’t live in, tenants might call you if something breaks. If you live next door, they might just knock on your door and expect you to handle the situation right away.
Finally, from a financial perspective, it’s important to mention that you’ll need to be able to qualify to buy the entire property on your own. In other words, if you’re buying a multi-unit property, you can’t use the expected rental income to justify getting a mortgage -- you’ll need to qualify for the mortgage based on your own income, debts, and credit.
The bottom line
House hacking can be a great way to buy your first investment property without having to come up with a ton of cash. However, like most other investment decisions, it isn’t right for everyone. It’s important to weigh the pros and cons before deciding if a house hack could be a smart move for you.