Buying a duplex: a different animal
When it comes to buy a duplex with less than 5 percent down, the strength of your application really counts. The question very often is not what you can afford, but whether you can fit within tight lender guidelines.
What exactly is a duplex?
A duplex is a property with two units at one address. It’s traditionally a way to get into the investment real estate game, because you get shelter for yourself, plus rental income and extra tax breaks. The rent can offset or even completely cover your mortgage and other costs.
Uncle Sam likes duplex properties, and rewards them with two sets of tax rules.
The owner-occupied unit can be treated as a primary residence. The rental unit can be treated as investment property. You can depreciate and write-off related repairs and improvements for the rental unit. For details, see a tax professional.
Buy a duplex with less than 5 percent down
Lenders have mixed feelings about duplex properties. The same property may or may not qualify for a mortgage depending on strange and obscure requirements. The chart below shows two ways that lenders can look at your income and mortgage. One (Lender B) allows you to qualify for a lot more.
First, nearly all lender reduce rental income by 25 percent to allow for vacancies and other income interruptions.
Underwriting can differ between programs
Then, some lending guidelines allow underwriters to “net” the adjusted rental income and payment. Lender B uses this method. If your payment was $2,000, and the rental income was $1,000, you’d only have to qualify based on a payment of $1,250.
$1,000 * .75 = $750 adjusted rental income. And the $2,000 payment minus the $750 rent equals $1,250. This makes qualifying easier.
However, other lenders, like Lender A, add the adjusted rental income to your other income, and then hit you with the entire mortgage payment when qualifying. You qualify to borrow less under these guidelines.
VA rules say qualified borrowers can purchase properties with one to four units and zero percent down. One unit, however, must be your primary residence.
Buying a duplex with the VA program can be very advantageous. First of all, purchasing with nothing down is extremely attractive. Also, you’ll get residential mortgage rates and not investor financing rates, and eligible borrowers can benefit under the VA’s unique qualification system.
Lenders generally qualify borrowers on the basis of credit, income, and down payment size. The VA program uses a system based on the borrower’s “residual income.” This is the money left over at the end of the month based on household size and geographic location. With a duplex, the income from the second unit can be used to increase residual income and qualify for a bigger loan.
FHA mortgages and duplex financing
The FHA, like the VA, does not make investment loans. It requires all financing in its basic 203(b) program to be secured by a primary residence. You have to occupy the home.
That said, you can use the FHA program with 3.5 percent down to buy property with one-to-four units, so a duplex is okay as long as you occupy one of the two units.
While financing with 580 credit is available in theory, don’t hold your breath. Only 5.5 percent of all FHA-backed loans have credit scores between 580 and 619. As is usually the case with mortgages, higher credit scores and / or larger down payments are a major key to underwriting success.
Conforming loans are those mortgages lenders can sell to Fannie Mae and Freddie Mac. They are commonly available with 5 percent down when financing a single-family prime residence. However, the rules change when financing a duplex.
For instance, the 95 percent financing available to single-unit residential buyers morphs into 15 percent down with Fannie Mae to buy a duplex ,while Freddie Mac demands 20 percent up front.
Why is it that duplex buyers are expected to have bigger down payments with conforming loans?
Buy a duplex can be risky
Ideally, you get great tenants who pay their rent and don’t drive you crazy. Unfortunately, the world is not ideal. You may not like your tenants. They may not like you. They may not pay their rent on time. Or at all.
Lenders dislike risk. In their eyes, the least risky mortgage finances an owner-occupied, single-family residence with 20 percent down and a credit score nudging 800.
A duplex is only half owner-occupied, and it’s something other than a single-family residence, a hybrid that’s half-house, half investment property.
The buyer presumes that some or all of the mortgage will be offset with unit rent. The lender wonders what happens if there are vacancies or big repairs.
While the FHA has a three-month reserve requirement for properties with three and four units, it does not have a cash requirement for a duplex. But the VA requires six-months of cash reserves to buy a duplex.
While borrowers may be able to get by without the equivalent of several monthly mortgage payments in the bank, it’s not a good idea. To protect your interests (and your credit score), always have real cash in the bank, and a checking account attached to a line of credit.
What are today’s mortgage rates?
Current mortgage rates are at or near the same level for a duplex that they are for a single family home. The combination of rising rents and low rates can make becoming a landlord a profitable proposition today.