How To Make Passive Income Through Rental Income
8-minute readJune 05, 2021
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Passive income is money that you earn without a regular daily time investment. Creating a passive income stream from rental income involves work upfront but allows you to reap financial rewards for years to come. One common passive income stream is real estate investing and rental management. But is owning a rental property right for you?
Today, we’ll take a closer look at how you can create passive income by owning and managing a rental property. We’ll also introduce you to a few other strategies you can use to earn passive income.
How Do You Create Passive Income In Real Estate?
Creating passive income in real estate usually involves buying a property and renting it out to tenants. Managing rental properties can be an excellent way to earn money. However, being a landlord isn’t a totally passive form of income and requires consistent effort. Tenants will expect you to continuously maintain and upgrade your property. You also need to invest time researching your property options and advertising your space.
Follow these steps to start investing in real estate and earning rental income.
Research, Research, Research
Before you even think about buying a rental property, you need to do tons of research in your local area. First, take a look at what rental units are currently available in your area using a real estate database. This will give you a good idea of how much you can reasonably expect to charge in rent. Keep in mind that property amenities, location and size will also influence how much rent you can charge.
You’ll also need to spend time learning about the laws you need to follow as a landlord. Most states have a myriad of housing laws that control what a landlord can and cannot do. Violating your state’s housing laws can land you in serious legal trouble. Some examples of law classifications you’ll need to study include:
- Right to privacy laws. Once you rent out your property, your tenant has the right to “quiet enjoyment” of the space. Each state has laws that dictate when you can enter your tenant’s property.
- Discriminatory housing laws. It’s against the law to refuse to rent to someone based on their status as a member of a protected class. Studying discriminatory housing laws will help you understand how to find the best possible tenants for your space without unintentionally violating the law.
- Eviction processes. Landlords must follow an incredibly specific procedure to evict a tenant. If you mess up any step in your state’s eviction process, your tenant may be legally allowed to remain in your space. Performing a “self-help eviction” (by shutting off a tenant’s utilities or threatening them) can even earn you a jail sentence in some states. You must always follow the legal eviction process — even if the tenant has destroyed your space or stopped paying rent.
It's a good idea to sign up for a class on landlord-tenant law before you decide to buy a rental property. A local course can help you understand your state’s specific laws and responsibilities. It can also give you a more intimate look at exactly what you’ll need to do to keep your property habitable. This can help you decide if you’re really ready for the commitment of owning a rental property.
Select A Property And Do The Math
After you’ve done your research on your local real estate market and housing laws, it’s time to choose a property. Select a property that’s affordable and in an area where you can charge enough rent to cover the mortgage if you need one. Research the average cost of utilities in the area where you want to buy. If you’re using a mortgage loan to buy the property, you should also research current interest rates.
Once you find the perfect property, sit down and calculate what you’ll need to charge in rent to create a profit. Some things you’ll need to account for include:
- Your monthly mortgage payment. If you’re taking out a mortgage on your property, you’ll need to make more than enough money from rental income to cover your monthly payment. Start by using a mortgage calculator like this one from Rocket Mortgage®. Estimate your home’s principal and interest to get an idea of what percentage of your monthly rent will go to your mortgage.
- Landlord Insurance. Landlord insurance is a type of homeowner’s insurance that protects your property when you have long-term tenants. Landlord insurance provides many of the same benefits as homeowner’s insurance but can be more expensive due to additional tenant risk. Contact an insurance agent to learn more about what you can expect to pay for landlord insurance.
- Property taxes. You’re responsible for covering your rental property’s tax burden — even if you don’t live there.
- Maintenance and upkeep. As the landlord, you’re responsible for maintaining your property and making sure all systems are running. You can expect to pay about 1% of your property’s total value a year in maintenance. For example, if you own a property worth $200,000, you can expect to pay about $2,000 a year in maintenance expenses.
After you calculate your total monthly and annual expected expenses, decide on a final monthly rental price.
Secure A Mortgage
If you don’t plan to pay for your rental property in cash, you’ll need to secure a mortgage. You cannot use a government-backed loan to buy a rental property. Instead, you’ll need to meet your lender’s requirements for a conventional investment property loan. These loans can be more difficult to qualify for, especially if you’ve never managed a rental property before.
To qualify for an investment property loan, you’ll usually need:
- A larger down payment. Mortgage insurance isn’t available for investment properties. This means that most lenders will require you to have at least 20% down. Even 25% – 30% down payments aren’t uncommon.
- A higher credit score. The minimum credit score required to get a conventional loan for an investment property is 620. However, if you have a score below 740, you’ll pay more in interest.
- A lower debt-to-income ratio. If you have a DTI ratio above 45%, you’ll have trouble finding a lender willing to finance your loan. Ideally, you should try to lower your DTI ratio to 36% or less before you apply for a loan.
- More in cash reserves. Lenders need to know that you can continue to pay your mortgage even if you get a set of bad tenants. Most lenders will require that you have at least 4 – 6 months’ worth of monthly mortgage payments in reserve.
Once you meet these requirements, you can apply for a mortgage preapproval and buy the home. To learn more about the home buying process, check out our complete buyer’s education center here.
Advertise Your Space And Choose Tenants
Once you’ve secured your home loan and your property is ready to go to market, it’s time to start advertising. Use real estate database websites like Apartments.com and local online marketplaces like Craigslist to advertise your space. Be sure to offer interested parties a clear way to contact you or apply for the space.
When you receive applications, carefully consider each candidate. Be picky about your tenants and wait for a few applications to roll in before you decide. Some states have very strong tenants’ rights laws, so you’ll want to be 100% sure about who you rent to. However, you’ll also need to make sure you aren’t using stereotypes or preconceived notions to influence your decision.
Some legal ways to evaluate tenants include:
- Credit checks. Run a credit check on each tenant who applies for your space. If you see an eviction or many missed loan payments on their record, it might signal that they may have trouble paying their bills on time.
- Contacting previous landlords. You should ask your tenant applicants for references from previous landlords. If the applicant has never rented an apartment before, you may want to ask for a reference from an employer or teacher.
- Verifying income information. Ask your applicant for permission to verify their income or bank account information. A tenant who has a lower credit score might be able to make up for it by proving they have 6 months’ worth of rent saved up and a steady job.
When you find the right tenant, ask him or her to sign a lease agreement. A lease agreement establishes things like the tenant’s monthly rent, how long they may live there and what utilities they must cover. You can find premade lease agreement templates online or you can hire a real estate attorney to draw one up for you. Remember that a lease agreement is a legally binding document for both you and the tenant. Double-check that all information is correct before you sign.
Be A Great Landlord
Now that your tenants have moved in, the only thing left to do is be a great landlord! Provide your tenants with clear expectations regarding rent and respond to maintenance requests quickly. If you respect your tenants, they’re more likely to respect your space.
How Much Money Do You Need To Live Off Passive Income?
Living off passive income is everyone’s dream. Unfortunately, it can take years of hard work before you can quit your day job and cover your expenses through passive income.
The amount of passive income you’ll need to live off your investment streams depends on your financial situation and location. If you have no debt obligations and you live in a more affordable area, you’ll need less money to cover your expenses. If you live in an area where the price of living is higher, you’ll need more money coming in before you can survive off passive income. Create a plan to produce multiple streams of passive income for the best chance of success.
What Is The Best Way To Make Passive Income?
As you can see, being a landlord isn’t a totally passive way to make money. The best passive income stream is one that you’re passionate about. If you love real estate and working with tenants, becoming a rental property owner might be right for you. If not, consider one of these other forms of passive income.
- Investing in high-yield dividend stocks. Dividends are payments a company makes to each of its stockholders. Though not every stock issues dividends, investing in stocks that regularly pay out a percentage of the company’s profits can result in a reliable stream of passive income.
- Creating and managing a blog. Do you have a flair for words? Create and manage your own blog. As soon as you get a decent amount of traffic, advertisers will come to you with affiliate links and opportunities to monetize.
- Write a course. If you have a subject that you’re passionate about, consider writing a course on it. You can sell your course on websites like Udemy and SkillShare.
It's possible to earn passive income for years to come by setting yourself up for success now. The most important thing to remember is that you need to be ready to do some initial research – and work. No passive income investment is without risk, but you can minimize your risk by taking plenty of time to plan and prepare yourself before you invest.
To create passive income through real estate, you’ll need to buy a property and rent it out. First, research local rental prices and learn about tenants’ rights laws unique to your state. Then, research homes for sale in your area and choose one you believe can help you generaterental income. If you need a mortgage to cover your home purchase, keep in mind that you’ll need to meet your lender’s income, debt and credit standards for an investment loan.
After you secure your property, select the best tenants for your space. A robust advertising strategy can make this easier. Have your tenants sign a lease agreement and respond to maintenance requests quickly. Use the tenant’s rent to cover your mortgage and repairs to the space.
If you think that owning a rental property isn’t for you, you can still earn passive income through another method. Writing a course, investing in dividend stocks and managing a blog can all be reliable ways to build passive income streams.
For more articles like this one, check out our personal finances learning center.
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