For most people, their rent or mortgage is their biggest expense. And even though experts say you should aim to spend 30% of your income on housing, many end up spending 40% or more.
Of course, there are a lot of ways to lower your housing costs. You could get a smaller apartment, get a roommate, or move to a cheaper area, for example. But one unique way that many people don’t know about is called house hacking. It can not only lower your housing costs but help you build wealth at the same time.
What is House Hacking?
The term house hacking was coined in 2016 by Brandon Turner of BiggerPockets. Though the investing strategy has become popular in recent years since, it’s been around for a long time. Many people just didn’t know about it.
Essentially, house hacking is renting out part of your house and using the rental income to help pay for your mortgage.
You could rent out a separate unit, a single bedroom, or even garage space. And your renters could be regular tenants who pay month to month or guests who only stay a short period, like for a vacation.
Benefits of House Hacking
The greatest benefit to house hacking is the opportunity to build wealth. Not only can you get most, if not all, of your monthly mortgage paid for by your tenants, but you can also build equity in your home.
Later you can leverage your equity and the money you save to buy a second rental property, and then another, until you gradually start building a real estate portfolio that will help you become financially free. But let’s not get too ahead of ourselves …
House hacking also lets you take advantage of better financing options. Conventional home loans require you to put down a 20-25% down payment. But if you occupy the home you purchase, you can get an FHA loan backed by the Federal Housing administration for a down payment as low as 3.5%. Of course, be aware that FHA loans also have some stricter rules in place for getting appraisals and mortgage insurance.
Once you’ve proven that you pay on time and have a steady income stream, you can even refinance your mortgage for a better interest rate.
Finally, house hacking helps you get your feet wet in real estate investing. Many never try because of the initial capital barrier of buying a second property. But with house hacking, you can buy your first house and start learning real estate investing skills at the same time.
How to House Hack
Now that you know the benefits of house hacking, let’s dive into the steps you need to take to get started:
- Determine your financing options
The first thing you need to do is find out what financing options you have. There are several ways to finance a property, but the most traditional way is through a mortgage. Shop around for a lender that will offer you a good interest rate and request a preapproval letter. This will help show sellers that you are a serious buyer.
Again, FHA loans are a great option here if you don’t have a lot of money for a down payment or if you have poor credit. But you can also look into other government-backed loans like the VA loan, which doesn’t require a down payment at all.
- Choose your house hacking strategy
Once you know what you can afford, decide on a house hacking strategy. You have a few options here:
- You could rent out units in a multi-family property, such as a duplex, triplex, or fourplex. These are some of the most popular options for house hacking because they already come with separate units.
- Or you could rent out a basement apartment in a single-family home. If the basement isn’t already a separate unit, you could turn it into one.
- Another option is to find a property with an accessory dwelling unit (ADU) and rent it out. An ADU is a smaller and separate unit on the same lot as a single-family home.
- You could also rent out spare bedrooms in a single-family house. If it doesn’t have extra bedrooms, you could convert other rooms into bedrooms.
- Finally, you can also rent out extra storage space. For example, your property might have a garage or a basement that you can list on a peer-to-peer (P2P) self-storage platform like Neighbor.
Whatever strategy you choose, you should always check that the neighborhood you want to invest in doesn’t have restrictions against renting out part of your house. And if you plan to do short-term renting, it needs to allow this as well.
- Shop for viable properties
Now it’s time to look for properties that match your budget and strategy.
The first thing you should do is find a good real estate agent that understands you and your market. They’ll be able to give you access to the multiple listing service (MLS) and help you find good deals.
When looking at properties, consider occupancy limits. How many residents can you have in one house? This will vary by location, but it’s usually determined by the total square footage of the property and the number of bedrooms. The relationship between all the tenants will play a factor as well.
Most importantly, do the math. You need to make sure that your investment will generate a good return. Use the following metrics to measure the true value of a property deal:
- The 1% rule—This states that you should be able to rent out a property for at least 1% of its total market value. So if the property is worth $200,000, you should be able to rent it out for $2,000. This isn’t a hard rule, but it’s a good rule of thumb.
- Cap rate—The cap rate is the rate of return that a property is expected to generate. It’s measured by dividing the property’s annual rent by its current market value. So if the house is worth $300,000 and you expect the total rent (including your own) to be $4,000, that’s a 16% cap rate ($4,000 x 12 months / $300,000). You should aim for a cap rate of 8% or more.
- Cash flow—Cash flow is the amount of money you can pocket from your rental income after all your property expenses have been paid. It’s measured by subtracting your monthly expenses from your monthly rent. So if your total monthly rental income is $3,000 and your total monthly property expenses equal $2,600, then your cash flow would be $400 ($3,000 – $2,600). The higher the cash flow, the better.
If a property checks your criteria on all of the metrics above, you’re ready to move on to the next step.
- Make an offer
Have your real estate agent help you decide how much to put in on an offer. They will be able to run a market analysis to see how much similar homes in the area recently sold for.
Make sure to include contingencies in your offer, like an appraisal and a home inspection, to see if the house has any issues that need fixing – like a bad roof or HVAC repairs.
- Close, move in, and make needed renovations
Once you close on the deal, you’re ready to move in. Finish any needed repairs so you can start renting out the extra units as soon as possible.
You want to make needed renovations not only to prepare the units for tenants but also to raise the value of the property so you can charge more rent.
- Rent out the extra units
At this point, you’re ready to rent out the extra units.
You should have decided on a competitive rent price before purchasing the property. All you have to do is take some quality photos of the units and then list them for rent online on websites like apartments.com or rentler.com.
- Track income and expenses
Finally, keep a careful record of all your property expenses and rental income. Establish a bookkeeping system and automate as much as possible.
This way, you make sure that your rental properties remain profitable by adjusting things as needed.
Final Thoughts
House hacking is a smart way to start building an income-generating asset. Most people only buy the house they live in. But if you start renting out part of your house, you’ll quickly learn how to run an investment property to buy more houses and take advantage of real estate tax advantages.
Eventually, you’ll generate enough rental income to escape your 9 to 5 and work on your own terms. Start by turning your first home into an asset and then move on from there.
