House-Hacking, The Foundation to Financial Freedom
Investing in real estate is one of the most effective methods for building long-term wealth. However, many people are discouraged by the high price of property in their market and the expenses that come with owning it. If you're buying an investment property in the traditional manner, you will need 20% down minimum which can (depending on your market) amount to quite a bit of money that greatly exceeds most peoples' savings. Additionally, if you don't have property management experience it can be intimidating to consider managing tenants yourself. Since you can realistically only inspect the property several times a year, it is extremely difficult to know whether or not your tenants are adhering to the lease and taking care of the property that you poured much of your life savings into! In this situation, house-hacking can be such a safer, less expensive, yet financially impactful first step into the world of real estate investing!
House-hacking, what is it?
Simply put, house-hacking is a form of real estate investing where you rent out extra units (if you own a multi-family property) or extra bedrooms (if you own a single-family property) in your home while living in the property as to reduce or completely eliminate your monthly housing costs. The benefit of living in the property is that you're able to obtain owner-occupied financing which means you need a much smaller down payment than you would if purchasing an investment property in the traditional manner and you typically receive a lower interest rate as well. Depending on your situation, you may qualify for a loan requiring no money down or as little as 5%. This makes house-hacking far more feasible for the average person as it does not require nearly as much capital. Residential loans will lend on up to 4 units which allows you to purchase up to a fourplex with an owner occupied loan but you can also be successful with a single-family house that has extra bedrooms as well.
The financial benefits
If you're like most people, housing is your single largest monthly expense taking up 1/3+ of your income. Consider how financially liberating it would be if you didn't have that expense anymore. Imagine what it would be like if someone else paid your housing, while increasing your savings, and lowering your taxes for you? Well that is exactly what house-hacking does! Consider the following scenario, you buy a duplex and your mortgage (principle, interest, taxes & insurance) is $950/month and your renter on the other side pays $900/month (this is 100% feasible!). You've just created a situation where your monthly housing expense is almost completely eliminated. Now imagine that each unit has 2 bedrooms and you also rent out the extra bedroom in your unit for $450/month. In this situation you would not only be living for free, but you would also be making money above and beyond your mortgage each month! Again, this is 100% doable and many investors have eliminated their housing expense while increasing their income exactly this way. The same concept works with a single-family home as well. In fact, house-hacking a single-family property can potentially be even more profitable if you buy the right investment. With the proper layout, a 4 bedroom house will often be substantially cheaper than a 4 unit building yet you can rent out the other 3 rooms while living in it and make a significant return.
As if having your monthly housing expense eliminated and making money on top of it wasn't enough, house-hacking (and real estate in general!) offers additional benefits through tax savings, appreciation and mortgage reduction. Let's go back to our example of house-hacking with a duplex. If you're living in one side of a 2 unit building while renting out the other, many of your living expenses now become deductible as well! Monthly utilities? 50% deductible. Weekly grass cutting? 50% deductible. The same principle applies to single-family house-hacks as well, the percent of the house rented will be the percent you're allowed to deduct of these types of expenses.
If you buy real estate in a city with strong population and job growth, it's reasonable to expect that it will increase in value over time. This is often the most significant way in which real estate builds wealth. If you're property is worth $300k and appreciates 3% in a given year, that's a (completely passive) $9,000 added to your net worth. If you buy right, appreciation is often substantially more than 3% in a given year which is why it's so essential to buy property in areas with strong demographic trends!
Last but not least, every month your mortgage is paid down which increases your equity in the property. The significance of this when house-hacking is that you are not the one paying the mortgage each month! Every month your tenants are paying down the principal on your loan for you which acts as a sort of forced savings account. At the beginning of your loan, the principle reduction is minimal but still (typically) results in an additional $3,000-$4,000 each year. As time goes on, the amount of principle paid each month increases at an exponential rate which leads to a snowball-effect of wealth building!
When one considers the financial implications of eliminating your housing expense, monthly cash-flow, tax benefits, appreciation, and mortgage pay down resulting from house-hacking, it becomes clear that there are few investments that compare. House-hacking sets you on a trajectory to be financially independent years (perhaps decades) before the average person and requires a minimal amount of effort. Additionally, few other investments allow you to get started with such a small amount of capital. Managing tenants in a house-hack tends to be much easier than managing them in a traditional rental as well.
Your tenants are easier to manage
For those concerned about potentially unruly tenants, house-hacking offers a solution to this too! Since you're living in the same building (maybe the same unit!) your tenants know that you're there on a daily basis and it will be far less viable for them to violate the lease. This is especially true if you're house-hacking a single-family home as the only area they occupy that you don't also use is their bedroom and (sometimes) bathroom. The communal living situation pressures them to keep the kitchen and other common areas clean while being considerate with noise in the evenings and early morning. There's no way for them to sneak animals into the house, renovate without your permission, or violate the lease without you knowing. Living with your tenants may sound uncomfortable, but if you do the work up-front and screen them thoroughly it can lead to a profitable win-win situation!
It's clear that house-hacking can have a tremendously positive effect on your financial situation, but it's still essential that you take the time to think through the subtleties of the arrangement such as the parking situation, your local laws, your tenants' schedules, and so on. Make sure that there is plenty of space for your tenants to park their vehicles! If they have to park on the street that's fine but they shouldn't have trouble finding a spot to park. Here in Colorado Springs the law states that no more than 4 unrelated individuals can live in one unit at a time. So if you're going to buy a single family home with 5 bedrooms and rent them out you would need 2 of the roommates to be related our you would technically be violating the law. Additionally, be mindful of your tenants' schedules when deciding who to rent to. If you and all 3 of your tenants have a typical 9-5 there may be conflict when everyone is getting ready for work at the same time and getting home at the same time. Ideally, you want roommates whose schedules vary to avoid multiple people using the common areas simultaneously.
Finally, screen your tenants thoroughly every time and do not vary from your policies/procedures. You should be conducting a background check on every tenant just as you would for a traditional rental. In addition, make sure that their (gross) income is 3 times the monthly rent, that you verify their income, and always call their previous landlords. Do not be lax on your due diligence or you are likely to create headaches for yourself in the future!
If you take the time to screen your tenants diligently, purchasing a home to house-hack can transform your financial situation and put you on a trajectory to retire years before the average person. With the elimination of your largest expense, house-hacking offers a level of financial freedom that few people have which ultimately gives you freedom to pursue the things that you enjoy!
This blog was written by Dan Haberkost - firstname.lastname@example.org