Conversion of principal residence to second home or investment property

Introduction
With this Announcement, Fannie Mae is introducing several new and updated policies that pertain to the following topics:

Conversion of principal residence to second home or investment property: new requirements for borrowers who are purchasing a new principal residence, and intend to convert their existing principal residence to a second home or investment property.

Selling Guide, Part X, Section 402.24 Rental Income, and Section 702.03 All Other Liabilities, D. Payments on real estate mortgages

Borrowers who currently own their home typically have three options when they decide to purchase a new principal residence. They can

  • sell the current residence and pay off the outstanding mortgage,
  • convert the property to a second home, assuming they can qualify with both the existing and new mortgage payments, or
  • convert the property to an investment property and provide documentation that they will rent the property and use the income to offset the mortgage payment.
  • In order to ensure that borrowers have sufficient equity and/or reserves to support both the existing financing and the new mortgage being originated, Fannie Mae is updating the policies for qualifying borrowers purchasing a new principal residence and converting their existing principal residence to a second home or investment property.

    Current Requirements

  • Rental income that will be generated from the prior principal residence is based solely on a fully executed lease agreement for that property provided by the borrower (now landlord).
  • If the lender uses current lease agreements, the net rental income will be 75 percent of the gross rent from the lease agreement, with the remaining 25 percent being absorbed by vacancy losses and ongoing maintenance expenses.
  • Minimum reserves are required for investment properties: 2 months for one-unit properties, and 6 months reserves for two- to four-unit properties. Minimum reserves are not required for second home transactions.
  • New Requirements

    1. Current principal residence is pending sale but the transaction will not be closed (with title transfer to a new owner) prior to the new transaction
  • Both the current and the proposed mortgage payments must be used to qualify the borrower for the new transaction.
  • 2. Conversion to a Second Home
  • Both the current and the proposed mortgage payments must be used to qualify the borrower for the new transaction; and
  • 6 months of PITI for both properties is required to be in reserves. Lender may consider reduced reserves of no less than 2 months for both properties if there is documented equity of at least 30 percent in the existing property (derived from an appraisal, automated valuation model (AVM), or Broker Price Opinion (BPO), minus outstanding liens)
  • 3. Conversion to an Investment Property Fannie Mae will continue to permit up to 75 percent of the rental income to be used to offset the mortgage payment in qualifying if there is documented equity of at least 30 percent in the existing property (derived from an appraisal, AVM, or BPO, minus outstanding liens).
    The rental income must be documented with:

  • a copy of the fully executed lease agreement; and
  • the receipt of a security deposit from the tenant and deposit into the borrower’s account.
  • If the 30 percent equity in the property cannot be documented, rental income may not be used to offset the mortgage payment.

  • Both the current and the proposed mortgage payments must be used to qualify the borrower for the new transaction; and
  • 6 months of PITI for both properties is required to be in reserves.
  • These guidelines are applicable to manually underwritten loans and, except for the additional reserve requirements, must also be applied (on a manual basis) to loan casefiles underwritten with DU. DU will determine the level of reserves for each casefile.

    What “DU” means, it means Desktop Underwriting. It is a software program provided by Fannie Mae to the mortgage and banking industry to help them make sure a borrower meets all financial requirements for a loan.

    So what does all of this mean? It means that it is going to get harder to purchase a new home before closing on the sale of your current residence, to own a second home, or to convert your current residence to investment property.

    To summarize,

    If you can’t close on the sale of an existing home first, you must qualify for both mortgages at the same time. For conversion to a second home, you must qualify for both loans AND have 2-6 months of PITI reserves and 30 percent equity in the existing property OR have 6 months PITI reserves for BOTH properties. For conversion to investment property, you can use 75 percent of the rental income to offset the mortgage payment IF you can document at least 30 percent equity OR qualify for both mortgage payments AND have 6 months reserves for BOTH properties. To use the rental income, you must have a fully executed lease and a security deposit from the tenant deposited in the borrower’s account.

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