Rental properties are a great way to build long-term wealth. Your initial investment will be significant, but as long as you pay your mortgage each month, you’ll eventually be generating pure profit.
Once you calculate your cap rate, you’ll know approximately how much money you can expect to make by renting your property. However, your profitability will ultimately depend on your tenants. You deserve to have good tenants, but let’s be honest – good tenants can be hard to find.
What happens when you find a tenant with a stable income, great references, and a perfect rental history, but also a bankruptcy? Should you rent to a tenant with a bankruptcy? While most people would say no, sometimes it’s not a bad idea.
What caused the bankruptcy?
When deciding whether to rent to a tenant with a bankruptcy, context matters. What caused their bankruptcy? Were they spending money frivolously, or did they genuinely experience hardship? They might not tell you the truth, but you can investigate to find out more.
When running a background check, look for liens related to property taxes, federal income taxes, and vehicles. These types of liens indicate a person either isn’t good with paying their bills on time, or they purchase too many big-ticket items on credit.
However, if you see liens related to student loans, the situation may not be so severe. In a perfect world, everyone would prioritize their student loans alongside other bills. Unfortunately, student loan debt can be more overwhelming than normal bills.
With interest rates ranging from around 5% to 12%, it doesn’t take long for someone to default on a student loan. Some lenders will negotiate a payment plan, but won’t accept anything less than a pre-decided minimum monthly payment amount.
Most people pay rent before other bills
Not all prospective tenants with a bankruptcy on their record are at risk for skipping out on the rent. People generally prioritize their bills in the following order:
- Rent
- Phone/internet
- Food
- Car-related expenses
- Credit card bills
- Entertainment
Most people don’t want to be evicted, so they prioritize rent even over food.
References will tell you plenty
Checking someone’s references will tell you plenty about their habits as tenants and their relationships with past landlords. If rental references give glowing reviews, you may not have anything to worry about. However, be on alert for potential fraud. Sometimes people have their friends pretend to be former landlords.
When checking references, make an extra effort to validate each reference. For example, require tenants to provide 3 rental references with a phone number and address where they lived. Verify that the person you speak with is connected to the address provided. You might need to run a background check on each reference to verify this information.
Which type of bankruptcy was filed?
When you’re considering a tenant with a bankruptcy, check to see which chapter they filed. Chapter 7 and Chapter 13 are the most common, but there are also Chapters 9, 12, and 15.
Chapter 7
This is for individuals and businesses. Chapter 7 bankruptcy liquidates all assets and gives someone a clean slate. Although some debts are excluded, they are not required to pay back their qualified debts.
Chapter 9
This is for municipalities and won’t apply to a tenant.
Chapter 12
This bankruptcy chapter is for farmers and fishermen.
Chapter 13
This chapter is for filings between multiple countries.
Chapter 15
This is only for individuals and works with creditors to create an income-based repayment plan.
Use caution when renting to someone with a bankruptcy
Sometimes people unexpectedly lose their source of income and have no choice but to file for bankruptcy. Outside of those unexpected circumstances, they don’t have any problems paying their bills. Other people file for bankruptcy to avoid paying their bills. They might even quit their job to make their situation more believable.
Bankruptcies aren’t as bad as evictions. For instance, some creditors will still extend credit to someone who has discharged their debt through bankruptcy.
While bankruptcy isn’t always a bad sign, use caution when renting to someone with a bankruptcy on their credit report. You might want to have them sign the lease with a guarantor or increase their security deposit.
If an applicant doesn’t have any other red flags, it’s probably safe to rent to them. However, if they have other red flags, like an eviction, frequent employment turnover, or frequent moves, it’s probably best to move to the next applicant.
Interesting related article: “What is a Landlord?”