If you are like most landlords, you think that the largest risk to being a landlord is getting your rent. You know that deposits will protect you, and if you are calculating your numbers correctly, you will make a big profit.
Make no mistake, if you think all you need is a deposit to protect you, you will be headed for disaster.
The number one way to protect your income stream from tenant defaults is to get great tenants to begin with. Good tenants will bring in a solid income of at least 3.5x the rent in income. Preferably much more. With the average family income over $50K annually, just getting an average income will probably be well over 3.5x the rent in income.
Income will tell you the tenant’s ability to pay rent.
The second piece of the puzzle is credit score. With a C-grade credit score north of 620, and the average tenant’s credit score being north of 650, it is easy to weed out lower scoring tenants to reduce risk.
Why take the bottom of the barrel tenants in terms of credit score, and increase your risk? These people may be great people, and some will definitely pay rent, but it is a higher risk potential. Mitigate your risk by selecting a tenant who has proven their ability to stand behind their financial commitments.
Credit score will tell you the tenant’s desire to pay rent.
Download Your FREE Tenant Screening Guide!
Hey there! Screening tenants can be a tricky business, and this critical step can be the difference between profits and disaster. To help you with your real estate investing journey, feel free to download BiggerPockets’ complimentary Tenant Screening Guide and get the information you need to find great tenants.
The Deposit is for Wear and Tear, Not Rent
Tenant screening will protect you from unpaid rent. The deposit is to cover damages beyond normal wear and tear.
I am not going to go into the difference between “wear and tear” and damages, but if a tenant has lived at a place for 5-7 years, most damages will actually be wear and tear. Ruined carpet after a year is damages. Ruined carpet after 7 years is wear and tear.
How Much to Charge for a Deposit
I charge $1,250 in deposit for a $1,000 to $1,100 apartment. I do not get any additional prepaid rent. Some states I have heard limit you to only a month’s worth of rent for a deposit. If that is the case, you may want to get the last month’s rent paid in advance. If you can charge at least two months’ rent, never collect the last month’s rent up front. Collect a deposit equal to two month’s rent instead.
Dollar for dollar, a deposit is always worth more than prepaid rent. Prepaid rent will be 100% used for the tenant; a deposit will be 100% used by the landlord to make them “whole” again.
Deposit Red Flags
So, you have a rental, and a nice tenant(s) applies. They do not have enough for a full deposit, or at least that is what they tell you. When a tenant cannot come up with the full deposit, that is a huge red flag.
Scenario One: Lack of Emergency Funds
The tenant flat out does not have the money. If the tenant does not have emergency funds, and that is what they are telling you when they do not have a full deposit, you need to run away. They should be getting a deposit back from the previous landlord, which can be used to replace the emergency funds they give you. You will have rent collection issues at some point, and you will be in worse shape than if you had let the rental go vacant.
Scenario Two: Not About to Lose Possession of Their Money
If the tenant has the money for a deposit and says they do not, that is even worse. And you will never really know, as you will decline them. They are afraid that they will not get the deposit back, so they do not want to part with the money. They already know, based on past experience, that their deposit will likely be kept, and it is better to be in their own hands, and not in possession of the landlords.
Deposits Paid After Move-in Never Come
Some tenants do not have the money up front for the deposit, so they offer to pay a bit extra each month. They are sincere and really want to pay more. If they do not have the money before move in, why would they magically have it after the move in? It will never come, and eventually your rent will never come. Get the full deposit before any keys get turned over — ALWAYS.
Never Let a Tenant Use the Deposit
Some tenants like to use the deposit for the last month’s rent. You only collected a month’s rent for a deposit, and somehow in the tenant’s mind, they think it is a good idea for you to go along with the idea.
The tenant expects you to trust them to return a place to you without any damages. They think you will trust them to return the unit 100% as clean as when they received it. Do this one time, and it will be your last. They used your rent as a deposit for their new place and left you with the expenses of their crazy, out of control lifestyle.
You would not let them use the deposit to purchase a new car, so why would you allow them to use it for rent?
State Laws and Last Month’s Rent
Some states, including Minnesota, make it illegal to use the deposit for the last month’s rent. That means it is illegal for the TENANT to use it, not the landlord. You can both agree to use it (though why would you?), and a landlord can use it to reimburse themselves for rent that is/was owned. Once a tenant moves out, unpaid rent becomes damages and is deducted from the security deposit.
I collected the last month’s rent from a tenant once. After a year, they used the last month’s rent as their rent payment, which was the purpose of it. And then the tenant stayed! So my deposit was cut in half. It sort of caught me off guard and was a great learning experience. They stayed another 18 months and left without proper notice or cleaning out the apartment. It would have been nice to have that money to cover my expenses.
When a tenant pays the last month’s rent as part of the move in funds, get a signed lease termination before they are allowed to use it. The last month’s rent is exactly that, used for their last month of residency at your place. Not the last month of the first lease term.
When is it Acceptable to Get a Lower Deposit?
Simply put, when you have lower risk. If you have a tenant with a 740+ credit score and 5x+ the rent in income, they are a low risk. Even though I have many tenants in that category, I get the same deposit. One time, I lowered the deposit by $150 to the rent amount to give additional incentive to the tenant to move in. The tenant was a nurse practitioner (steady job, high income) and the credit score was 784 (rockstar).
Mitigate your landlord risk with great tenants. Get a full deposit; you may very well need it. Keep the deposit until the tenant has vacated and you have had a chance to assess the damages. Then, return the deposit back to the tenant less any deductions, as you should.
Do you have any interesting tenant deposit stories? What is your policy on deposits, or what have you experienced as a tenant?
Be sure to leave your comments below!