One of the more common problems people run into while purchasing real estate is a high debt-to-income ratio. In addition to your credit score and loan history, your debt-to-income ratio is examined by a lender to determine if you’re eligible for a loan. If you have a lot of debt and insufficient income, it can be challenging to get a mortgage loan. That said, here’s why the debt-to-income ratio for rental property matters to investors.
What Is Your Debt-to-Income Ratio?
Your debt-to-income ratio for rental property refers to how much of your gross monthly income you use to pay off debts. Your gross monthly income refers to how much money you generate each month before making any deductions. For instance, if you owe $2,000 each month in debt payments and earn $6,000 of gross income, you’d have a debt-to-income ratio of around 33%.
Before getting a mortgage loan, lenders will examine your debt-to-income ratio to determine the risk of taking on more debt. If your ratio is already quite high, it can be more difficult to finance a rental property. On the other hand, lenders are more apt to help you finance your investment if you have a low debt-to-income ratio.
Why Does Debt-to-Income Ratio For Rental Property Matter to Investors?
It can be more challenging to get a loan if your debt-to-income ratio is too high. Additionally, determining your debt-to-income ratio is a little different if you own rental properties. For instance, if you’re planning to purchase real estate, you must calculate the new mortgage payment against your debt-to-income ratio.
Essentially, even if you have a ratio of 33% right now, adding on another mortgage loan can bump that number up to 43% or higher. You may not qualify for a new mortgage with a debt-to-income ratio this high. That said, your DTI is generally the deciding factor in how large of a loan you qualify for.
Generally, the amount you qualify for on a new mortgage would be the maximum debt-to-income ratio a lender allows. For instance, if a lender allows a 40% DTI ratio and a new payment of $1,000 pushes you to 40%, that’s the highest payment you qualify for. Next, let’s go over how you can calculate your debt-to-income ratio for rental properties.
How to Calculate Debt-to-Income Ratio for Rental Property
Calculating your debt-to-income ratio for rental property is quite simple. The formula to calculate your ratio looks like this:
- Monthly Debt Payments / Gross Monthly Income = DTI Ratio
While the formula is extremely easy to use, knowing what income and debt components get factored in is important. When calculating your monthly debt payments and gross monthly income, here’s what to include.
Monthly Debt Payments
Your monthly debt payments can be split into two different categories–front-end payments and back-end payments. Front-end payments are directly related to housing expenses, while back-end payments are for other recurring debt. Here are a few examples of payments you may have.
- Primary residence mortgage payment
- Rental property mortgage payment(s)
- Mortgage interest
- Mortgage insurance premium
- Property taxes
- Landlord insurance
- Northern Virginia property management services
- Homeowner’s Association Fees
- Credit card payments
- Auto loans
- Student loans
- Personal loans
- Medical bills
- Child support payments
- Alimony payments
Next, let’s go over what to include in your gross monthly income.
Gross Monthly Income
All sources of income must be documented while applying for a mortgage for a rental property. That said, it’s crucial to keep documentation of all of the following:
- Rental income received each month from each property
- Additional income like pet rent or roommate rent
- Security deposits for rental properties
- Other income, like a full-time job, disability payments, child support, etc.
When you apply for a mortgage loan, you’ll need to show proof of income. You can do this by providing bank statements showing the amount of rent received or a copy of your Schedule E tax form used to report income and expenses.
It can be difficult to calculate your debt-to-income ratio since banks often calculate things differently. As such, it’s best to let your lender calculate your DTI, then double-check the numbers if something seems off. Later, we’ll talk about the benefits of a low DTI ratio. But first, here’s an example of how you’d calculate your DTI.
Example of DTI Calculation
For this example, say you’re looking to buy a single-family property for $150,000. You put 25% down and finance the rest of the purchase price to pay for it.
Next, let’s say the rental property generates $1,500 each month, and operating expenses for the rental are around $400. Now, let’s calculate the DTI according to income and debt expenses.
- Full-Time Day Job Gross Monthly Income = $12,000
- Monthly Rental Income = $1,500
Total Income = $13,500
- Primary Residence Mortgage Payment = $1,400
- Rental Property Mortgage Payment = $500
- Rental Property Operating Expenses = $350
- Back-End Debt Payments = $1,700
Total Expenses = $3,950
- DTI = Debt Payments / Monthly Income
- $3,950 Debt Payments / $13,500 Monthly Income = ~29% DTI Ratio
Benefits of a Low Debt-to-Income Ratio
A low debt-to-income ratio is better for investors looking to expand because lenders are more likely to work with you. Conversely, if you have a higher ratio, lenders may assume you have too much debt to take on another expense.
Most lenders look for a DTI ratio of around 36% when it comes to mortgage loans. However, the maximum may depend on the lender and loan program. Generally, you want to keep your debt-to-income ratio as low as possible, especially if you want to invest in more rental properties.
Aside from qualifying for loans easier, keeping your debt-to-income ratio low can also help investors score better financing deals. So next, let’s go over how you can improve your debt-to-income ratio and qualify for financing easier.
Tips For Improving Your Debt-to-Income Ratio
You can improve your debt-to-income ratio in a few ways, like making more money or lowering debt. Here are a few things investors can do to lower DTI.
- Increase Your Monthly Income- The easiest way to lower your DTI ratio is by making more money. One way landlords can increase income is by raising rental rates or making the property pet-friendly while implementing an additional fee.
- Pay Off High-Interest Debt First- If you have high-interest rates from an auto loan or personal loan, pay off these debts quicker to reduce your monthly payment amount.
- Consider a Larger Down Payment- For your next investment, consider putting more money down to reduce the amount of financing you need for the rest of the payment.
- Minimize Tenant Turnover- Screen tenants before they move into your rental to reduce tenant turnover and poor tenant experiences.
- Hire Property Management– Hiring professional property management can help landlords keep operating expenses low and business returns high.
Maximize Your Portfolio With Professional Property Management
If you’re a landlord looking to expand your rental portfolio with another investment property, consider hiring property management. With the help of our dedicated experts, your rental business can reach its maximum potential. In addition, our property management professionals can help with the day-to-day tasks of your rental business, so you don’t have to.
Whether you need help finding new tenants, maintenance within your properties, or rent collection services, PPM can help you. Contact us today if you need rental management services in Northern Virginia.