For many aspiring investors just getting their feet wet, questions like “how does a rental property affect the debt-to-income ratio” are a natural starting point as they begin to wonder about future investments.
As debt-to-income ratio (DTI) is a standard requirement for approving loans, it’s only logical to consider how investment property might affect it.
With most lenders preferring a low debt-to-income ratio, frequently less than 45%, trying to discover methods to avoid or trying to find methods to get around it may be distressing.
After all, you probably won’t stop at getting a single rental property and instead will want to build a substantial portfolio, which may leave you wondering whether and how this may impact the ratio.
What Is A Debt-to-Income Ratio?
As one of the most used variables to get approved for a loan, debt-to-income ratio is calculated based on your monthly debt payments and divided by your gross income before taxes.
This means that if you have $2000 of monthly debt and $500 of gross income, you would have a debt-to-income ratio of 40% – calculated: $2000/$5000 = 0.4 = 40%
With 40%, your chances of getting approved may be good, though if you get a new mortgage, it could be pushed up to 50%.
Consider this example:
Suppose your monthly gross income is $5000 and your total monthly expenses are $2000. In that case, your debt-to-income ratio is 40%, and a mortgage payment of $1,000 would put you in the red, making you not qualify anymore despite being initially under their needed 45%.
Here’s why: With a prospective additional mortgage of $1,000, your total debt would be $3,000. If your gross monthly income is still only $5,000, your debt-to-income ratio would go to 60%, making you ineligible for it – calculated: $3000/$5000 = 0.6 = 60%.
For a certain DTI, it is not enough to just be under that threshold at the time of application; you must also be under that threshold once the new mortgage has been factored in.
The only practical solutions to a high debt-to-income ratio are increasing one’s income, paying off debt or finding a more lenient lender. But do rental properties count towards that debt? And would the rent count towards the income and potentially equalling it out?
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What Expenses And Debt Is Included in DTI?
Mortgage and credit card debt go against DTI, but what additional payments do you have to make that you aren’t aware of?
Here’s a list of everything going into your debt-to-income ratio:
- Minimum credit card payments
- Car loans
- Student loans
- Medical bills with a repayment plan
- Private or consumer loans
- Financial obligations such as alimony or child support
- Current mortgage payments, including taxes, interest, HOA fees, and insurance (these don’t count only if you plan to sell your property before buying the new one)
- Property taxes
- Hazard insurance premium
- Mortgage insurance premium (MIP) or private insurance premium (PMI), if necessary
- Rent will only count towards DTI if you plan on buying a property but continue renting
- Estimated future expenses, including the loan principal, interest, taxes, insurances, and any HOA fees
- Landlord insurance coverage
What Income Is Included in DTI?
Now that you know which expenses and debts go into calculating your DTI, you may be wondering which sources of income would be included as well.
Here’s a list:
- Gross monthly salary before taxes
- Any overtime and bonuses
- Alimony payments
- Child support
- Rental property profits, although some lenders may not count it until it shows up on your taxes, while others may count 75% of it if you’re an experienced investor
Understanding how your debt-to-income ratio is calculated is helpful, but it may be tricky since different banks use different methods. Though, if a lender gives you a number much higher than you expected, you might ask them to break it down so you can determine whether or not they made a mistake.
Although it isn’t a regular cost, some lenders may consider the depreciation of investment properties when determining your loan amount and count it against you.
What’s The Difference Between Front-End And Back-End Ratios?
While most investors understand that the DTI ratio is calculated by dividing the monthly interest payments by the monthly interest-free cash flow, they may not realize there is more to the ratio than meets the eye.
Mortgage principal, interest, taxes, insurance, and homeowner’s association (HOA) fees are all included on the debt side of the equation. In contrast, only the regular gross income without overtime or bonuses is included on the income side.
In other words, the front-end ratio solely considers a person’s regular monthly debt payments and income.
Lenders frequently give greater weight to the debt-to-income ratio calculated when loan payments have been added to the borrower’s monthly income. Bonuses and overtime pay are included on the income side, but back-end debt would only include debts like credit card bills, student loans, auto payments, and possibly alimony or child support payments.
Demonstrating that the back-end debt-to-income ratio includes extra obligations and earnings than normal debts and incomes.
Do Rental Properties Affect Your Debt-to-Income Ratio?
Knowing what factors into the debt-to-income ratio and which do not will help speed up the loan approval process. It seems that a borrower’s debt-to-income ratio would rise due to a mortgage, but the renter’s increased income would offset this – but does it really work like this?
Here’s how it works with rental properties:
Debt costs (mortgage payment) and revenue (rental payment) components of the debt-to-income ratio are both affected by rental property ownership.
As much as 75% of the market rate of rent may be considered, but this varies by lender.
Consider this example:
If the average monthly rent for your rental property is $1,500 and the costs are $1,000 per month – you may add $1,125 to the revenue side (75%) and $1,000 to the debt side (debt service) to get your debt-to-income ratio.
Taking the rent payment into account, let’s assume you also have $5,000 in personal income, making it a grand total of $6,125 in cash each month. Some lenders may be hesitant to provide you a loan if your monthly expenses are more than $1,143, as your back-end debt-to-income ratio would be over 35%, making it a higher risk for them to approve you.
One method to reduce the impact of a high debt-to-income ratio on the back end is to make a larger down payment and improve your credit score. Alternatively, you may want to look into purchasing a multi-family home with a debt-to-income ratio as high as 50%.
Does Debt-to-Income Ratio Include Investment Property?
When calculating your debt-to-income ratio, both your primary residence and any investment properties you own will be included.
Income from rental properties used as investments may contribute toward the income side of the ratio. However, only up to 75% and only if the rent is actually collected from a tenant who is either now living in the property or is seriously considering moving in.
Having a tenant in place at a prospective property may need extra paperwork and even a special evaluation to verify that rental rates are competitive with others in the area to have it count towards your DTI ratio.
Do Investment Properties Hurt Your Credit?
You may be concerned about the impact of a rental property on your credit score, which is often considered alongside the debt-to-income ratio as a requirement for future investment property loans.
Credit scores are not affected by mortgage amounts, as is the case with the DTI ratio. However, amounts owed (30% of the FICO score) and credit usage impact your credit score.
The percentage of your available credit currently being utilized is known as your credit utilization and it may negatively impact your credit score depending on how much of it you use. If you spend more than 30% of your available credit limit on credit cards, it might have a negative impact on your credit score.
There are two possible explanations for a drop in credit score after the acquisition of a new mortgage (whether for a primary residence or an investment property):
- Any new credit queries will temporarily drop your score by a few points.
- The mortgage you recently took out is “unseasoned,” which means it’s a fresh account and can drop your score slightly for up to 120 days.
If you have fewer active accounts, you may have “thin” credit, which indicates that this new mortgage account will have a higher influence on your credit. Increasing your credit “footprint” before opening that mortgage account may be advantageous in such an instance.
This may include getting a new credit card and using it on a regular basis while paying it off each month to avoid accumulating a larger back-end ratio.
A new credit card account will still temporarily lower your score, but over time it will help your score rise and the mortgage account will have less of an impact. In addition to improving your credit score, you can also get ready for the mortgage account by requesting a limit increase on each of your credit cards once a year.
How Does Having A Rental Property Affect Mortgage?
Mortgage lenders may look favorably on applicants who already have rental revenue coming in from either their home house or another property they own and rent out. Rental income may be used as income when applying for a mortgage or refinancing an existing mortgage on investment property, as can the costs associated with the property.
Although the sort of loan you seek will determine how it is credited against your new mortgage. For instance, according to Fannie Mae’s rental income requirements, you need to show that the income will likely be stable over time and that the property is a two- to four-unit primary home in which you, as the borrower, reside for the income to be considered.
If you own a commercial property and collect rental income on it, the money you bring in may be included as income as long as it is not the property you intend to finance.
While the specific rules and requirements for including rental income in your loan application might be challenging and frustrating, having the correct paperwork on hand and a proven rental history is crucial.
How A Rental Property Affects Your Debt-To-Income Ratio
Investing in rental properties is a common first step since they may provide passive income while expanding a person’s investment portfolio and they can be used as collateral for future loans. In spite of the difficulty in being approved for investment loans, it is still feasible to do so provided you have a good enough debt-to-income ratio, among other factors.
Though it might be beneficial to merely calculate the average debt-to-income ratio, various lenders will calculate the front-end and back-end ratios in different ways, which can affect your score. Debt-to-income ratio is impacted in two ways by investment rental properties: first, on the income side, since you may add as much as 75% to your monthly cash flow from rent; and second, on the debt side, because you now have an extra mortgage payment to make each month.
Lender approval generally hinges on the expected return on investment, which may be affected by factors such as the kind of rental property offered. That’s where New Western comes in. We’ll assist you in locating high-potential, off-market properties so you can begin this exciting new chapter of your real estate investing career.
In addition to our extensive selection of high-potential and in-demand properties, we also provide investors with hassle-free investment opportunities that include state-of-the-art investment concepts and facilitate a streamlined closing process.
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