If you’re considering purchasing a rental property, you may wonder how this will affect your debt-to-income ratio. Learn more about the impact & ways to reduce it.
If you’re exploring property investment loans, there’s one calculation you’ll run across repeatedly— the debt-to-income ratio (DTI), which shows how much income is expected from the investment vs. how much debt you will incur to purchase it.
Measuring debt to income is helpful when researching rental properties and determining which could provide the best ROI (Return on Investment). But more importantly, it’s a vital factor when lenders decide whether to provide a loan for property investors and determine the limits of that loan.
Let’s take a closer look at what that means, what to look for, and how you can reduce your debt-to-income ratio with the right financial steps.
The Impact of a Rental Property on Debt-to-Income Ratio
The DTI ratio is expressed as a percentage and is very easy to calculate once you’ve gathered the right financial information: Monthly debt payments divided by monthly gross income, multiplied by 100.
However, behind this simple equation there are a lot of moving parts and choosing an investment property can have a large impact. Unless you’re buying with cash, you’ll be taking out a sizable loan to purchase the new real estate. Lenders want to make sure that you can handle that kind of debt (along with associated rental property expenses) on a month-to-month basis.
The good news is that a rental property will also have a lot of influence on your monthly income, the other side of the equation. So, lenders will look at how much income the property would add to your monthly income, and how much that offsets the new debt. That’s why purchasing rental property in a high-demand area where income would be relatively high can help with the debt-to-income ratio – as long as the mortgage doesn’t outpace the rental revenue.
There’s also a difference between front-end DTI ratios and back-end DTI ratios. Front-end models tend to look at rental expenses and major sources of rent like mortgage payments, property taxes, homeowners’ insurance, and so on. Back-end models are more granular and tend to include other factors like credit card payments, student loans, alimony, and so on. Lenders tend to use back-end DTI to get a more comprehensive look at finances when making their decisions.
Keep in mind, there’s a lot of estimation involved in the DTI process. Lenders can’t say for certain how much a property will rent for, they can only look at similar properties in similar markets and calculate a likely number. Also, it’s hard to predict how much of the time a property will be vacant, or what additional property expenses may be involved. That’s why lenders will typically make an estimate of rental income, then use 75% of that number to account for those additional risks.
Does a Rental Property Help or Hurt My Debt-to-Income Ratio?
As we mentioned, a rental property affects both sides of the DTI ratio, so the effect can vary depending on what kind of property you want to buy and where. Lenders account for both debt and potential rental income, so the fact that your monthly gross income will go up is good news. But you’ll still need a DTI within healthy limits for a mortgage lender to provide a new mortgage. The lower the percentage, the better.
In the best possible case, DTI is around 35% or less, so only about a third of income goes to monthly debt payments. That typically happens if you already have a large source of income, or if you have paid off a lot of previous debt like your mortgage, etc. This tends to make getting an investment loan easy.
More average DTIs are around 36% to 49%. That means a fair portion of your income is going to debt payments, a common scenario if you have a mortgage, student loans, and other significant debts (as well as areas with high property taxes, etc.). In these cases, a mortgage lender will want to see a good credit score on your credit report, and possibly ask for more information for a back-end ratio analysis. Property investment loans are more likely to have additional requirements, like a higher down payment and other assurances.
If more than 50% of your income is currently going to paying off debts, lenders won’t be willing to give you a loan. The best hope here is that rental income looks so good on paper – like finding a great price in a market that’s currently very hot for rentals – that the income would actually improve your DTI numbers even with the new expenses.
How to Reduce Your Debt-to-Income Ratio
At first, a DTI ratio may seem difficult to change without major financial decisions like purchasing a property. But many different steps can affect debt-to-income: Most investors have a variety of options to lower their DTI in preparation for an investment property. Let’s take a look at a few of the most effective:
- Switch to lower-interest credit cards: If it’s been a while since you’ve looked at your credit card debt, take a look at the interest rates on the cards that you use, and if you could find better interest rates by transferring your balance to a new card. Transferring or consolidating credit card debt is a simple way to cut down on interest payments and improve your debt ratios, and you don’t have to jump through as many hoops as some other steps.
- Refinance larger loans: Take a look at current offered terms for large loans like mortgages, auto loans, and student loans. There are several ways to improve these loans through a refinance. If you can find better interest rates, for example, you can directly cut down your monthly payments while lowering interest. Or you could refinance to a loan with a longer duration, which would also lower monthly payments and indirectly improve your DTI (at the cost of more interest in the future). And when it comes to student loans, don’t forget to look at the latest options for forgiveness and loan cancellation.
- Bring in a new source of income: The other side of DTI is, of course, income – and if you can raise your income, you will improve the ratio. That could mean getting a new job or requesting a raise, for example. While “side hustles” like Uber or Survey Junkie can generate income, they aren’t usually of much help for serious property investors. Consider starting a small online business to offer specialty goods and services instead. And don’t forget to count important sources of income that are sometimes overlooked, such as child support or pension payments. These also count for the purposes of DTI.
- Pay off smaller loans and avoid additional debt: After you’ve looked at your credit cards and loans, you may have a good idea what types of debt will be easiest to pay off and remove entirely from the equation. It may be worth it to use some cash now and cancel certain cards or pay off some loans to get a better DTI.
- Find ways to control housing expenses: This tactic can take many forms, depending on the types of property you are looking at. For example, if you can find property with lower property taxes or property that doesn’t have any homeowner’s association fees, that will reflect positively on your DTI ratio. Any consistent, important monthly housing expenses (not counting utility payments) are worth looking at to save money. A property management company can often help you understand these expenses and may be able to suggest ways to lower them.
- Choose your tax deductions carefully: This tip is for small business owners specifically. Taking business tax deductions can help lower the amount of income that you will be taxed on. While casual DTI estimates use your gross income, underwriters will be taking a closer look at your net income, which means deductions to it could lower your results. If you can afford to avoid some major deductions in your business for a specific year, it may lead to better DTI numbers from lenders.
- Talk to your lender: Your lender will have the best available advice for improving your DTI ratio after taking a look at your financial information. While our list is a good place to start, talk openly to your lender about the best specific options for your situation.
- Start with a lease on your primary residence: If you want to start renting, consider a room on property you already own like your primary residence. That could include building an additional home, renovating a basement, and other options that won’t incur large mortgage debt. That makes it easier to start renting, learn about leases, and improve your income ratio for when you are ready to purchase a separate property.
Looking for a Company to Manage Your Rental Property?
The right property management company can help you take care of the details, arrange reliable payments from tenants, and control costs related to maintenance and repairs. That kind of stability can help you save money and calculate more accurate income ratio numbers. If you’ve been looking for the high quality property management services in the Central Oregon area, Mt. Bachelor Property Management can help. You can take a look at our owner resources, see how we list properties, and much more. If you have any specific questions, contact us today!
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