Debt to income ratio and its elements is an important concepts for you to be aware of if you are planning to take a mortgage for a new home or a big project in life. Know more about Debt-To-Income Ratio
There are multiple factors included in the DTI calculation. One of them is Rent. Yes, rent is included in the Debt-to-Income ratio. However, Banks or Lenders have unique rules for their institutions and that might affect rent inclusion in the calculation. There is ambiguity on why and how it’s not included or not included.
How do banks determine if rent is to be considered an income?
When you own a rental property and then apply for a mortgage then the banks will look at your schedule E, the form where you report income and expenses from a rental property. They go through a process to understand if rent is a positive number or negative. To get to that number they follow the below steps
- Starting with the Principal fund. Deduct all your expenses from the 75% of rental income you collected.
- Add back depreciation to it (available in schedule E). Depreciation doesn’t affect your cash flow
- Add back PITI which is mortgage interest, property taxes, and insurance. (If paying monthly)
- Collect and add mortgage statement in the investment property, HOA, tax bill, and insurance bill and calculate the full payment
- Refer to schedule E for all the other miscellaneous expenses and add it back.
- Divide this number by twelve to get a monthly figure.
- Deduct your monthly payment (principal, interest, taxes, and insurance) from the monthly total to arrive at your monthly net rental income.
- If the net rental income figure is positive, the banks will add it to your income. If it is negative, they will add it to your monthly debt.
This is as per the new Fanny and Freddie guidelines; the older approach was much simpler. If you are showing at least one full year on your tax returns (According to the older approach) we would look at schedule E at the very bottom and add back the depreciation which gave the positive or negative rent.
Now, they go through this process of adding back and then subtracting mortgage interest because our monthly payment typically includes a principal component, which does not appear on your tax return.
In case you are currently renting a home:
It’s clear how rent counts as income and lowers the debt-to-income ratio. As mentioned, mostly 75% of the rent is considered for DTI calculation but at times complete rent is included or not included this depends on the mortgage company’s policies. For example:
- If you are currently renting a home and you want to buy another one as your main abode or for vacation, then the current rent will not be considered for DTI.
- But if you are renting a home and want to buy another one as an investment property then it is considered in DTI.
It’s quite evident that this is no cakewalk. The complete process is complicated for a layman to understand. What is mentioned above is just the theory and when we get into the practical part it’s going to be even more cumbersome. Today, even the most senior financial professionals might not understand this process completely. The best way is to find a seasoned mortgage consultant and maintain a good relationship with them. Being a landlord is not always profitable. Only over years when rents increase you will get income.
Frequently asked questions:
1) Why not consider the complete rent?
Strangely, the banks don’t consider the complete rental income sometimes. It’s documented every month one of the possible reasons could be to make us liable even if the tenant defaults on the rent.
2) Why is rent not considered when you are purchasing the main house or for vacation?
Because it’s not generating an income. We are just replacing the home that we are renting.
3) Does owning multiple investment properties change the rent consideration?
According to Fanny and Freddie standard guidelines, if you own more than four residential property investments (not commercial property) that have mortgages, it becomes even more complicated. The max loaned value should be not more than 70% as per the guidelines. We need to show six months of reserves for each of your properties in the bank.
4) What happens if there is a vacancy for a couple of months and no rental income?
If we have a good letter of explanation, we can show the new lease agreement and potentially show the payments received and count the increase in the rents to offset the expenses.
5) What are Fannie and Freddie’s guidelines?
They are two mortgage companies created by United States Congress. These agencies make the mortgage market more liquid, stable, and affordable.
