The average American has more than $90,000 in debt when you include all types of consumer debt products, including student debt, mortgages, personal loans, and credit cards.
Of course, debt isn’t necessarily a bad thing. When used wisely, taking on debt can be a huge help in your quest to increase your net worth. It’s also completely necessary for many Americans to be able to purchase essential big-ticket items like a home.
When you’re applying for financing for a rental property, lenders aren’t going to send you away simply because you have some debts. However, they are quite concerned with how much money you are making in relation to how much you are paying towards your debt each month.
For this reason, lenders will use the debt-to-income (DTI) ratio when they are considering your loan application. This metric allows them to assess how risky you are as a borrower. Let’s take a look at what you need to know about the DTI ratio if you’re thinking about investing in a rental property.
Your debt-to-income ratio is represented by a percentage that is calculated by dividing your monthly debt payments by your gross monthly income. The resulting number measures how much of your income is being generated to service debt.
For example, if your gross monthly income is $4,000 and you owe $500 in debt payments each month, your DTI is 12.5%.
When you have a low DTI, it indicates to lenders that you have a healthy balance between your income and debts. On the flip side, a high DTI shows that you are carrying a large amount of debt in relation to how much income you are bringing in.
You can easily determine your debt-to-income ratio on your own. All you have to do is add up all of the monthly debts you carry and divide them by the total gross household income. Let’s take a look at an example.
When you are calculating your DTI, you will only want to be concerned with regular, recurring, and required debt monthly payments. You don’t want to use your account balance or your regular payment amount, but instead your minimum payments.
As an example, let’s say that you have a $15,000 student loan debt with a minimum monthly payment of $250. You will use the $250 number to add up your debt rather than the total amount of the debt.
Some of the types of debt that are generally included in a debt-to-income ratio calculation include:
Examples of expenses that you should not include when calculating your DTI include:
Let’s say that your monthly debt repayment expenses are as follows:
To find the “debt” part of your DTI, you would simply add these numbers to get a total of $2000 in minimum monthly payments.
Your gross monthly income is simply the amount of total compensation you receive during the month before taxes or any other deductions. This is a much simpler figure to find than your net income, which is your income after you factor in taxes and other deductions.
To determine your gross monthly income, you will want to take into account your salary in addition to any commissions, bonuses, freelance earnings, and money from side hustles.
Continuing our example above, let’s say that you receive $5,000 a month before taxes from your full-time job and $1,000 a month from your side business. This gives you a gross monthly income of $6,000.
If you are applying for a loan with another person, you will need to also take into account their gross monthly income as well as their debts. Once you have added up the minimum debt payments and gross monthly income for all parties that will be on the loan, it’s time to divide your monthly debt payments by the gross monthly income figure.
In the example above, this would mean taking your $2,000 minimum monthly debt payment and dividing it by your $6,000 gross monthly income. This leaves you with the quotient of about .33.
When you divide your monthly debt by your gross income, you’ll end up with a decimal. In order to convert this number into a percentage, you’ll simply have to multiply it by 100.
Above, we found that the result of this formula was .33. When you multiply .33 by 100, you are left with your DTI: 33%.
While you’ll frequently hear debt-to-income ratios discussed as a part of qualifying for a mortgage, you might not realize that there are actually two different types of DTIs.
Your front-end DTI, also referred to as a household ratio, is the monetary value of your home-related expenses divided by your monthly gross income. Home-related expenses might include property taxes, mortgage payments, HOA fees, and insurance.
Your back-end DTI is a ratio that takes into account all of the other debts you are responsible for repaying each month on top of the home-related expenses discussed above. This might include student loans, credit cards, auto loans, and personal loans.
Since this type of DTI ratio takes into account the totality of your debt obligations each month, this ratio tends to be higher than your front-end DTI.
When you apply for a mortgage, lenders will usually look at both of these DTI types. That being said, your back-end DTI usually carries more weight because it is a more complete picture of your debt to income ratio.
When you’re applying for a mortgage, the lower your DTI the better. Lenders see borrowers with low DTIs as more likely to effectively manage their monthly debt payments.
The general rule of thumb is that lenders tend to prefer DTIs that are lower than 36% so long as no more than 28% is being put towards rent payments or a mortgage. A debt-to-income ratio of 43% is typically considered the highest ratio that an individual can have and still have a lender approve their mortgage application.
Different lenders will have different maximum debt-to-income ratios. However, all lenders will see a lower DTI as an indication of a less risky borrower.
On top of that, a lower DTI can have other benefits. It can help you boost your credit score, which can help you lock down a better mortgage interest rate in combination with a lower DTI ratio.
Calculating your DTI ratio can be a useful tool even if you aren't expecting to try and take out a loan anytime soon. This simple formula can help you understand whether you are carrying a reasonable amount of debt.
Once you have your number, though, what does it mean? Let’s break it down to help give you a general sense of what your DTI means for your ability to pay down your debt.
If you have a DTI below 36%, it typically means that you have debt that is manageable when seen in relation to your income. Assuming all else is in good order, you should have an easy time getting approved for loans or new lines of credit.
Lenders can start getting concerned when borrowers have this range of DTI ratio. This might mean that you struggle to borrow money when you need to.
At this level of debt in relation to your income, you will want to use a DIY approach to debt repayment. Consider utilizing either the debt snowball method or the debt avalanche method discussed above.
When you reach this level of debt in relation to your income, it can become difficult to pay it off. You might have a hard time being approved for applications for more credit as well.
If your debt is largely in the form of credit card debt, you might want to look into a low APR balance transfer card or a credit card consolidation loan. You might also find it’s helpful to receive free consultations about your debt relief options from a nonprofit credit counseling agency.
You will find that your borrowing options are quite limited when your DTI is this high. It can also be very hard to pay down this much debt in relation to your income. You will want to consider all of the options available to you at this point, and consider which will be the least damaging to the big picture and which will bring you relief fastest.
There are two primary ways that you can lower your debt-to-income ratio if you find your DTI is too high to predictably qualify for a loan. The first is increasing your income and the second is paying down your debt.
Depending on your circumstance, one of these two tactics might be more realistic for you. Or, you can work to slightly increase your income and pay down your debt at the same time.
Let’s take a look at some potential approaches for reducing your DTI so you can qualify for a loan.
One of the most straightforward ways to reduce your DTI is to reduce the amount of debt you are carrying. Instead of paying the minimum monthly payments on your loan repayments or credit card bills, you can make extra payments in order to reduce your debt and decrease the amount of time you will hold the debt.
One popular method of getting out of debt is known as the debt snowball method. This is when you focus first on the smallest debt that you have. Any extra money you have budgeted towards paying down debt you will put towards this smallest debt first.
Once you have paid off the smallest debt, you can move up to the next smallest. You’ll continue this way until you have completely paid off your debt.
Another common strategy for paying down debt is known as the avalanche method. This is when you focus solely on paying down your highest interest rate debt first. Then, you will move to the next highest, and so on, until you have paid off all of your debt.
Of course, with both of these methods, you will need to make the minimum monthly payments on the rest of your debts so they stay current.
As you pay down your debt and your monthly minimum payments decrease, your DTI will become more favorable assuming all other variables remain the same.
Many people might not realize how much money they can save in interest over the life of their mortgage if they focus on paying down the principal ahead of schedule. You can learn more about amortization schedules here.
If you work a salaried job and the timing is right, you might consider negotiating a higher income in order to lower your DTI.
As a simple example, a person who makes $4,000 a month and pays $2,000 towards loans has a DTI ratio of 50%. However, if they maintain the same debt and are able to increase their income to $6,000 a month, their DTI drops to 33%.
Of course, this example is a bit unrealistic– you shouldn’t bank on a 50% income increase overnight. However, strategically lowering your debt and increasing your income could together help you get your DTI into a workable zone.
One out of every three Americans has a side hustle of some kind. Of course, as a person that is trying to buy a rental property, you’re obviously aiming towards this outcome. In order to qualify for a mortgage for your investment property, though, you might need to temporarily earn some extra cash.
This can help you in two ways. First, it can help to boost yours on paper income. Second, it can give you the extra money you need to start chipping away at that debt.
How soon you are planning on applying for a mortgage should influence the type of side hustle you go with. Some side hustles, like being a ridesharing or delivery driver, help put extra cash in your pocket right away. Others, such as starting a business or a blog, might have higher earning potential in the long run but can take longer to become profitable.
If you anticipate that you’re going to apply for a home loan, you’ll want to be mindful of any new debt you take on. If you have any large purchases you were planning on making, consider holding off until after you’ve qualified for your mortgage. If you simply can’t avoid making a big purchase right now, you might want to try and pay for it in cash rather than using a credit card.
If you have credit card debt spread out over a number of different cards, consider taking advantage of a balance transfer card that offers an introductory 0% APR. While this won’t reduce the amount of debt you owe, it will save you from the painfully fast process of racking up interest payments. This can help you pay down your debt faster and allow you to qualify for a mortgage sooner.
Additionally, this will lower your monthly minimum payments which will, in turn, reduce your debt to income ratio.
When you are gearing up to apply for a mortgage, you might want to institute a stricter budget than you are used to. Take a look at your spending history and identify where you have bought non-essential items or services. During the period of time when you are actively trying to lower your DTI, work on controlling non-essential purchases to avoid racking up new debt.
If you are struggling to lower your DTI enough to help you qualify for a rental property, you’ll be glad to know that your potential future income might help you boost your qualifying income. Let’s take a look at what you need to know.
If you are seeking a mortgage for a rental property and you’re worried about your DTI, you’ll want to know that you might be able to use a percentage of your potential monthly rental income to help reduce your DTI.
While this is the case with many lenders, it isn’t a given. In many cases, though, you can count 75% of the monthly rental income you anticipate receiving towards your monthly gross income.
Of course, you can’t just artificially make up an exorbitant rent price in order to lower your DTI. The potential monthly rental income is, instead, determined during the appraisal.
The reason that lenders don’t allow you to add all of your potential rental income to your gross monthly income is to account for vacancies in the future. It’s also worth noting that you might be out of luck if you don’t have any history as a landlord, as lenders might not consider future rental income if you don’t have a track record. This would mean that you would be relying on your personal income in order to get a mortgage for your first rental property.
One strategy to building up a real estate portfolio is to purchase properties and use them as a primary residence while renting out the other units.
Going this route means that you can purchase the property as an owner-occupied piece of real estate while also using potential rental income to boost your qualifying income.
Just like if you were buying a rental property that you wouldn’t use as a primary residence, you might be able to count 75% of the appraiser’s projected rental income towards your income. This can help to lower your DTI and increase your likelihood of being approved for a mortgage.
If you are planning on going this route, you will want to shop around when it comes to lenders. Not all lenders will be willing to use projected income in your DTI, and they might be particularly wary of doing so if you don’t have any history of being a landlord. Rather than going with the first mortgage lender you talk to, shop around for a lender that allows this more favorable read on your gross monthly income.
It’s important to understand that, while DTI is an essential piece of the puzzle when you’re looking to receive financing for a property, there are other metrics used in making a lending decision. Your credit score and credit history will also be important factors in determining whether or not you are approved as a borrower.
While this simple formula can be a good way for lenders (and you) to get a sense of how much of your income is going towards debt repayment, there are some limitations to the DTI ratio as a metric.
For one, there is no distinction made between the cost of servicing various debts or the different types of debt. For example, if you consolidate your high-interest debt using a low-interest credit card, you would reduce your monthly minimum debt payments and therefore your DTI, even though you maintain the same total outstanding debt.
There are countless potential upsides to owning rental properties (as well as significant risks, of course,) but getting your foot in the door isn’t always easy. While your DTI is one important metric, there are other factors that lenders will look at when determining if they are willing to take on the risk of lending money to you.
Just because you qualified for a mortgage for your primary residence doesn’t mean you’re a shoo-in for another mortgage. This is particularly true because it can be difficult to qualify for another loan when you are making monthly mortgage payments. Lenders will require that you can meet certain standards before they will take you on as a borrower.
When you’re buying a primary residence using a conventional mortgage, you might be able to put down as little as 3% for a down payment. Of course, this depends on the loan program and lender you’re using. However, you’ll be required to pay private mortgage insurance if your down payment is less than 20%, which is insurance for the lender in case you end up defaulting.
Private mortgage insurance doesn’t apply to loans taken out to finance rental or investment properties, though. This means that you will probably need to make a much more substantial down payment. Investors will commonly put down 15% or 20% when they are buying an investment property.
For certain types of properties, lenders might require that you put a minimum of 25% down.
A down payment of this size can be a real hurdle to cross for new investors. Depending on the property that you’re looking at, a down payment of 20% can be hard to scrape together. Even if you purchase a relatively inexpensive property by today’s standards, for example, a $100,000 single-family home, a 20% down payment means you need to come up with $20,000 in cash. That’s in addition to the other associated costs of purchasing a rental property, such as closing costs, renovation costs, marketing costs, and more.
When lenders are financing rental property, they usually require that your credit score is at least 620 or higher. If you want to lock down the best terms and interest rates, though, you will want to have a much better credit score than that. The “very good” range for credit is usually considered to be in the 740 or higher range.
Lenders will want to know that you have money saved for a rainy day in case you run into cash flow issues with your rental property. This means that on top of factoring in your DTI, your credit score, and your down payment abilities, they’ll also want to peer into your savings.
It’s advisable to have between three and six months of reserves to help you cover the mortgage payment, insurance, taxes, and other expenses. You’ll want to keep these savings in a liquid bank account, as it’s likely not enough to have the funds stored away in illiquid assets.
If you're buying a rental property for the first time, the process can feel pretty overwhelming. While a lot of the same concepts apply between mortgages for primary residences and investment properties, the lending requirements are often quite a bit stricter when you're investing in real estate. Understanding how important your debt-to-income ratio is in your ability to qualify for a mortgage is essential to ensure you don't run into any unsavory obstacles when you find the perfect property.
That being said, your debt-to-income ratio isn't the only thing that matters when it comes to the dollars and cents of your rental investment dreams. While having a good DTI is important for mortgage qualification, you're likely much more concerned with the prospects of your rental property after the closing.
At RentalPropertyCalculator.com, we know just how important it is for all of the numbers to add up when you own a rental property. Our easy-to-use calculator lets you input your information and immediately spits out everything you could want to know about your ROI, expenses, and so much more.
Put down that pen and paper and head over to RentalPropertyCalculator.com to ensure that you pick the property that best suits your financial goals.
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