Knowing how much you can afford is one of the most important but least understood aspects of buying an investment property. If you’re thinking about multiple properties, this is especially important, as it adds a timing component to the problem as well. Let’s start with the basics.
Debt-to-Income Ratio (DTI)
Lenders look at your monthly debt obligation as a ratio to your monthly income. Simply put, add up all of your monthly debt payments and divide that number by your monthly income, and you get your DTI. This ratio, coupled with your credit score, are the two biggest factors in determining loan eligibility.
Standard conventional (FannieMae) loans allow for a maximum DTI between 45-50%, the actual amount ultimately determined by your lender and how the loans are underwritten. Your goal as an investor is to maximize your buying power, thereby maximizing your DTI.
Rule #1: Your primary residence is a huge debt sink that just raises your DTI. There isn’t a lot you can do about it, other than to make sure your loan payment is as low as possible.
Rule #2: Current rental properties require two years of tax returns to “qualify” (count) their income, even if you’ve owned them less than two years. Banks will take the reported income for the property and divide that amount by 24 months to get your “qualified” monthly income. For properties with less than two years of tax returns, this can seriously cut down the income needed to help lower your DTI!
Enter the “loophole”. IF a property is not yet on a tax return, the bank is allowed to use the existing lease as proof of qualified income. The lease is typically counted at 75% to account for vacancy and other expenses. My clients often here me reference this “loophole” when timing multiple property buys. If you want to buy multiple properties, you should try to do them all in the same tax year, filing an extension if need be to give you a little extra time. Because once you file that first tax return showing a property, you may be stuck waiting 2 tax years before you’re able to count the full amount of rental income for that property.
Rule #3: You CAN count expected rental income for the property you’re about to purchase. Your lender will order what is known as a “rent survey” as part of the appraisal. It costs an extra $150-200 but allows you to count the same 75% of expected rent as income. It’s not exactly the same as a lease, as you’re at the mercy of whatever the appraiser comes back with for expected rent, but it’s still better than not counting ANY income!
The easiest way to visualize all of this is with an interactive worksheet. Play around with different scenarios to map out your investment strategy.
Investing is all about maximizing your use of other people’s money, and requires a solid understanding of the effects of DTI and affordability. If you’re running into DTI pressure, consider paying off your current debt (car/student loans, credit cards, etc), refinancing your other properties to reduce monthly payments (30yr, lower rate, higher downpayment, etc), and try to group your purchases into a single tax year. A common strategy is to buy a group until you max-out your DTI, wait two tax years, buy the next group, and repeat. Over this time you will be raising rents and possibly getting salary raises, all while your loan payments remain fixed, thereby reducing your DTI.
And there you have it for today’s investing tip.
Read more real estate investing articles like this on the Ten Properties blog