Renting Out Rooms in My Residence

[Mike Rodrigues]

Hi all, I have been lurking around here for a few weeks and have a few questions about my situation.

I purchased my first home about 8 months ago and have been renting out to two people: my girlfriend and her best friend (both of them are financially insecure) and I am renting to them well below market value. We also just have a verbal agreement, no lease. My monthly payments are at 1,100 and they are paying 600 between the two of them.

Currently, I am renting to them at $300/mo for each person where if I was to leave the property and rent it out market value would be at $1,500 per month in my community (and I have the most updated property so I likely could command more).

Now to some questions: I would like to start my real estate investing business, specifically becoming a landlord sooner than later. I have 98k of my 100k loan left on my current property, so I am assuming my debt to income ratio is high. What steps right off the bat should I be taking here?

I would like to make a lease for these two, probably a month to month type since I am just helping out one of them and the other is my girlfriend. I do want to look legit to banks and show some income coming in. Will I even look like a solid investor with the rent I am charging?

[Jon Holdman]

First, the balance on your loan only indirectly affects your debt to income ratio (DTI). DTI is total monthly loan payments divided by total monthly gross income. Its your loan payment that matters. That payment will stay the same even as you pay down the loan.

I think you question is really how can you improve your DTI based on the rent you're collecting. In general for rental properties, banks will want to see you having been a landlord for two years before they will consider the rental income. What that means, practically, is that they want to see the rental income on two tax returns. To compute DTI, they will start by ignoring the rental properties completely. They will add up all your debt payments, including the payments on any residences (places you live). They will add up all your income. They will do the division and get a ratio. Remember, we're ignoring both rental debt payments and rental income. Now we want to put that back in. They will look at your tax return and figure up the bottom line effect of your rental properties. That's going to be the net from the rentals - line 26 on Schedule E. They will typically add back in the depreciation (line 18). If that number is positive, you're making money. They add that to the income part of the DTI calculation. That is, it increased the income in the denominator, reducing your DTI. If that number is negative. They add the value to the debt side. That is, if you're net loss is $1200 a year, the divide by 12 and add $100 to the debt part of the DTI calculation, increasing your DTI.

If you have a new property, banks will use the formula (75% * rent) - PITI to estimate the effect of the new property. So, if you're buying a property with a PITI of $1000, and the rent from that place is $1600, they take 75% of the $1600 (which is $1200), subtract PITI of $1000 and get a net rental income of $200. That helps your DTI. If the rent is $1200, they take 75$ of that ($900), subtract the $1000 PITI for a net loss of $100. That hurts your DTI.

Now, your situation is messier. You don't really have a rental property. You're just renting out rooms. Its my understanding the won't consider this income at all as far as your DTI. You do still have to report it to the IRS. So, it will show up and affect your DTI eventually. But you won't be able to go to the bank with a lease from your girlfriend and get them to count that as income. For that matter, if you just bought your first real renatl property, and went to the bank with that lease, most would not consider that, either. They would expect you to fully qualify for the new debt based on existing income. After two years, they would consider the existing rental income, and if you were buying an additional property, they would factor in the net rental income using the (75% * rent)- PITI formula.