Debt to income ratio with investment property?

Question

I understand that debt to income ratio is very important with the first property you buy, mine is comfortable 30 %. However, if looking to go into a 4-unit property as a second property, in my case it would raise my debt to income to about 60-65 %.

Someone told me that debt to income ratio isn't considered as much by lenders on second properties, that LTV is... he said there are different standards for an investment property loan.

I have 20 % down I'd like to put and enough in savings to cover any repairs and down periods. I don't see it as a monthly cash flow investment as much as a long-term investment in equity.

How would I be able to get a mortgage for it, and what might I run into? If the debt to income ratio is the most important, how is everyone managing to buy several properties which keeps increasing DTR? I have a solid job but not enough to own multiple properties and maintain the recommended DTR of 30 % or less.

Jon Holdman · Answer

When you're first starting in the landlord business, lenders don't want to count your rental income.  Many will require you two have two years experience.  I believe that means rental income on two years tax returns.  Generally, DTI limits are around 45-50%, though this varies some from lender to lender.

Once you have experience, lenders will include the rental income.  For existing rentals, they will look at your tax returns and use the actual numbers.  Knowledgable lenders will back out the depreciation, since that's not an actual cash outlay.  Now all lenders understand this.  Net rental income is the rental income less all expenses (except, hopefully, depreciation.)  This is all on you Schedule E.

For a new rentals (i.e., when you're an experienced landlord trying to get a new loan), they have a rule of thumb.  That rule is:  net rental income = (75% * rent) - PITI.  Some will want a signed lease (before you've bought it? right?)  Or an appraiser to include a rent estimate as part of the appraisal.

OK, so now you have a new rental income number.  Start with your DTI calculation before the rental(s).  You have the numerator (debt) and denominator (income.)  If your net rental income is negative (i.e., a loss, not all that unusual, with crummy rentals), you add the value to the numerator.  Say you have a $2000 per year loss.  Add $2000 to the debt side of the calculation.  If your net rental income is positive (what you hope for, usually), you add it to the income.  So, it improves your DTI.

Now, with a four plex you should be able to find conventional lending.  Should being the keyword.  You may end up getting a commercial loan, though.  Those are typically at a slightly higher rate than conventional loans (i.e., loans that conform to the freddie mac and fannie may rules and that are typically sold on the secondary market.)  Commercial loands typically have a shorter term - 15, maybe 20 years, rather than 30.  With these, and especially if you buy anything bigger than four units, DSCR comes into play.  DSCR is debt service coverage ration.  Sometime other variations of the abbreviation and phrase get used.  This ratio is net operating income divided by debt service payments.  Net operating income is collected rent less all expenses.  Debt service is the P&I part of the payment.  I'm not sure what lenders are looking for in this ratio these days.  Used to be 1.2 or a bit higher was OK.  But I think I recall someone posting recently the bank they were using was looking for 2.0.

A 20% down payment would be unusual.  Typically more like 25%.  If you get a conventional loan, the lender will also want to see six months PITIA (A = anything else like HOA or utility district fees) plus two months PITIA for any existing loans in cash reserves.

You might want to consider buying an SFR to start.  For one, its cheaper and may get you in under your DTI limits.  Run it a couple of years to get the experience.  If you decided you don't like landlording (this is what bankers are worried about), you can sell it relatively quickly.  Lots of buyers for SFRs.  Only investors buy four plexes, so they're harder to ditch if you want out.

Chris Mason · Answer

Hi @Art T.,

An REI friendly Fannie/Freddie lender can and will count rental income from the property you are purchasing to offset it's PITI and solve DTI issues, assuming it's a cash flow positive property.

Hi @Jon Holdman,

FYI: An REI friendly Fannie/Freddie lender can also count rental income from properties that you've purchased too recently for it to have an opportunity to appear on tax returns. If 2 years of tax returns is holding you up and slowing your progress, seek a new lender.

Hi @Steven Johnson,

We look at PITI, not the interest you write off on Schedule E. If we tweak your numbers a bit to say $100k/12 in monthly rental income, $50k/12 in PITI, and pretend there are no other debts appearing on your credit report and nothing you write off, and further if we pretend that you do NOT live in this property (eg, house hacking math is different and less generous), then your DTI would hypothetically be 0%. In reality I've never seen 0% DTI, what we more commonly see is DTIs that approach but do not reach zero, asymptotically. The way we do our math, we'd add the income from the property (less PITI and vacancy/maintenance assumption of 25%) to the "income" column, but not add anything new to the "debt" column, and then do our division.

Hi @Ned Outtadebter,

Funny alias.

Two plus years if you walk into a big bank, zero days if you're working with an REI friendly lender.

For an explanation on why what I am posting here differs from what big bank LOs and non-REI friendly mortgage brokers say, relevant link: How Lender Overlays Kill and Prevent Deals.

For those that want to see something a little more official than a random guy on a forum, from FannieMae.com I present "Rental Income Calculation Worksheets." There you have it, direct from the ultimate source of the bulk of residential 30 year fixed mortgage money that is lent out in the United States.

Bill Gulley · Answer

As Jon explained above the debt coverage ratio, minimum target is 125% over the debt, many will require more, like 150% when reserves and experience are less.

Welcome Steven, review what Jon posted. In your question you don't have any debts to compute the ratio, you have a net income figure, even if you had depreciation, it's added back as depreciationis not a cash expenses it's the nature of the tax beast.

All of your debts are, obligations with more than 6 months remaining to be paid on all installment credits, credit cards, other mortgages with taxes and insurance, student loans or other business obligations. Things like phone bills, utilities or club dues are not counted, but child support would be.

Then your total debts are divided by your net income before taxes..  :)

Steve Babiak · Answer

Jon Holdman - I believe that the word that I have emboldened in your quote is a typo; did you intend to say "Not" rather than "Now" in that sentence?

Callum K. · Answer

In my brief experience, John is spot on.  Most lenders adhere to Fannie Mae/Freddie Mac guidelines but each lender seems to interpret them differently.  I would suggest sitting down and talking with multiple lenders to get a better idea of what you can and can't afford.  I made the mistake of taking one lender's word on my first property and struggled to get approved given my financial situation.

I am in the process of acquiring another property but am struggling to get a commitment from a lender to apply the two years of rental income history for the borrower instead of two years of rental income per property.

Good luck to you!

Aaron Hoyle · Answer

What was the resolution on this?  I'm in the same boat.  I have the credit and down payment to acquire more investment property, but I'm going to hit the DTI limit soon if I can't find a lender that will calculate things "favorably."  I'm trying to find a lender in Louisiana that does 30 year Freddie/Fannie loans who won't simply calculate DTI on investment property as "monthly note over here, 75% of rental income over there."

There are a lot of great methods for figuring DTI mentioned in this thread.  It seems finding a lender that offers a 30 year mortgage AND knows all the ins and outs of REI is the tough part.  From what I've seen, Freddie/Fannie lenders know all about primary residences and commercial lenders know all the tricks for REI, but finding someone that can do both is like looking for a unicorn.

Martha Daisley · Answer

@Chris Mason. Thanks for the explanation. Is your company a REI friendly lender?

Martha

Chris Mason · Answer

An REI friendly lender will completely exclude PITI of that property from DTI calculations if and only if, when and only when, your buyer has lifted their loan contingency. It's not enough just to throw it on the MLS. It needs to go under contract and have any/all loan contingencies lifted. An underwriter's human judgement call may require all contingencies, such as appraisal and inspection, to be lifted as well, and they may balk if there has been no substantive earnest money deposit made ("all contingencies lifted!" with a $1 earnest money deposit... come on, could you blame the underwriter when only $1 is on the line?).

In the exact scenario you outlined, however, your rent would be included in DTI.

Otto Gudiel · Answer

"how is everyone managing to buy several properties which keeps increasing DTR? I have a solid job but not enough to own multiple properties and maintain the recommended DTR of 30 % or less"

I believe you're referring to the apparent weaker buying (loan) power of rental income dollars. If target DTI is 45%, then only 45 cents of each rental income dollar would help you toward another loan. If so, research the "rental income offset" topic. It looks like only the net income or loss of rental income counts toward your DTI, not the actual dollars in or out.

Debt to income ratio with investment property?

Most Popular Reply