How to Screen Applicants like a Pro, Part 2: Debt-to-Income Ratios

The industry standard for screening prospective tenants’ ability to pay is to use the rule that their income should be 3x the rent amount (not including utilities).

However, a prospect’s ability to pay and their likelihood of paying on time and in full, every month, are two different things. How many tenants do you think would pay their car payment before their rent payment? How about credit cards and student loans? Finally, how many tenants have child support payments deducted directly from their pay stubs, so they can’t use those funds to pay rent, even if they wanted to risk jail for nonpayment? The traditional method of calculating this is to use “income equal to 3x rent” - which assumes that tenants know how to budget and prioritize their rent payment above all other payments. Thousands of eviction cases across the country each month are proof that this may not be the best method.

So, how do the pros do it when screening applicants?

How to Calculate DTI Ratios like a Pro

The mortgage industry has thrown a lot more money at this problem than the rental industry. The mortgage industry has historically used Debt Ratios to approve applicants. Let’s take a quick look at how this is done.

1. Calculate Gross Income:

instead of calculating “take home pay”, you’ll want to calculate an applicant’s stable monthly gross income. The good news is that you’ll only need one paystub, as long as it shows year-to-date numbers, but you should also get last year’s W-2’s. We highly recommend calculating income 3 different ways:

- YTD Gross divided by number of months that YTD amount covers 

- The hourly amount x 40 hours/week x 52 week/year, divided by 12 months. 

- Finally (if the tenant has been in the same job for over 12 months) the YTD from the pay stub, added to the W-2 (only for the same job), and divided by the number of months the W-2 and paystub cover

If their income is fairly stable, all three numbers shouldn’t vary by more than 5-10%. Otherwise, you should investigate why the numbers differ, as it’s a sign of layoff, a raise or misrepresented time on the job.

2. Identify All Debts: 

These can be easily found on the credit report. Just be careful of student loan payments as they are often listed incorrectly. The applicant should be able to supply a letter showing the actual payment(s). Another issue is child support payments. They may not be disclosed or may show as a deduction on the paystub. You may want to request that the applicant supply a letter from the local Friend of the Court office for the correct amount. Pay stubs should also be checked for garnishments, and additional information should be requested to clarify the monthly payments. All these monthly debt payments get added up. What you don’t include is expenses like utilities, cell phones, cable, etc.

3. Don’t Forget Rent: 

To the monthly debt total, add the rent for the home the applicant is applying for.

4. Calculate Debt-to-Income (DTI) Ratio: 

Now divide the total of all the monthly debt payments and rent, by the gross monthly income you calculated. Then multiply by 100, to turn this into a percentage.

5. Making Sense of the DTI: 

The lower the DTI number, the lower the percentage of income an applicant is spending on their debts + rent. So, the better qualified they are from an income point of view. Traditionally, the mortgage industry looks for a DTI under 40%. In many low demographic areas, tenants pay a higher percentage of their income towards their rent, so in those areas you may need to approve applicants with DTIs of 45%, or even 50%.

The traditional requirement of “income = 3x rent” is a lot quicker than what we’ve outlined above, and if it’s worked for you, then by all means keep using it. On the other hand, if you’ve had issues with tenants paying rent on time, or have had to evict tenants in the past, you may want to consider using the more robust DTI method.

Keep an eye out for next week’s installment of our How to Screen Applicants like a Pro series, where we’ll be looking at how to verify an applicant’s income stability - not just their most recent pay stub.

Do you have any further suggestions for building a well-rounded picture of a prospect’s financial reliability? We’d love to hear them, so feel free to share in the comments below!

Image courtesy of Karolina Grabowska