In a previous post I talked about the basics of mortgage debt ratios—the calculations lenders use to determine if you qualify for a mortgage. This prompted this reader question:
Q: If I own a rental property, which debt ratio does that get included in? GDS or TDS or both? In other words, which debt ratio do you add the rental property mortgage payment, rental income, taxes and heat to?
A: Good question. While the short answer is TDS (the total debt service ratio), the mechanics of how a rental property is assessed when applying for a mortgage are important. As such, I thought it would be a good idea to provide a brief explanation of how lenders use rental property income and expenses when you apply for a mortgage.
In general, lenders will apply two calculations when examining a rental property:
Debt Service Coverage ratio
This is calculated by dividing the Net Operating Income (all rental income minus all reasonable operating expenses) by the Debt Service (cash required during a specified time period to cover the payment of interest and principal on a debt). For example, if your property’s rental income is $2,000 each month and it costs you $500 in expenses along with a $1,200 monthly mortgage payment, then your DSCR would equal 1.25 ($2,000 – $500 / $1,200).
Most lenders want to see a minimum 1.1% return on a rental property—so for every dollar you spend on the rental property, you earn at least $1.10 in income.
Rental offset rules
The lender will use 50% to 70% of the rental income to offset the principle, interest and tax mortgage payments (PIT) you make on the property. So if your property earns you $2,000 per month, the lender will only account for $1,000 to $1,400 in income to offset the PIT payment. To see how this works, let’s assume PIT payments equal $1,425. Since you earn $2,000 in income, and the lender uses a 70% rental offset rule, you deduct $1,400 from the $1,425 PIT payment. The remaining $25 shortfall will be added to your debt—thereby increasing the debt portion of your total debt service ratio.
Unfortunately, though, there is no standard. Some lenders use debt service coverage ratio while others use rental offset rules. The best approach is to talk to a mortgage professional to determine your best options.
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