Managing Debt-to-Income Ratio as a Real Estate Investor

When you own or are buying rentals, a lender counts 75% of each property's rent (or the cash flow on your Schedule E), subtracts that property's full monthly payment, and adds the result to your income if it is positive or to your debts if it is negative. Fannie Mae requires a loan on a rental you will not live in to be approved through its automated system, Desktop Underwriter (DU), which allows a debt-to-income ratio (DTI) of up to 50%. FHA loans, available only if you live in the building, start at 31% for housing and 43% for total debt when underwritten by hand.

How lenders calculate DTI when you own rentals

DTI is your total monthly debt payments divided by your gross monthly income. For a rental owner, it has three parts:

1. Your own home. The full payment on your principal residence, or your rent, always counts as a debt.
2. Each rental, one at a time. The lender takes the qualifying rent, subtracts the property's full PITIA (principal, interest, taxes, insurance, and association dues), and gets a net figure for that property. Fannie Mae calls this adjusted net rental income. The figures for your existing rentals are then combined: a positive total is added to income and a net loss is added to debts. The property you are buying gets its own figure under the same rule.
3. Everything else. Car loans, student loans, card minimums, and other debts from your credit report.

A rental's payment is not counted twice. It goes into that property's net figure, and only the net amount enters the ratio. The exception is a 2-4 unit building you live in: Fannie Mae and FHA both add the qualifying rent from the other units to your income and count the full mortgage payment as debt, without netting one against the other.

Fannie Mae adds two conditions that change many first-time investors' numbers:

• 12 months of experience. You need at least 12 months of property management experience, usually shown by a rental on your last tax return with a full year of fair rental days, to add a rental's positive net income to your qualifying income. With less experience, a positive figure can only cancel out that property's own payment, and a negative figure still counts as debt.
• A documented housing payment. No rent from the property you are buying can count unless the lender documents what you currently pay for your own home. If you live rent-free, the new property's full payment goes into your debts.

How much of the rent counts, and from which document

The document depends on how long you have owned the property and whether it is on your tax return.

On the Schedule E method, depreciation is added back because it is a tax deduction, not a cash cost. Interest, taxes, insurance, and HOA dues are added back because the lender subtracts the full PITIA separately, so leaving them in would count them twice.

FHA uses the same idea with different details. For a rental without a tax-return history, FHA counts 75% of the lesser of the appraiser's market rent or the lease rent. For a rental already on your returns, FHA averages Schedule E over two years with the same add-backs.

Current DTI limits by loan type

FHA's compensating factors are reserves (cash left after closing equal to at least three monthly payments for 1-2 units or six for 3-4 units, not counting gifts or borrowed money), a new payment no more than $100 or 5% above your current housing payment, whichever is less, with 12 months of housing payments and no more than one 30-day late, and residual income (income left after taxes, debts, and estimated upkeep) that meets VA's regional tables.

The FHA table applies to manually underwritten loans, which includes files that get a Refer from FHA's TOTAL Mortgage Scorecard or are downgraded to manual review. Files that get an Accept are qualified by the scorecard instead. Any lender can set a lower cap than Fannie Mae or FHA allows, so ask what limit your lender uses.

Worked example: an investor buying a second rental

You earn $7,500 a month in salary. Your home's payment is $2,000, you have a $450 car payment with 14 payments left, and your card minimums total $100. You have owned one rental for two years.

Existing rental (Schedule E): $24,000 rent minus $22,420 of expenses gives net income of $1,580. Add back depreciation ($5,500), mortgage interest ($9,600), taxes ($2,400), and insurance ($1,200): $1,580 + $18,700 = $20,280 a year, or $1,690 a month. Subtract its PITIA of $1,248: net +$442.

Rental you are buying: The appraiser's rent schedule shows $2,400. 75% x $2,400 = $1,800. Its PITIA is $2,190, so the net is -$390.

That is under DU's 50% cap, but DU weighs your credit, reserves, and the rest of the file before it approves. If you had owned the first rental for under 12 months, its +$442 could not be added to income, and the ratio would be $2,940 / $7,500 = 39.2%. If you pay the car loan down to 10 remaining payments and the lender agrees those payments do not significantly affect your ability to repay, the $450 drops out and the ratio falls to $2,490 / $7,942 = 31.4%.

Steps that lower DTI before you apply

1. Pay installment loans down to 10 or fewer payments. Fannie Mae lets the lender leave out an installment debt paid down to 10 or fewer remaining payments, unless the lender decides the remaining payments still significantly affect your ability to repay. Lease payments, such as a car lease, always count no matter how few months remain.
2. Pay off card balances. A card paid to zero drops out of the ratio, and you do not have to close the account. If your credit report shows a balance but no minimum payment, the lender uses 5% of the balance unless you document a lower required payment, such as with a current card statement.
3. Document debts someone else pays. A loan you co-signed can be left out if the other person has made the payments for the last 12 months, shown by canceled checks or bank statements, with nothing late.
4. Show debts your business pays. A debt in your name that your company pays can be left out with 12 months of company payment records, no late payments, and a business cash flow analysis that already counts it.
5. Fix your student loan payment. If you are on an income-driven plan with a documented $0 payment, the lender may use $0. Otherwise a deferred loan is counted at 1% of the balance or at a fully amortizing payment calculated from your documented repayment terms.
6. Keep full-year rental history on your return. A rental listed with 365 fair rental days on Schedule E qualifies you for full use of positive rental income. If repairs took a unit offline, keep the invoices so the lender can add back documented one-time expenses.
7. Put more down on the new property. A smaller loan lowers its PITIA and shrinks its negative figure.

If your personal DTI is the limit and the property's rent covers its payment, a DSCR loan or a portfolio loan may approve you where a conventional loan will not. For the rest of what lenders check, including reserves and the 10-property limit, see tips for getting approved for an investment property mortgage.