Landlords: Screen Potential Tenants Like Lenders Screen Borrowers
Using borrower approval models set by lenders offers a reliable gauge for landlords to screen tenants
Essentially, a landlord uses their credit to hold a mortgage on a home for someone they’ve never met, who in many cases has a poor payment history. If a large percentage of tenants aren’t credit worthy in the eyes lenders who issue mortgages, then why do landlords use their own credit to hold a mortgage for them? This article will show you how to screen tenants like a mortgage lender would screen a potential borrower, maximizing your chances of receiving on time monthly rent payments.
The application gathers essential information
It benefits both parties to put together the renter’s personal and financial information on a formal application. This information should be used by the landlord to select the best possible tenant and can be gathered on a standard rental application; although the application process is best done by someone such as a mortgage or property management professional who can instantly pull the prospective tenant’s credit report at the time of application, streamlining the entire tenant selection process. The application should include the following personal information from the prospective tenant:
- Tenant’s full name
- Social security number
- Home/main phone number
- Date of birth
- Marital status
- Number of dependents/ages
- Present address
- Subject (property to be rented) address
- Complete two year residence history (own or rent) with landlord contact info
- Source of security deposit (savings, gift, etc.)
The rental application should also contain the following employment information from the tenant:
- Name and address of current employer(s)
- Years on current job(s)
- Years employed in this particular line of work/profession
- Position/title/type of business
- Business/work phone
- Supervisor’s name and phone number
Complete two year work history if holding current job for less than two years. For each job, include the employment information asked for above for each employer
Finally, the rental application should include the prospective tenant’s financial information, consisting of:
- Monthly base employment or self employed income
- Other monthly income: bonuses, overtime, commissions, dividends, interest, net rental income
- Monthly expenses
- Bank account information, consisting of name and address of bank, savings and loan institution or credit union.
- Type of account(s) held (savings, checking, CD, money market etc.) and account numbers.
- List other assets (with their current market values) such as stocks, bonds, mutual funds or any valuable items that will be sold to fund the down payment for the purchase of the subject home.
- Liabilities such as credit card debts, auto loans, alimony, child support or judgments. Include account numbers, outstanding balances, minimum monthly payment amount and months left to pay.
If you are a new landlord and your rental application is home-made, make sure it mirrors the application that mortgage professionals use: a Uniform Residential Loan Application (also called a 1003 Loan Application). The information provided in the application, in combination with a signed Credit Authorization Form, which authorizes the landlord or a designee to pull the prospective tenant’s credit report, will be all that’s needed to determine if the applicant is a waste of time or has a strong payment history. Do not have the prospective tenant apply on an actual Mortgage Application; it’s better to create or download a rental application.
Download these useful forms:
Uniform Residential Loan Application
Credit Authorization Form
The main goal in having a potential renter fill out an application and a credit authorization form is to gain access to their credit history. Most mortgage lenders in today’s market generally require a home buyer to have two of their three credit scores above 620; this is also a good scoring acceptance model for landlords or property managers to follow as well. Credit scores in this range are considered marginal at best but generally display a reliable pay history. Because most renters will not have perfect credit at the time of application, it becomes imperative for landlords to decide which potential renters are hopeless from a credit standpoint and which ones have demonstrated a reasonable payment history. A good rule to follow is that the lower the credit score, the higher the potential tenant’s income must be to offset the poor payment history. Any applicant with credit in the 400-550 range should be cast aside no matter how much money they make.
If an applicant’s credit report reveals large outstanding tax liens, judgments that are too large to be paid off immediately, large sum collections, and consumer credit charge offs or repossessions that are under three years old, a landlord should deny them occupancy. The IRS and various debtors who are owed money from items like the ones above can pass wage garnishments and seize bank accounts. If you approve a tenant who has credit issues like these, they may stop paying rent out of necessity after their creditors drain them financially. Recent bankruptcy or foreclosures reflected on an applicant’s credit report are a symptom of today’s economy. Mortgage lenders require a borrower be at least three years outside of a foreclosure or bankruptcy in today’s real estate market, but this is a situational issue and is a judgment call for the landlord. There should be a reasonable explanation from the applicant as to why the foreclosure or bankruptcy took place accompanied by proof of financial recovery.
In order to obtain a mortgage, a potential borrower needs to show mortgage lenders that they make enough money to afford the home they hope to buy. Generally mortgage lenders deem a home “affordable” if a buyer’s debt to income (DTI) ratio is under 45%. A copy of the prospective buyer’s credit report and last 2 year’s W-2’s or income taxes are required to calculate a buyer’s debt to income ratio. Landlords need to use a model similar to this to determine if an applicant can afford the subject home. This can be done by following the steps below:
- Determine the proposed rental payment. For this example, let’s state this to be $1,200/mo.
- Add the proposed rental payment to all of the monthly debt obligations currently listed on the rental applicant’s credit report. In this example, let’s assume that the prospective tenant has a $250 monthly car payment, a $200 minimum credit card payment and another minimum credit card payment of $75 per month. These minimum monthly debt obligations total out to be $525 per month. Remember that other monthly obligations such as child support, alimony or a money judgment needs to be factored into a loan candidate’s debt obligations as well because expenses such as these can “pinch” a potential tenant, causing them to miss rent payments.
- Next, add the total proposed rent payment to the prospective buyer’s minimum monthly debt obligations of $525, listed on their credit report. The buyer’s total monthly debt obligations in this example would be $1,725.00.
- Calculate the rental applicant’s monthly income. Mortgage lenders use a monthly average of a borrower’s 2 year combined income, usually evidenced by their W-2 earnings statements or tax returns. In this example, the prospective tenant made $38,750 in 2008 and $42,200 in 2009. If we add these two figures together and divide by 24 months, we get an average two year income of $3,372.91. Please note that other income sources such as alimony or child support should be factored into a loan candidate’s income.
- Finally, divide all monthly debt obligations by the mortgage candidate’s average monthly income over the past 24 months, then multiply this figure by 100 to get the borrower’s DTI ratio expressed as a percentage.
In this example, our applicant cannot afford the subject home based on bank guidelines for borrowers because they have a DTI ratio of 51.1%; this is 6.1% higher than the 45% DTI ratio that most mortgage providers look for in a borrower. However, a DTI ratio of 51.1% is not bad at all. Assuming this applicant had good credit and steady employment, they would probably make a good tenant. Any tenant with a debt to income ratio above 60% is dangerous because they still have to afford food, clothing, entertainment, transportation, and monthly cell phone bills.
Bank statements prove down payment source and reserve requirements
Before closing a loan for any borrower, lenders want to see the monetary equivalent of a down payment and several months (usually 3-6 months) worth of mortgage payments set aside. These funds need to be “seasoned” for 60-90 days or more. In other words, the funds need to be in the prospective borrower’s possession for a minimum of 60-90 days, as evidenced by 2-3 month’s bank statements. Before turning possession of a house or apartment over to a tenant, the landlord or property manager should request the rental candidate’s last three month’s bank statements to verify their liquidity. Examining these bank statements will indicate if the applicant lives hand to mouth or that they have enough money saved up to afford a security deposit and several month’s worth of rental payments should their income suddenly stop. If an applicant has the money in a 401K, CD, money market, IRA or other type of investment vehicle, this will suffice. These documents will need to be gathered and filed by the landlord and verified by either calling the institutions that the funds are parked at, or by obtaining Verification of Funds forms filled out by staff members at the various deposit institutions.
Cover your ass-et
A maximum security deposit acts like a partial insurance policy for landlords. Most states have laws that cap security deposits at 1.5% of one month’s rent. To protect themselves, landlords should always make sure to collect the maximum allowable security deposit from the tenant. Some renters will leave a home without giving prior notice to the landlord, opening the door for vandalism of a now unoccupied house. Spiteful tenants will trash a house so that the landlord suffers a financial loss on a house. A maximum security deposit at least covers a portion of the cost of a minor renovation, which usually includes paint, carpet and intense cleaning. Renters who aren’t good tenants usually aren’t willing to put up so much money, therefore the size of the security deposit also serves as a good screening mechanism.
Another good tip to screen tenants is to show up at their current address prior to accepting them as tenants. They will take care of your home the same way they take care of the dwelling they’re in now. You’d be surprised at how animalistic some tenants live, which is why this is an excellent screening mechanism.
A criminal background check on a selected tenant is mandatory before move in. It is very hard for law offenders to become homeowners; therefore the majority of offenders are tenants. This means that it is only a matter of time before a criminal applies to live in your home. Once inside, any criminal activity that exists as a result of bad tenants can wreak legal havoc on the landlord.
Mortgage lenders want to see that a potential borrower has a 2 year continuous job history with no gaps in employment. This is a general rule of thumb. Sometimes a lender will allow a recent college graduate who may have been working an internship or only has 6 months working at their new job to receive home financing. In other cases, a gap in employment may be overlooked by a lender if the potential borrower switched jobs but stayed in the same profession. This is a good guideline for landlords to follow. Steady employment or proof of rental subsidy (such as FIA or Section Eight) is mandatory. A personal phone call to a work supervisor is a must as well.
Mortgage providers look for a potential borrower’s two year residence history, consisting of at least two consecutive year’s on time rent or mortgage payments. Cancelled checks going towards rent or a mortgage is usually the proof the lender will want from a potential borrower. Many applicants will not be able to provide a full two year’s history of on time cancelled checks, so call the former landlord. Be careful though as the applicant’s former landlord may be saying nice things to dump a bad tenant on you.
Sometimes a younger borrower can obtain a mortgage with no residence history at all. This usually occurs in a situation where the borrower has good credit, sufficient income to afford the subject home, 2+ years in the same line of work, but has lived with their parents and is moving out for the first time. This is a common scenario that landlords see. Applicants like this should be treated on a case by case basis. A good idea is to have a parent or guardian guarantee rental payments.
Great tips for landlords
- Borrowers capable of obtaining a mortgage have the following: 620+ credit scores with no tax liens or debts/judgments that are too large to be paid off within a year, no foreclosures or bankruptcies within two years, >2 continuous year job history, >2 year residence history (provable with on time cancelled rent checks), >2 months bank statements (or other investment vehicle statements) with 2-6 months worth of reserves set aside, and a <45% DTI ratio. Potential tenants who have a DTI ratio above 60%, or those that have massive credit problems should be cast aside immediately.
- Always work through an attorney when it comes to structuring agreements and turning over possession of a house to someone else.
- President Ronald Reagan was famous for saying “trust, but verify”. This is the best advice for a landlord who should listen to their applicants, but also verify everything to be safe. You’d be amazed at the games tenants play to take possession of a home. Many are “professionals” and are just trying to get in, knowing it takes 3+ months to get them out.
- Performing a criminal background check on a potential tenant should be considered mandatory.