The Dreaded Debt-To-Income Ratio

This past week, I met with a 35-year-old real estate investor who had two rental properties under their belt and wanted to know how they could accumulate more properties without crushing their debt-to-income ratio to the point they would not be able to qualify for another mortgage.

For those folks not familiar with this term, the debt-to-income ratio (DTI for short) is a calculation a lender will use to see if you have too much debt.It is good to know what your particular number is and to know whether it is considered in the good range or if it is in the danger zone.

Simply stated, your DTI is the percentage of your income needed to cover your loan payments.In other words, for every dollar of income, how many cents are eaten up with debt payments?If a person has $2,000 per month going out in debt payments (mortgage, car note, credit cards, student loans, etc.) and their gross monthly income (before taxes and deductions) was $6,000 then this person’s DTI would be 33% (2,000 divided by 6,000 = .33).

Most lenders have internal guidelines for what they want this ratio not to exceed.Some lenders will even split that figure into two.They want to know how much of a person’s income is needed solely to pay their mortgage debt (typically, lenders want to see this below 33%) and a second calculation used to see how much total debt a person (or couple) has relative to their income.The maximum total DTI for a lot of lenders is 43%.They do not think it would be prudent for a borrower to have more than 43 cents of every dollar a person earns going to pay debt since the higher this number is, the greater the probability for a person to get into financial problems and default on their loan payments.

Here is the problem with this calculation.It does not work well for a person who wants to accumulate a lot of assets by investing in multiple rental properties.Each lender can arbitrarily apply different rules to different sets of circumstances.For example, it someone is going to buy a house to fix up and eventually rent out for income, a lender may decide not to include the income from this new property until it shows up on a tax return.

If you buy a house in January, this would mean the income from this house will not show up until around April 15th the following year which is 15 months later!But here is the kicker:the lender WILL count the debt against you on the calculation of the ratio.It is clear to see the implication of counting 100% of the debt with 0% of the income as it will hamper your ability to do very many of these transactions, depending on how high your personal income is.

The DTI ratio is applied mostly to folks with jobs that use debt to finance their personal residence, their personal car, and their personal consumption for bigger ticket items.In short, this is consumer debt used to purchase liabilities. Liabilities, you may recall, are made up of stuff that takes money out of your pocket every month like this type of debt is designed to do.

However, if you want to break free from having this calculation used against you which will severely limit the number of properties you will be able to purchase, then you need to utilize a different strategy.

Instead of using a mortgage banker who typically finance owner-occupied residential properties which are a liability, you need to cultivate a relationship with a bona-fide professional commercial banker.These people are much fewer in number than mortgage bankers and they are in the business of financing the purchase of income producing assets.

A commercial banker will look at the property you want to purchase and will use the income generated by the property to calculate a Debt Service Coverage ratio (DSC for short).Instead of the DTI, the lender will want to know the DSC which is made up of the following:

Gross rental income minus property taxes and insurance minus repairs and maintenance = Net Operating Income (NOI).Then they will divide the NOI by the monthly principal and interest payment to get a DSC ratio which should be higher than 1.25.In other words, the asset (rental property) is generating $1.25 of cash (NOI) for every $1 of debt payments.

Let’s input some real numbers.If a property generates $1,650 per month in rent and, after the expenses listed above the NOI is $1,431.Assume a monthly payment of $516 for principal and interest would equate to a 2.77 DCR (1,431 divided by 516 = 2.77).

This is how real estate investors can accumulate a larger number of properties than a typical individual that hits the proverbial brick wall and cannot finance anymore due to going to the wrong type of lender (mortgage lender which uses the DTI ratio) instead of using the right lender (commercial banker which uses the DSC ratio).

If you want to grow your wealth and own multiple properties either as an individual or a team, then you have just learned a very important distinction that will get you there much quicker!