Debt to Income Ratio

18 Replies

Will building a real estate porfolio of positive cash flowing properties lower my debt to income ratio? And thereby limit my ability to purchase a $1,000,000 2nd home?

I own a primary and 3 positive cash flowing rentals. I'd like to add 5 more cash flowing rentals to my portfolio, and then afterwards, purchase a 2nd home beach house. With regard to rental properties in a debt:income calculation, Ive heard you must consider PIMIT, and can count monthly rents at 75%. Following that formula, unless my rents are double my expenses, my debt:income ratio goes up, and after the addition of five properties, may be into the 40s, making a 2nd home purchase difficult.

Am I looking at the correctly? I've also been told that positive cash flow rentals do not increase/worsen the DTI ratio.

Larry

Lenders generally consider "net rental income" to be (0.75*rent)-PITI. If that value is positive, the rental is helping your DTI. If its negative, its hurting.

IMHO, to get positive cash flow you need rent to be double the P&I part of your payment. This lender formula is a bit more optimistic.

And, if you have a down payment into the place, you would like the cash flow to be more than a little positive.

Of course, there are always other ways to make money, such as long term appreciation and principle paydown.

The primer is OK for a homeowner, but doesn't address some of the most important things for actual real estate investors: how (and when) rental income and investment property mortgages are factored in, how flipping/wholesaling/other self employment income is scored. Once you get beyond a couple of properties, these things become pretty important.

To Larry Burchett's point though,

One technical question I have is whether or not there is a sort of moratorium with regards to DTI. In other words I've been told he can't consider the income from his new investment property(ies) for 2 years – in fact his DTI would be to high because of the new mortgage(s) – to get another property. How do you get around this? (or does this only apply to new investors). It seems to me after one year with cash positive income on your returns, the bank would recalculate the DTI using the new income and not just the debt, no?

Originally posted by @Larry Burchett :
Will building a real estate porfolio of positive cash flowing properties lower my debt to income ratio? And thereby limit my ability to purchase a $1,000,000 2nd home?
I own a primary and 3 positive cash flowing rentals. I'd like to add 5 more cash flowing rentals to my portfolio, and then afterwards, purchase a 2nd home beach house. With regard to rental properties in a debt:income calculation, Ive heard you must consider PIMIT, and can count monthly rents at 75%. Following that formula, unless my rents are double my expenses, my debt:income ratio goes up, and after the addition of five properties, may be into the 40s, making a 2nd home purchase difficult. Am I looking at the correctly? I've also been told that positive cash flow rentals do not increase/worsen the DTI ratio.
Larry

Great Question Larry,

If you buy the properties right and structure them to show "cash flow," on your tax returns you'll be doing yourself a favor by increasing your qualifying income to purchase additional real estate or primary homes.

The key is having your mortgage professional work in unison with your tax advisor. I will often go back and forth, do quarterly Profit & Loss reviews, and reviews during tax time to let the clients know how the filing on their returns will affect their financial plans and qualification going forward. This lets the client know okay 1st quarter 2014.... I am on track or not? what do I have to net with depreciation and non cash deductions added back in Q2 to qualify for X going forward? How will a commercial lender judge my financial statements, etc etc.

The 75% formula is only used when there is no tax returns for the property being reviewed if you have only 1 year tax return its a 12 month average or 75% gross - PITIA (up to underwriter/judgement call/grey area) but generally its the one year return / 12 months. If you have two years tax returns available its the most recent year divided by 12 if the most recent year is shows declining income from prior year or 24 month average if most recent year is better than prior year. I know its a bit info heavy but if you want specifics to your given scenario let me know I am located in CA.

Also I routinely see investors who tell me they have "cash flow," properties and say "oh ya it shouldnt be any problem to qualify," but the problem is when I go to their tax returns it shows negative cash flow. Not that the investor is concealing the truth but rather what generally happens is what the investor is actually making from a month to month perspective is not reflective of what the tax preparer has displayed. The bank will use what you're claiming to IRS before they take a representation from you unfortunately. This is why its important to have your taxes structured in unison with a mortgage professional who is proficient at understanding the language which accountants speak. This will then allow you or the mortgage professional to better explain/negotiate the cash flow or loan scenario to the underwriter in a way that will yield the best possible outcome. A lot of the issues at underwriting are "complex," because the underwriters themselves are not very versed with how to review financial statements either they use "self employment income evaluation," methods designed from Fannie Mae which help in determining risk analysis but to objectively know how to read the statements like a finance professional thats a different story as most loan officers are not finance professionals.

Best of Luck,

Originally posted by @Joshua Dorkin :
Larry - Here's a fantastic [url=http://www.biggerpockets.com/mortgage/home/debt-to-income-ratio-dti/]Debt to Income Ratio Primer[/url] that we just put out on our mortgage blog. I think you and others should find it to be valuable.

I've studied this area a lot first for my own rental properties to determine how I was going to structure my own rentals and the affects to my debt to income with regards to rental and investment properties and secondly for investor clients as well. So perhaps I can help in this area if you have any questions.

Not all lenders give you positive income from rentals to your qualifying scenario. If we're talking about conventional lending then yes cash flow properties (cash flow on tax returns/financial statements) can be used to increase income but some local/community banks or HELOC lenders may only allow the positive income to "0" out or wash out the mortgage against your DTI but not allow the positive income to be used in helping you qualify for additional loans or financing because of the exposure to additional leverage and risk they may have to take on.

OMG!

If you need tax planning with respect to 3 rentals, you have no business looking at a million dollar second home!

Portfolio lenders will vary on what they consider, depends on the type of loan.

With the blog Josh listed, you can also exclude installment debts scheduled to be paid off within 6 months.

Larry, welcome to BP! Get to know those who post in the forums. Visit profiles. You can read between the lines with many posters as they spin answers off into their area of business or expertise suggesting you do something, like finding certain vendors, often you'll see them as being one of those vendors. Most everyone here is here for business, but some just can't answer something without under the radar plugs.

If you are really considering a million dollar second home, which makes some here salivate, you already have a tax attorney or CPA, an attorney, a bank relationship (or several) and you're no dummy in business matters. :)

I own 8 rentals properties with mortgages including the duplex I live in. Each of my investment properties positive cash flow $15,000-$25,000/yr. Earlier this year, I applied and barely received a car loan as the adjustor said my debt to income ratio is over 45%. After I had that loan, I've been able to finance two more properties with mortgages so I"m confused as to what the exact calculation is being used since my mortgage broker has never had an issue financing me or selling off my loans. When calculating income, do I take my credit report debt ( my PITI + car loan) / my wife and my "job" income along with adding my gross rental receipts or is it just "job" income + schedule E rental net income(line 26) + depreciation? I have numerous years of tax return rental income so substantiating it isn't an issue and they are seasoned except the two I got this year. It seems if it is the second scenario, I'll never be able to get another loan or HELOC which is actually what I'd like to do since I would like to pay cash for my next place and sell after renovations. On average I have a 50% equity stake in all of my properties. HELP in understanding? Thanks

Another note on this. DTI us usually for conventional/consumer loans. And I suspect the exact inputs for the calculation could vary by product/lender.

If at some point you switch over to commercial loans (and it sounds like you are getting big enough where this will happen soon) then DTI is usually less relevant or not used at all. Commercial lenders, like what I do, primarily look at Debt Service Coverage Ratio. There is a DSCR applied to the project that is being lent, and to you globally. It is a more appropriate measurement for what you do as a business. DTI is more a consumer lending tool. It sounds like you cash flow in a way where your DSCR would be more than good enough.

Thanks Matt but after reading John's posts it sounds like he is saying the PITI from my investment properties doesn't get added into my debt number since all of my properties cash flow on my schedule E. If that is so, I'm in good shape. If my PITI from all of my properties are added to my personal mortgage, I won't qualify as in essence that is counted twice. Thoughts?

@Jon Holdman  

just learned how to add prior notes so it alerts someone I refer to. Jon, can you read my post and advise as I can't get a straight answer from my bank or other companies I call to see if I am ok on my DTI. Thanks

I'd like to get HELOC so I can buy properties with cash and flip them now that I've had several years of doing this with keeping them for rentals but need the cash available to make the offers on the foreclosures.

Bruce

My understanding is that it works like this:

income = income from all sources except rentals

debt = debt payments from all loans except mortgages on the rentals

net rental income = income from rentals after deducting all expenses including mortgage interest but not depreciation.  If this is negative, its a net rental loss

If net rental income is positive, DTI = (income + net rental income) /debt

if you have a rental loss, DTI = (income)/(debt + net rental loss)

IDK if every bank does it like this or of if there are variations.  Only the specific lender you're dealing with at some point in time can really tell you what they do.

If you do get a HELOC on your residence, that falls purely into the debt side. A LOC on a rental would fall under the net rental income calculation.

@Bruce Runn   Each of your 8 rentals nets you $1,500-$2,000 a month?  What is the rent on these properties?

@Pat Martin Monthly net  is $1250 -$2,100/month=($15,000-$25,000) -

Rent is $3,200-4,500/month .  Some are large duplexes and some are triplexes.

@Jon Holdman

Hi Jon, if I use your calculation I have a DTI of 17%. I wonder why my bank isn't welcoming my in with open arms even though I have a long history with them. Of course I can't get them to tell me exactly how they calculate it since you can't talk to an underwriter. Hopefully it's not because their underwriter is less than experienced or doesn't know how to read a sophisticated tax return. I should be able to get a HELOC for $250,000 without any issues if I could convince a bank to use the calculation you are advising.

Bruce Runn we own 5 rentals. I have found that we have had to shop around for different brokers because each firm seems to have different rules. For example, wellsfargo will my lend to us but they have no problem buying our loans from the broker ;) so I would recommend you ship around. The place you find might not be the cheapest but there is a price to pay when you start having so many loans

Originally posted by @Bruce Runn :

Thanks Matt but after reading John's posts it sounds like he is saying the PITI from my investment properties doesn't get added into my debt number since all of my properties cash flow on my schedule E. If that is so, I'm in good shape. If my PITI from all of my properties are added to my personal mortgage, I won't qualify as in essence that is counted twice. Thoughts?

The question of whether the PITIA of the rental property gets added into your monthly expense for the DTI formula or not depends on whether the rental property is owner occupied (house hack) or if its truely a rental property from the stand point that it shows up as a rental on the tax returns.

If its a non owner property the rental income gets "netted," against the monthly expense or PITIA so only the net income or loss is counted.

If the property is an owner occupied 2-4 unit property where the owner lives in one and rents the rest then yes the full PITIA gets added to your monthly expense and the income is added to your monthly income as well which is completely different calculation than "netting," income and expenses then using the "net," income from a non owner/investment property scenario.

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