2

If I own a house that I rent out, and I apply for a mortgage to purchase a new primary residence, how do the rental income and costs factor into a debt to income (DTI) ratio for that new mortgage?

My understanding so far is that the 'front end' DTI is based only on the cost (mortgage, insurance, tax) of the new home and my salary/compensation.

The 'back end' DTI includes other types of cost, including the rental, but there is a couple of way this could be applied:

The first way would factor the rental income into both the numerator and the denominator:

DTI = (all costs for new home + all costs for rental property) / (salary + rental_income * 80%)

The second way would factor the rental loss/profit only into the numerator

DTI = (all costs for new home + rental_profit_or_loss) / (salary)

rental_profit_or_loss = rental_income * 80% - rental_cost

Or maybe it's neither of those? Or maybe it varies from lender to lender. In any case it would be valuable to know the range of approaches that exists.

Thank you!

3

Lenders are generally cautious about consumers that own income property which is mortgaged. This is based on the perception that such arrangements are very high risk - what happens if there's an issue with the rental property or it's mortgage that changes your finances to the point that you can no longer afford your newly-purchased primary residence? In part, this fear was driven by the fallout from the mortgage crisis in the US in 2008 - people had tried to build mini-empires by stacking income properties - borrowing against one property to fund downpayments on another - and sometimes including their primary residence in such arrangements. It was easy for these mini-empires to crumble, because an issue in one income property would mean that you no longer had the income to support it.

So, you've got a bit of an uphill battle compared to someone with more "traditional" income from a salary.

And of course, the rules will vary depending on what type of mortgage you're taking out on your new primary residence (i.e. is it fannie/freddie backed?) and also somewhat from bank to bank. For a typical conforming loan for your new primary residence, most banks will count rental income as income in DTI only once you've had at least two annual tax returns which show that income. And the rental income is often discounted by 25%, so if you've got $1,000 of monthly income it'll only count as $750 when figuring DTI.

In terms of which of your two example DTI calculations is used, it's typically neither of those. If you've got two years of tax returns showing rental income, the bank will simply use your net rental income from your tax return (times .75) as income in the denominator of the calculation, along with salary or any other income you have. This is nice and clean because it keeps the whole mess of figuring out rental income as a separate problem from DTI.

If you don't have two years of tax returns showing rental income, you may have to search for a bank that's willing to work with you (and likely it will be on a nonconforming loan for your new primary residence), and you will likely find that they have their own formula for deciding how to include rental income and expense in DTI. Typically, this is done by derating rent by a standard factor - usually 75% - then subtracting PITI (on the rental property, not your new loan), and including that as an estimate of rental income.

  • 1
    This covers the bases nicely, one important distinction is OP's usage of 'total cost' vs what actually counts as debt in the DTI. – Hart CO Oct 17 at 17:08
  • Yes, agreed. Ultimately, from the DTI perspective, the important point is "go figure out what rental income you would use for tax purposes" is the answer, and the subtleties of how any expenses or costs related to the rental property impact your DTI are solved there, versus being directly included in the DTI calculation. – dwizum Oct 17 at 17:45
  • Thanks for this answer. When you say "the bank will simply use your net rental income from your tax return (times .75) as income in the denominator of the calculation", I have 2 Qs: 1) does 'net income' here mean rental revenue minus rental costs (PITI+), or just rental revenue? 2) you say this would go in the denominator - makes sense. Does that also mean that nothing from the rental would go in the numerator in that case? thanks again. – tom Oct 17 at 20:20
  • 1
    @tom Net income in this case literally means the amount of income you report for the rental property when you file your taxes. Whether or not that net income number includes things other than PITI, or how it's calculated, is a tax accounting question. From the lender's perspective, for a typical conforming mortgage, they just want the final number (with the tax returns to back it up), so they can plug it into the "income" side of their DTI. They don't want to be involved in deciding how to calculate it. – dwizum Oct 17 at 20:51
  • 1
    @tom in the case that you don't have two years of tax returns showing your rental income, or some other extenuating circumstance, then you'll have to work on finding a lender who will do a non-standard product for you (i.e. something the bank is backing themselves), in which case they will calculate a number to use, based on their own formula - typically, rent minus PITI times a derating factor - and again, it's a final number used in the denominator of the DTI calculation, it's not usually the case where they split gross income and expenses separately in the actual DTI formula). – dwizum Oct 17 at 20:55

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.