One of the most consistent and safe investments continues to be real estate. Yes, there are always ups and downs but over time real estate as an investment asset is hard to beat. Flipping houses was a fad several years ago when No-Doc loans and loans for those with damaged credit were everywhere. Yet experienced real estate investors held firm, and many bought during the downturns. They saw their assets not only recover but increase in value over time. Of course, any investment decision should be made in concert with your financial adviser. But if you’ve been thinking about buying a home and renting it out, you’ll want to know in advance how a lender will evaluate your loan application, especially when it comes to debt ratios. Debt ratios and affordability can affect the terms of you loan and getting the best rate.
Debt Ratios and Affordability
Affordability is determined by calculating debt ratios. Most loan programs ask for two such debt ratios, a housing ratio that compares the total monthly mortgage payment with gross monthly income and a combined ratio which adds the mortgage payment along with other monthly credit obligations. Most debt ratios come as “guidelines” and less so as hard-and-fast rules. A loan program might ask for a “33” housing ratio which means the mortgage payment is 33% of gross monthly income. A combined ratio might also be 41 which is the total monthly credit obligations compared to income.
One of the unique aspects of real estate investing is how lenders view the monthly payments associated with the rental property, along with the income the property generates. Ideally, a real estate investor wants to see the potential property generate cash flow. Meaning, the income generated from the unit is more than the total costs of ownership. If not, the proposed transaction is an expense, not income, something experienced real estate investors want to avoid.
First-Time Property Investors
When first-time investors begin looking for a home to buy, they might look at the market rent for the area and compare it to the estimated mortgage payments. If the rent is more than the mortgage payment, they might think it’s time to move forward and make an offer. But there’s a catch with first-time real estate investing. And that catch can surprise many would-be investors.
With a first-time purchase, lenders will not give the buyers any credit for rental income coming from the proposed purchase. That sounds odd, doesn’t it? After all, it’s obvious the property will generate cash flow so why would the lender ignore established income? There are a couple of reasons, the main one being how much experience the borrower might have.
Showing a Track Record
Lenders want to see a track record of being a successful landlord. That means not only making the monthly payments on time each month but also keeping the property occupied. Occupancy can be an issue and many lenders will discount monthly rent by a certain amount to compensate for the times when the property is vacant and in-between tenants.
Many times, this discount is 25% of the established rent. If rental income is verified at $1,000 per month, the lender will use $750 for qualifying purposes. This not only addresses vacancies but also monthly expenses for the unit such as major repairs to the plumbing system or electrical work. While tenants are often responsible for utilities and such, the owner is responsible for structural and mechanical repairs. This adjustment will increase the borrower’s debt ratios. But until this two-year period is met, the potential buyers will have to qualify without the benefit of the rental income. The lender wants to make sure you can manage the property, tenants and the mortgage.
However, once this two-year period is met, the rental income can be used to offset the new mortgage payment. This dramatically reduces qualifying debt ratios and the new benefit is any subsequent real estate investment will use the rental income to help qualify. At this stage, the income does count, the property does cash-flow and it’s so much easier to qualify based upon debt ratios.