How To Master Your Debt-to-Income Ratio: A Guide for Rental Homeowners

When you’re looking at home financing, you’ll need to get acquainted with a figure known as your debt-to-income ratio (DTI). Before your eyes glaze over, it’s not too hard to calculate. 

What is a debt-to-income ratio and why does it matter? Mortgage lenders look at how much you earn every month and work out what percentage of that is attached to debt repayments. DTI won’t calculate your borrowing limit, but it helps assess your capacity to service a mortgage i.e. more debt. 

If your debt ratio is too high, it means you don’t have a lot of spare cash to make repayments. Or for a rental home, that you may not have enough cash flow to cover your expenses. 

In this article, we’ll cover how to calculate your debt-to-income ratio and how to lower it to secure an investment property for the rental market. 

Key takeaways

• A debt-to-income ratio is all monthly debt repayments divided by your gross monthly income. It’s used to determine your ability to manage mortgage repayments.

• A debt-to-income ratio below 36% makes it easier to get approval for a mortgage. 

• A debt-to-income ratio above 43-50% suggests that your debt is too high for the amount of income earned.
  
  
• Increasing your income or paying down small high interest debt such as car loans and credit cards can improve your DTI. 

• There are ways to prove potential income for a rental home to be included in your DTI calculation, but this will depend on your lender. 

What is a debt-to-income ratio?

A debt-to-income ratio (or DTI) is calculated by adding up monthly debt payments and dividing them by your monthly income (before tax) to work out the percentage of debt vs income. 

When applying for a mortgage, lenders look at your income vs how much of it is attached two categories of financial obligations:

Front-end DTI

The dollar amount of ongoing household expenses such as mortgage payments, property taxes, insurance, HOA fees etc. 

Back-end DTI

The dollar amount of regular debt repayments such as credit cards or car loan, plus any other financial obligations you may have like student loans, child support or alimony payments.

This means a DTI only calculates debt and the fixed cost of ongoing financial arrangements. It doesn’t account for your household spending such as groceries or school fees. 

Example of a debt-to-income ratio calculation

If you had a salary of $75,000 per year, you would earn approx. $6,250.40 per month. Let’s say your household expenses total $1,500 per month and paying off a credit card and student loan costs you $350 per month. 

Gross monthly income = $6,250.40

Front-end DTI = $1,500

Back-end DTI = $350

Debt-to-income calculation: 1,850/6250.40 = 0.295

Debt-to-income ratio: 30%

If you were earning rental income from your property, you would add this to your gross monthly income. If you paid down a student loan or canceled a credit card, this would come off your back-end DTI. 

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What is a good debt-to-income ratio for a rental property?

If you want to buy an investment property for the rental market, you’ll need a favorable debt-to-income ratio. A ‘good’ DTI vs ‘bad’ DTI depends on many factors, including:

• Your credit score and financial history
• The size of your down payment
• The type of loan you’re applying for

Most lenders prefer a debt-to-income ratio of 36% or less. Others may accept up to 50%, depending on the above factors. 

If you’re buying a home for the sole purpose of having a long-term rental, the potential to add rental income to your gross income may also come into play. Again, whether this will be considered as part of your DTI depends on the lender you’re working with. But there are ways to make this process easier.

If the home you intend to buy is already a rental home, try to get a copy of the existing lease agreement or rental history. Some lenders will apply 75% of the lease agreement as rental income to your total gross monthly income as a projection. 

If the home has never been rented before, or you are buying it vacant, some lenders will use the home’s appraised value to calculate the 75% as gross monthly income. It’s worth having this discussion with your chosen lender to look at your options. 

Don’t forget that you will also have to account for the home's operating expenses such as the mortgage, property taxes, insurance premiums and any HOA fees. 

How can I lower my debt-to-income ratio to buy a rental home?

Having a high debt-to-income ratio can affect you in a few ways. It will make it harder for you to make repayments and also work against you when it comes to finding a low interest rate with your preferred lender. While some lenders accept higher DTIs, they may also charge more for these loans. 

If your current DTI is too high to apply for an investment property, here are four ways to reduce your debt-to-income ratio:

Save for more of a deposit

The down payment will affect your ongoing mortgage repayments, so if your DTI is too high, it could pay to wait until you have a larger deposit. Draw up a household budget and look at where you could cut expenses to focus more cash on your down payment. Don’t refocus any of the money you make on repaying credit, because you want your debt to lower too. 

Reduce debt

Instead of adding to your downpayment, you could also focus on reducing your high interest debts such as credit cards and loans. Smaller loans such as car loans or credit cards often have higher interest rates and repayments than student loans. Paying these will lower your back-end DTI and improve your ratio. You could also look at consolidating your debt or lowering your credit card interest by shopping around for a better deal. 

Avoid taking on any new debt

While you’re in the market for a mortgage, avoid the temptation of signing up for another credit card or adding any new debt if you’re consolidating loans. Even if you can afford the repayments or there’s an irresistible sign up deal, the amount can count against. Most lenders will consider the amount you’re approved for as a potential liability.

Increase your income

Are there any ways you can add to your gross monthly income? Whether it’s asking for a pay rise or taking up a side hustle, any regular income can improve your DTI. If you already own a rental property, you consider ways to increase the value of the home and charge higher rates to improve your cash flow. 

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Financial security for owners of rental homes

Once you’ve achieved your optimal debt-to-income ratio and secured a rental home, the real work begins. Staying cash flow positive is not as simple as putting your home on the rental market. That’s where Belong can help. 

Belong is simplifying the rental experience across the US and helping homeowners reach their financial goals on their own terms. For people who want a completely hassle-free home management experience with guaranteed rent and 24/7 concierge service, check out Belong PRO.

Disclaimer: This article provides information on how to calculate a debt-to-income ratio but should not be considered financial advice. Always consult a professional regarding your personal financial situation before making any decisions.