Understanding Rental Income and Mortgage Guidelines for Investment Properties

Introduction: If you buy a house strictly to rent it out, can the rental income be used to pay the mortgage but not counted as qualifying income for a new loan? This article clarifies these complexities and explores the nuances of rental income, mortgage payments, and the debt to income ratio (DTI) for investment properties.

Rental Income: Taxable and a Key Part of Financial Planning

Rental Income as Taxable Income: Rental income is a form of taxable income. Therefore, it is reported on your income tax return and can indeed be used to pay the mortgage for the said property. However, it cannot be used to qualify for a new loan until you actually receive it. This principle holds for both investment properties and vacation rentals, although the rules differ for financing.

Financing Investment Properties

Different Rules for Investment and Owner-Occupied Homes: When it comes to financing, the rules are different for investment and owner-occupied properties. Investment properties often come with higher interest rates and a lower Loan-to-Value (LTV) ratio. For many homeowners, renting their current home and using the proceeds to purchase a new primary home can be a strategic option.

Example: A Homeowner’s Strategy

For instance, a homeowner could rent out their current home and use the rental income to buy a new primary home. Once they have a steady stream of rental income, they may be able to refinance for better terms. This strategy requires careful planning and understanding of underwriting rules.

Lender Requirements: Debt to Income Ratio (DTI)

DTI and Investment Properties: Lenders use the debt to income ratio (DTI) as their primary criterion for approving loans. DTI is calculated by dividing the borrower’s total housing expense by their gross monthly income. A typical maximum DTI for conventional loans is 50%. However, for investment properties, lenders calculate DTI slightly differently.

Calculation for Rental Properties

Market Rent and Expenses: For investment properties, lenders start by determining the market rent for the property. They then multiply this by 75% to cover vacancy and operating expenses, excluding taxes and insurance. The difference between this figure and the total payment of PITI (Principal, Interest, Taxes, and Insurance) is added to the borrower’s other debt and housing expenses.

Example Calculation: For a $200,000 property with a 25% down payment, let's say the market rent is $1,200 per month. Here’s the breakdown:

Cash flow: $1,200 (rent) - $1,389 (PITI) -$189 (negative cash flow) Monthly Housing Expense: $1,389 Other Debt: As per borrower’s credit report

For a borrower earning $7,000 per month, their DTI would look like this:

DTI: ($1,389 other debt) / $7,000 Assuming the DTI is below 50%, the loan would be approvable

Reserves and Loan Terms

Required Reserves for Investment Properties: Even if a property produces positive cash flow, lenders may require documentation of cash reserves after closing. For a borrower with only one investment property, they might need around 3-4 months of PITI reserves. This ensures that the borrower has sufficient funds to cover unexpected expenses and maintain the rental property.

Positive Cash Flow and Documentation: If the property produces a positive cash flow, the net rents are considered income. However, to qualify for a loan, the borrower must document these funds and ensure they have sufficient reserves.

Conclusion

In summary, unless you have a small mortgage, you are likely to have negative cash flow from the investment property. The debt service is significant, and underwriting guidelines might reduce your rental income by 25% as a vacancy factor. This makes it challenging to qualify for a new loan with just rental income.

For those considering investment properties, it is advisable to seek professional financial advice and carefully review the terms and conditions of any loan. Good luck with your investment journey!