How is a rental property treated when you apply for a mortgage?
When you apply for a mortgage on your primary residence, lenders include the cash flow income or loss from any rental properties you own in your debt-to-income ratio. Below we explain how lenders determine rental property cash flow so you better understand how it affects your ability to qualify for a mortgage.
To calculate rental income, lenders start with the net income or loss attributable to the property according to Schedule E of your tax returns. Lenders then add back the following items listed on the Schedule E to determine rental income:
Depreciation
Interest expense
Property tax
Homeowners insurance
Homeowners association dues
One-time property costs that can be documented
For example, if your Schedule E shows $35,000 in net income and $13,000 in “add-backs” -- such as depreciation, interest, taxes and insurance -- the annual rental income for the property according to mortgage guidelines is $48,000. Lenders then average this income figure over twelve months to determine the monthly rental income, which is $4,000 in this example.
Please note that if you cannot provide Schedule E from your tax returns, lenders use 75% of rental income according to a signed lease agreement or 75% of income according to a rental appraisal report to determine the income attributable to the property. Lenders apply a 25% discount to account for vacancies and ongoing property costs.
After the lender determines the rental income for the property, the next step is to calculate the cash flow for the property. Lenders do this by subtracting total monthly housing expense for the property -- which is also known as PITIA and includes the mortgage payment, property tax, homeowners insurance and homeowners association dues (if applicable) -- from the rental income.
Returning to the prior example, if the total monthly housing expense for the property is $3,250, the monthly cash flow for the property is $750 ($4,000 (rental income) - $3,250 (PITIA) = $750 (cash flow)).
If the property generates positive monthly cash flow or net income according to the lender’s analysis, this figure is added to your income for your debt-to-income ratio. The higher your monthly income, the higher the mortgage amount you can afford. In this case, the rental property improves your ability to qualify for the mortgage on your primary residence.
If the property produces negative monthly cash flow or a net loss, the figure is added to your debt for your debt-to-income ratio. The higher your monthly debt payments, the lower the mortgage amount you can afford. In this scenario, the rental property makes it more challenging for you to qualify for the mortgage.
Use ourMORTGAGE QUALIFICATION CALCULATORto determine the loan you can afford
If the rental property is cash flow breakeven according to the lender’s calculations, then it should not affect your debt-to-income ratio or the mortgage you qualify for.
The example below illustrates how rental property income or loss affects your debt-to-income ratio when you apply for a mortgage. In the first case, the rental property is cash flow positive and in the second case the property generates a loss. This example assumes a 30 year fixed rate mortgage with a 4.000% interest rate.
Rental Property Income Mortgage Qualification Example
Applicant Assumptions
Monthly Gross Income: $5,000
Monthly Debt Expenses: $1,000
Case 1: Rental Property Produces $1,000 in Monthly Cash Flow
Total Monthly Gross Income: $6,000 ($5,000 in personal income + $1,000 in rental property income)
Monthly Debt Expenses: $1,000
Mortgage Applicant Can Afford: $330,000
Case 2: Rental Property Loses $1,000 Per Month
Total Monthly Gross Income: $5,000
Monthly Debt Expenses: $2,000 ($1,000 in personal expenses + $1,000 rental property loss)
Mortgage Applicant Can Afford: $83,000
The example above demonstrates how negative cash flow from a rental property makes it significantly more challenging to qualify for another mortgage or reduces the loan you can afford. On the other hand, a property that produces positive cash flow helps your application.
Please note that the guidelines above explain how rental property income is treated when you apply for a mortgage on your primary residence. For example, if you own an investment property and want to include rental income from that property to qualify for a loan to buy a home that you live in.
The guidelines are different for rental income attributable to your primary residence -- for example, if you occupy one unit in a multi-unit property and rent out the other units. In this case, the gross rental income is added to your personal income and the total monthly housing expense for the property is included in your monthly debt expense to calculate your debt-to-income ratio.
The table below shows mortgage terms for leading lenders near you. We recommend that you contact multiple lenders to confirm the mortgage you qualify for including rental property income.
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Please note that certain guidelines apply if you are buying or refinancing a multi-family primary residence or an investment property with up to four units. In this scenario, if you currently own or rent your primary residence and have at least a year of experience receiving rental income or managing properties, there is no limit to the rental property income that you can include in your mortgage application.
If you own or rent your primary residence but generated rental income or managed properties for less than a year, then you can only include rental income less than or equal to the total monthly housing expense for property being financed, whether it is your primary residence or a rental property.
If you do not currently own or rent your primary residence, you cannot use rental income from the property being financed to qualify for a mortgage. You may, however, be able to use income from a rental property to qualify for a loan on your primary residence.
Sources
"B3-3.1-08, Calculating Monthly Qualifying Rental Income (or Loss)." Selling Guide: Fannie Mae Single Family. Fannie Mae, February 5 2020. Web.
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