Too much debt can prevent you from obtaining financing on your rental property and ultimately lead to financial hardship. By tallying up your monthly debt payments and dividing by your total monthly income, you can determine where you stand. This is known as your debt-to-income ratio. The higher the ratio, the riskier your financial position.
The main component of your income when it comes to a rental investment is the actual rental income. Even if you have a solid alternate source of income, lenders still get cold feet financing a property that doesn't generate revenue -- the theory being that if your other income dries up, the bank is left financing a dud of a property with no earning potential. Divide your yearly rental income by 12 to obtain the monthly figure. For example, you receive $1,500 per month in rent.
Since rental income is secondary for many borrowers, you want to take into account all cash inflows. While the bank doesn't want to finance a property that doesn't make money, it also wants a cushion in case your tenant ever decides to hit the road. Like your rental property, divide your yearly gross income by 12 to get your gross monthly income. For example, you make $5,500 per month. This figure, plus your monthly rental income, gives you a total income of $7,000 per month.
Strong income doesn't mean a thing if you have an equal amount of debt. Tally up all of your monthly payments on home loans, auto loans, lines of credit and credit cards. The best way to gather this information is by obtaining a copy of your credit report. You are entitled to one free copy per year from the government's Annual Credit Report website. Since the bank will use your credit report to calculate your debt, it's wise for you to do the same. Get a copy and add up all your monthly payments. For example, your monthly debt runs $2,500.
Interpreting the Numbers
Divide your total monthly debt by your total monthly income. Using the example above -- $2,500 in debt divided by $7,000 in income -- you have a debt-to-income ratio of 35 percent. This means 35 percent of your income is tied up in paying debt. This is a decent number. Typically, anything higher than 40 percent debt-to-income is cause for concern. While banks will certainly lend to riskier clients, they will be subject to higher interest rates and fees.
- Understanding Debt Management Ratios
- Debt-Load Ratio
- The Percentage of a Mortgage to a Paycheck
- How to Calculate Positive Cash Flow on a Real Estate Investment
- What Is Included in the Debt-to-Income Ratio When Doing Home Mortgages?
- Does Debt to Income Affect Credit Card Approvals?
- What Is Unmanageable Debt?
- How to Calculate Total Debt Ratio