Financing Rental Properties

I was talking to a friend of mine the other day and he brought up something interesting.  He was interested in buying a rental property but he was worried that if he did he would have a hard time buying a home for himself in a couple years (he currently lives in an apartment and wants to stay there - for now).

Its an interesting predicament because he recognizes the incredible opportunity there is right now for investors to own rental properties, however, he doesn't want the banks to hold it against him and not lend to him when he wants to buy a home himself.  As I told him - if its a good deal don't worry about not being able to qualify in the future since, if there is a positive cash flow, the effect will be minimal.

Banks typically lend based on a debt to income ratio.  This debt to income ratio is calculated one of two ways - either by taking your gross earnings for the month - yes, gross earnings before taxes, insurance, 401k, etc and comparing it to your mortgage payment (including principal, insurance and property taxes).  This is a simple and fairly aggressive method of determining how much a person can afford to pay on a mortgage since it uses gross income and it ignores other expenses such as credit card or car payments.

The second method takes into account the mortgage but also adds in the other expenses that a typical family would have, such as credit card payments, car payments, student loan expenses, etc.  That is then divided over gross income to come up with a ratio.

The two debt to income ratios are known as the front end ratio and the back end ratio (respectively) and in general a rule of thumb is that when applying for a mortgage it is assumed that a homeowner could afford a front end ratio of up to .28, or 28% of gross income going to the mortgage and a back end ratio of .36 or 36% of gross income goes to total revolving debt.

So, how is our debt to income ratio affected by the addition of a rental property?  Lets look at some numbers:

Lets say for example our potential rental property investor makes $100,000 per year, which equals $8,333 gross per month, lets also assume that investor were to purchase a house and take out a $200,000 mortgage at 5% interest and amortizes the loan over 30 years (a payback period of 30 years).  The Principal and interest payments would be $1,074 and assuming another $300 in insurance and taxes that would mean that the PITI (Principal, Interest, Taxes & Insurance) would equal $1,374.  Taking the PITI over the gross income of $8,333 equals a very manageable front end ratio of 16.5%.  Adding an assumed $800 in other monthly debt gets us to a back end ratio of 26.1%

All in all, assuming that this investor has a decent credit score - at least above 680 and a down payment of 25% then there shouldn't be any problem getting a loan for the first house.  Now we see the effect of renting out this house and buying a new house.

We will use the same assumptions as above but assume that this house is rented out for $1,500 per month - just barely producing a positive cash flow.  We need to assume some maintenance and will subtract $100 per month for maintenance on the house, leaving this investor with rental income of $1,400.  Next we'll perform a simple calculation to see what is the maximum that this investor could take out on another property and still fall under the .28 and .36 thresholds for front and back end ratios.
As it turns out this investor can take out another $250,000 before hitting the .28 and .36 thresholds.  Assuming that this investor was happy living in a house with a mortgage of $250,000 then there shouldn't be any problem.  Naturally, the investor would have to have the extra down payment and still have a qualifying credit score - at least a 680 in this lending environment.

This is just one scenario and in actuality the investor could certainly, if purchasing wisely, do much better than cash flow $50 per month.  However, for purposes of this example I wanted to show a conservative guess and to show that you can indeed take advantage of the incredible buying opportunities out there and still be able to finance a personal residence.

If interested, I would be happy to send out the spreadsheet that I used to analyze the debt to income ratio for our investor friend.  Leave a comment or follow my blog, make sure to include an email address and I'll send you my custom built spreadsheet free of charge.