Debt-to-Income for Real Estate Investors

Bonus Module

As a real estate investor, understanding your debt-to-income (DTI) ratio is important for analyzing deals and securing traditional financing for your properties.

While you can always ask your lender to calculate this for you, knowing how it works can give you a significant advantage, especially when you're planning to acquire multiple properties.

So, what is Debt-to-Income (DTI)?

Your DTI ratio is a key metric that lenders use to assess your ability to manage monthly payments and repay debts.

As an aside, it is also one of the ways that we measure risk in your real estate portfolio.

We'll dive deep into the world of DTI ratios. You'll learn how to calculate it, what factors influence it, and most importantly, how to optimize it for your real estate investments.

Whether you're a seasoned investor or just starting out, mastering this concept can make a substantial difference in your ability to secure favorable financing terms and grow your real estate portfolio.

Table of Contents

Included in this module:

• Front-End vs Back-End

• Debt-To-Income Ratio

• What To Include/Exclude in DTI?

• Debt-To-Income Is Not...

• But Wait...

• Income for DTI Rules of Thumb

• Debt-To-Income Ratio from DU’s Evaluation

• Calculating DTI

• Basic Example

• Target Debt-To-Income Ratio

• Grading Debt-To-Income

• Calculating Max Debt

• How Do Rentals Affect DTI?

• Calculating Monthly Qualifying Rental Income (or Loss) from Fannie Mae Website

• Establishing History of Property Management

• Documenting Rental Income from Property Other Than the Subject Property

• Reconciling Partial or No Rental History on Tax Returns

• Qualifying Impact of Other Real Estate Owned

• Method of Calculating the Income

• Lease Agreements or Form 1007 or Form 1025

• Treatment of the Income (or Loss)

• 75% of Gross Rent - PITIA

• Example: 75% of Gross Rent - PITIA

• Maximum DTI Ratios

• Exceptions to the Maximum DTI Ratio

• Monthly Housing Expense

• Calculating Monthly Real Estate Tax Payment

• Calculating Total Monthly Obligation

• Factors Impacting DTI and Possible Solutions

• New DTI Rules of Thumb

Front-End vs Back-End

There are two variations of Debt-To-Income ratios: Front-End DTI and Back-End DTI.

• Front-End Debt-To-Income Ratio - This ratio focuses solely on your housing-related expenses. It includes your monthly mortgage payment (principal and interest), property taxes, homeowners association fees, homeowner's insurance, and monthly private mortgage insurance (often abbreviated as PITIHP).

• Back-End Debt-To-Income Ratio - This ratio is more comprehensive. It includes all your minimum monthly debts, including your housing expenses. This means it covers everything in the Front-End DTI plus other debts like car loans, student loans, credit card minimums, and any other regular monthly obligations.

The main difference? Front-End DTI gives you a snapshot of how much of your income goes towards housing, while Back-End DTI provides a more complete picture of your overall debt obligations.

As a real estate investor, you'll want to pay close attention to both ratios, but most lenders will focus primarily on your Back-End DTI when evaluating your loan application. This is because it gives them a more comprehensive view of your financial commitments.

Debt-To-Income Ratio

Your Debt-To-Income (DTI) ratio is calculated by dividing your total monthly debt payments by your gross monthly income.

DTI = (Total Monthly Debt Payments / Gross Monthly Income) x 100

A lower DTI ratio shows that you have more of your income available after paying debts. Lenders see this as a sign that you can handle new debt responsibly.

With a lower DTI, you’re considered less risky, so lenders are more likely to offer you better loan terms. This can include lower interest rates, lower down payments, or even more flexible loan terms.

Your DTI ratio important because even a small reduction in your interest rate can save you thousands over the life of a loan. Additionally, lower payments make it easier for your property to generate positive cash flow. This is one of the reasons we’re discussing it as part of deal analysis.

A low DTI gives you an advantage when expanding your portfolio, as it shows you can handle the debt from multiple properties. This can be a limitation—especially if you’re acquiring properties with little or no down payments where cash flow can be tighter.

Understanding and improving your DTI can help you avoid this limitation and qualify for loans even in these situations.

What To Include/Exclude in DTI?

When calculating your DTI for real estate investing, you’ll need to understand what should and shouldn't be included.

Here's what you should include in your DTI calculation:

• Monthly Mortgage Payments - This includes payments for your primary residence and—with some important caveats—the investment properties you own. We will talk about how we deal with investment property mortgages in just a bit.

• Escrowed Expenses - Real estate taxes, homeowner's insurance, and private mortgage insurance (if applicable) are typically included.

• Vehicle Loans - Your monthly car payments should be factored into your DTI.

• Student Loans - Even if they're in deferment, lenders often include a percentage of the outstanding balance in your DTI.

• Credit Card Payments - The minimum monthly payment on your credit cards should be included.

• Other Regular Debts - This includes timeshare payments, personal loans, and any co-signed loan payments you're responsible for.

• Child Support and Alimony - If you're required to make these payments, they should be included in your DTI calculation.

Now, let's look at what you should exclude from your DTI calculation:

• Utility Bills - Your regular monthly utilities like water, electricity, gas, and garbage are not included in DTI calculations.

• Insurance Premiums - Car insurance, health insurance, and life insurance premiums are typically not included.

• Discretionary Expenses - Things like cable bills, cell phone bills, groceries, and entertainment expenses are not part of your DTI.

Debt-To-Income Is Not…

When calculating your debt-to-income (DTI) ratio, there are a few common misconceptions about what affects this number.

It helps to understand what does and doesn’t factor into your DTI, especially when preparing for real estate investments.

Here are some key points to keep in mind: