Do you own rental property? If yes, and you're looking to borrow money with a new mortgage, your gain or loss identified by your tax returns may help or hinder your chances of procuring favorable credit. Lenders can use up to 75% of the rents generated, however, if there is a history of rental losses, those losses may limit borrowing power. What to pay attention to if you have a mortgaged rental property…
Know Your Schedule E
The schedule E of your Form 1040 is the area of your personal income tax return where you report rental property. If at the end of the calendar year, you have a net loss on your tax return, you could face a tough time qualifying for a mortgage because the loss is counted as a liability much like a minimum payment is on a car loan, credit card or other consumer debt.
Lenders will usually average a two year history for each rental property owned. An averaged gain or loss from the Schedule E will determine if you cut the mustard for qualifying.
How The Math Pencils
For each rental property, not as simple as using gross income to offset a mortgage payment (comprised of lender payment + taxes +insurance). The other factors that come into play include for carrying rental property maintenance expenses as well as depreciation, which by the way is required on rental properties. This is especially important if a previous home was a primary residence and has been converted into a rental property. The depreciation schedule will specifically delineate at what point in time the property became a rental which is crucial for the lender to consider income generated.
Here is the special formula lenders use to determine if your rental property is a liability against your income
Using the annualized figures from the Schedule E:
The Calculation →gross rents + taxes+ plus mortgage interest + insurance+ depreciation+ HOA (homeowner's association if applicable) -total expenses divided by 12 = net gain or loss
Knowing the lender into turning how you qualify will look at the most recent last 24 months, this formula will be performed for each rental property you have whether or not there is a mortgage on that particular property.
*Mortgage Tip: if any rental property is free and clear of any mortgages, there is almost always a gain -resulting in more useable income for the loan.
The debt to income ratio is an anchor component in the making of a favorable credit disposition, i.e. a loan approval. Essentially, the debt to income is the amount of your gross monthly income that goes to a total mortgage payment including taxes and insurance plus any minimum payment obligations you may have on other debts like credit cards, car loans, personal loans, student loans, child support among others. The larger percentage of liabilities against your income the less borrowing ability you have as a mortgage applicant.
Consider this scenario, Borrower A with $10kper month in income, with a 500 per month car payment and two rental properties showing equal breakeven.
Consider the same scenario with Borrower B having $10k per month loss per property per year.
Each borrower is trying to qualify for a 450,000 mortgage assuming a 30 year fixed rate at 4.375%. Assuming taxes and insurance are $600 per month, principal and interest payment, is $2246.78 per month, so total payment is $2,846.
$10,000 monthly income x .45% as debt ratio (common ratio number lenders use to qualify borrowers) equals $4,500 per month, the maximum threshold for the total liability payments in relationship to the income. $4,500 – $500 car payment is a $4k mortgage payment, this person would easily qualify for the $2,846 or mortgage payment. This represents a healthy debt ratio of 33%.
$10,000 monthly income x .45% equals $4,500 less than $500 car payment is a $4k in total liabilities this consumer can take. $4k, less $2k in rental losses, less $2,846 per month as the target mortgage payment, leaving the borrower negative $846 per month, resulting in a 53% debt to ratio to income, causing a would be lender to deny such transaction or reduce the loan amount.
Rental Property Finance Tips
- 75% of gross rents are used for income calculating as lender must account for vacancies
- More than four financed properties? Some lenders may not allow, others may charge a pricing premium to go up to 10 finance properties
- The rule of averaging the rents, is reduced if one of the rentals is the subject property being refinanced for payment reduction
- Lender will require a copy of the lease agreement for each rental
- If there is a new rental agreement in place with higher rent than what the tax returns support, lender will use the tax returns for rental income as that is the only sufficient supporting documentation for income history.
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