Tuesday, March 18, 2014

Debt to Income for Real Estate Investors

This will be a 7 part blog post that highlights important aspects that residential real estate investors need to know to plan for growth.  Please subscribe to stay updated on each portion as they are released.   

Documented Rental Income
Taxes and Tax Deductions
Cash reserves
Fannie Mae Guidelines and portfolio loans

Debt to Income
As independent contractors, real estate investors walk the difficult line between claiming income that they make and taking tax write offs that may limit their ability to get loans due to their Debt-to-Income ratio (DTI) not being low enough.  I work with a lot of investors whose biggest obstacle is their DTI ratio; I felt it necessary to help clear up questions investors might have. 

A Short History
When proposed, the Dodd Frank Act required lenders to have a standard for their loans that they originate.  This is called a “Qualified Residential Mortgage” or QRM. This definition was so constricting (back-end DTI maximum of 36%) that there was a lot of protest from real estate agents and lenders alike to broaden this definition.(cited www.sec.gov)  The push prompted the Dodd frank to be amended to say that a QRM will be defined as a QM, or Qualified Mortgage.  The Consumer Financial Protection Bureau is the bureau that defines a QM and that definition is subject to change.  Currently it is defined as one where there is a maximum DTI of 43% by the borrower.  FHA guidelines also requiring borrowers to have a maximum debt to income ratio of 43%. So that is the number that you want to shoot for. 

How is Debt defined in DTI?
There are two types of DTI.  Front End and Back End.  When applying for a mortgage, creditors look at Back End DTI so that is what we will cover. 
If you were to pull your credit right now, add up every minimum reoccurring payment that would show up on your credit report.  If you have a credit card debt of $20,000 but your minimum payment is $35…then you would add $35 to the total amount.  If you own your home, remember to add all property taxes, insurance, and home owner association dues.  If you’re renting, make sure to add in your rent for your place of residence. (Yes they will ask to see your lease)
***If your spouse or parent pays your rent or mortgage, AND you can provide a 12 month documented history of it, then you can negate that payment. If you can only provide 11 months of documentation of them paying that debt for you…then that cost will be calculated in your ratio.

When configuring your Debt in DTI, you should also take into consideration the minimum payment for any potential new loans you will soon incur. i.e. the PITI payment you are applying for.
***Note that if you have claimed to be a real estate investor for 2 years on your tax returns, you can also consider 75% of the potential income that you will receive for your rental property you plan to purchase.

How is Income defined in Debt to income?
This is your adjusted GROSS MONTHLY Income.  You can add back in depreciation on real estate owned.  Unless you own a ton of houses, I would recommend that you pretend that you can’t add in depreciation and keep that as a buffer when deciphering income. You never know if/when they will change the requirements. 
***If you are an independent contractor and get paid on a 1099, add up two years of claimed income on your tax returns, line 31 of your 1040, and divide by 24 months.   If you are a W2 employee you would calculate two years of line 21 of your 1040 then divide that number by 24.

I have created a simple spreadsheet that can help you calculate it your debt-to-income.  If you would like a free copy of it, or are interested in purchasing investment real estate and you are looking for Hard Money starting at 7.99% and 3pts or a new 100% FREE source of property, please click here and someone will contact you.  

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