|Rental properties can hurt mortgage chances
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 percent of the rents generated. However, if there is a history of rental losses, those losses may limit borrowing power. The following are 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.
• How the math pencils out: For each rental property, it’s not as simple as using gross income to offset a mortgage payment (comprised of lender payment plus taxes plus insurance). The other factors that come into play include 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 is gross rents plus taxes plus mortgage interest plus insurance plus depreciation plus HOA (homeowner’s association if applicable) minus total expenses divided by 12, which equals net gain or loss.
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 $10,000 per 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 $10,000 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 percent. Assuming taxes and insurance are $600 per month, principal and interest payment, is $2246.78 per month, so total payment is $2,846.
• Borrower A: $10,000 monthly income times .45 percent 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. With $4,500 per month and a $500 car payment, this makes for a $4,000 mortgage payment, so this person would easily qualify for the $2,846 or mortgage payment. This represents a healthy debt ratio of 33 percent.
• Borrower B: $10,000 monthly income times .45 percent equals $4,500 less than $500 car payment is $4,000 in total liabilities this consumer can take. $4,000, less $2,000 in rental losses, less $2,846 per month as the target mortgage payment, leaving the borrower negative $846 per month, resulting in a 53 percent debt to ratio to income, causing a would-be lender to deny such transaction or reduce the loan amount.
Rental property finance tips
• 75 percent 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.
• 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.
Scott Sheldon is a local mortgage lender, with over six years of experience helping people purchase and refinance primary residences, second homes and investment properties. Visit him at www.sonomacountymortgages.com.