Part 2 of 4 - Rental Income and Mortgage Qualification
In Part 1, we talked about why rental income isn’t automatically treated like income when you’re qualifying for a mortgage. Just because a tenant hands you $2,500 every month doesn’t mean the lender can simply add $2,500 to your income.
Now let’s get to the question borrowers and Realtors really want answered: When can rental income actually help you qualify?
This is where the situation matters.
You might already own an investment property. You might be moving out of your current home and turning it into a rental. You might be buying a duplex and renting the other unit. Or you might have just purchased a property that you’re planning to put into service as a rental.
Those situations may all involve rental income, but they don’t necessarily follow the same underwriting rules.
You Already Own a Rental Property
Let’s start with the most straightforward scenario.
You’ve owned an investment property for a while. You have a tenant, you’ve been collecting rent, and the property has an established rental history.
Now you’re ready to buy another home.
This is a situation where rental income may be used to help you qualify. The lender will review the rental property’s history and the documentation required by the applicable mortgage program to determine how to treat the income.
If you’ve rented the property long enough for that activity to appear on your tax returns, those returns may become an important part of the documentation used to determine how the income is treated. The lender isn’t just interested in how much rent your tenant pays. They’re looking at the rental activity under the rules for the loan you’re applying for.
This is also where your history of managing rental property can matter.
It’s important here to explain what “managing rental property” actually means. Managing rental property doesn’t mean that you are a licensed realtor or that you can’t have a property manager. It means that you have an established history of owning and reporting rental income and expenses from an investment property on your tax returns.
Someone who has owned and managed rental property for several years may be treated differently from someone who has just become a landlord. Some mortgage programs may restrict the use of positive rental income when the borrower doesn’t have an established history of managing rental property.
So if you already own a rental, don’t assume the answer is simply, “Yes, I can use the rent.” The better question is, “How will the lender treat the rental income from this property?”
We’ll get into the actual calculation in Part 3. It is different for each agency and loan program.
You’re Moving Out of Your Current Home and Renting It
This is probably one of the most common scenarios I see.
Your primary residence is becoming a rental. You currently live there, and with this new purchase, instead of selling your existing home, you are converting it into an investment property.
Maybe you’ve already found a tenant who will pay $3,000 a month.
Sounds great, right?
Well, this is where things get interesting.
Mortgage guidelines often refer to this as a departing residence, and specific rules apply to documenting and using rental income from that property.
The lender will need documentation of the property’s market rent. A lease may work, if permitted under the applicable program, and a Market Rent Analysis (1007) from a licensed appraiser may also be required. The lender will also need information about the existing mortgage payment, taxes, insurance, HOA (PITIA), and other documentation depending on the loan type and your circumstances.
And here’s something important: having a tenant doesn’t automatically mean the lender will treat that income the same way as income from an established investment property. Also, just because you have a signed lease doesn’t mean the market will support that monthly lease amount. Proof of market rents will come into play. That’s where the Market Rent Analysis (1007) from a licensed appraiser comes into play.
The agencies have different rules for this situation.
For example, VA guidelines allow prospective market-supported rental income from a property you’re leaving to offset the mortgage payment on that property under certain circumstances. That doesn’t necessarily mean the rental income gets added to your income.
That distinction matters. Offsetting a debt is different than adding income.
FHA won’t consider departing-residence rental income under this provision unless you’re relocating more than 100 miles from your current principal residence, you have at least 25% equity in the exit property (proven by an appraisal), market rents supported by the same appraisal with Form 1007, proof of a signed lease, and receipt of a security deposit or first month’s rent.
If you’re a borrower, you want to know what the rental income will actually do to your qualification. If you’re a Realtor, you want to know that before you tell your buyer that renting the old house will make the new house affordable.
The rules get more and more specific.
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You Recently Converted a Property Into a Rental
Now let’s make the scenario a little more complicated.
Maybe you bought a property recently and decided to rent it. Or perhaps you’ve owned the property for a while but only recently converted it from your residence to an investment property. This is not a departing residence. It is a property that you’ve owned that is being converted to an investment property.
You may be saying, “Ummm, what’s the difference?” Let me give two examples to help you wrap your mind around this.
Let’s say you own a property and lived there for four years. You moved into your fiancé’s house six months ago, and now you’re both buying a new primary residence together. Now that you’ve made this big decision, you decided to rent out your prior home. This is not a departing residence. You didn’t live there prior to this purchase.
Or maybe you bought a condo for your son/daughter to reside in while attending university. They didn’t pay rent. It was simply more cost-effective than paying for housing at the university. Now that they have graduated, you have decided to rent this condo out on the open market. It’s a new rental because it was never used as an investment property.
The lender now has to determine what documentation is available and what the applicable mortgage guidelines allow.
Has the property been rented long enough to establish a history? Is there a current lease? Has rental income appeared on a tax return yet? When was the property purchased or converted? What does the property actually support in terms of market rent?
These questions matter because mortgage underwriting needs more than a prediction that a property should rent for a certain amount.
This is one of those situations where timing can make a difference.
If the property is brand new to the rental market, the lender may have to rely on different documentation than if you’ve been renting it for several years. The rules also vary depending on whether the property is the one you’re buying, a property you already own, or a former residence you’re converting to a rental.
And this is exactly why I don’t recommend trying to figure this out based on what your neighbor’s lender did.
Your neighbor’s property may have been in a completely different situation.
You’re Buying a Duplex, Triplex, or Fourplex to Live In
Now let’s flip the situation around.
Instead of already owning a rental property, you’re buying a property that will serve as your primary residence and an investment property.
Maybe you’re purchasing a duplex and planning to live in one unit while renting the other. Or you’re buying a three-unit or four-unit property and occupying one of the units as your primary residence.
This is another situation where rental income may help with qualification.
But again, the lender has to determine the property’s eligibility, document the expected rental income, and apply the rules for the particular mortgage program.
This is especially important for Realtors because rental income can be a big part of how a buyer evaluates a multi-unit property.
A duplex might rent for $2,000 a month on the second unit. A buyer may look at that and think, “Great. That’s $2,000 toward my housing payment.”
The lender may not view it quite that simply.
The rental income has to be documented and treated according to the applicable guidelines. There may also be requirements related to the borrower’s rental management experience, depending on the program and the circumstances.
It can get even more complicated if the property is a 3-4 unit property; you will occupy one unit, rent out the other 2-3 units, and you want to utilize an FHA loan. There is a requirement that the property be self-sustaining. That means that, even if you qualify for the mortgage without rental income, the property must be able to be rented out, have the applicable vacancy factor applied to market rents, and cover the PITIA in full. Simply stated, self-sustaining assumes all other income disappears, and the property expenses can still be covered by the “adjusted” rental income.
And then there is the question we are deliberately saving for Part 3: How much of that $2,000 actually becomes qualifying rental income?
That’s where the math comes in.
You’re Buying an Investment Property
What if you’re buying a property that you won’t live in at all?
Now we’re talking about a true investment property.
You may already own your primary residence and be purchasing another property specifically to rent to someone else. This is a very common scenario, as many people utilize real estate as an investment strategy for their future.
Rental income can potentially be used in the qualification process, but the lender needs to establish that the property and the proposed rental income meet the applicable requirements.
In this situation, you would be utilizing a Conventional mortgage agency product, like Fannie Mae or Freddie Mac. You could be using a completely different portfolio product or Non-QM loan, but we are not talking about those here. So think agency like Fannie or Freddie (we’re on a first-name basis at this point in my career).
This is another situation where the property’s expected rent and the lender’s qualifying rental income calculation aren’t necessarily the same.
A Realtor might pull comparable rentals and determine that a property should rent for $3,500 a month. That’s valuable information for the buyer when evaluating the investment.
But the lender has a separate question to answer:
What amount of that rental income can be used under the mortgage guidelines?
Those are two different questions.
The first is about the rental market.
The second is about mortgage qualification.
Both matter, but they aren’t interchangeable.
What If You Don’t Have a History of Managing Rental Property?
This is where first-time landlords sometimes get caught off guard.
You don’t necessarily need to be a professional landlord with a portfolio of properties for rental income to be considered. But mortgage agencies may have different requirements for borrowers without an established history of managing rental property.
In some circumstances, a borrower without the required rental management experience may be able to use rental income only to offset the property’s housing expense rather than having positive rental income added to their qualifying income.
That distinction is important enough that I want to repeat it without getting into the math yet.
Rental income can sometimes help you qualify without actually increasing your qualifying income.
Instead, it may reduce or offset the impact of the property’s PITIA.
That’s one of those mortgage concepts that sounds like a technicality until you’re sitting at the maximum debt-to-income ratio and every dollar matters.
Why Rental Income Matters Before You Write an Offer
This is where I want to put on my Realtor hat for a minute.
If you’re working with a buyer who plans to use rental income to help qualify, you need to have this conversation before the buyer falls in love with the property.
Don’t just ask, “What will it rent for?”
Ask the lender how that rental income is likely to be treated for qualification.
That doesn’t mean you need to know the FHA, VA, Fannie Mae, and Freddie Mac guidelines yourself. Please don’t make me turn you into an underwriter.
It means recognizing that rental income or loss can be an important part of the financing conversation and getting the lender involved early enough to evaluate it is critical.
The same advice applies to borrowers.
If you’re keeping your current home as a rental, buying a multi-unit property, purchasing an investment property, or recently converting a property to a rental, tell your lender.
Don’t wait until underwriting discovers it in the middle of the loan.
The more information the lender has at the beginning, the better.
Next Up: Why Your Rental Income Isn’t Really $2,500
In Part 3, we’re going to do the math.
We’ll look at how lenders take gross rental income and turn it into qualifying rental income, why you may hear people talk about using 75% of the rent, and what happens when the property’s mortgage payment and other expenses enter the calculation.
We’ll use actual numbers because this makes a whole lot more sense when you can see it on paper.
Because $2,500 in rent is still $2,500 in rent.
The question is what the mortgage guidelines allow the lender to do with it.
