Part 3 of 4 - Rental Income and Mortgage Qualification
In Part 1, we talked about why rental income isn’t automatically qualifying income when you’re applying for a mortgage. In Part 2, we looked at the different situations where rental income might help you qualify, whether you already own an investment property, are moving out of your current home and renting it, or are buying a property with additional rental units.
Now it’s time to get into the math, because this is where the difference between the rent you collect and the income a lender can actually use becomes much clearer.
Let’s say you own a rental property and your tenant pays you $2,500 every month. That’s $30,000 a year in rent, and you might reasonably think that money should count toward your income when you’re applying for another mortgage. After all, it’s money coming into your household every month. But mortgage qualification doesn’t work quite that way. The lender must calculate rental income according to the guidelines for the loan you’re applying for, and the qualifying amount may differ significantly from what your tenant pays.
Your Gross Rent Is Just the Starting Point
When a lender looks at rental income, one of the first things to understand is the difference between gross rent and qualifying rental income. Gross rent is the amount your tenant pays before you consider expenses and adjustments. Qualifying rental income is the amount the lender can use under the applicable mortgage guidelines.
That distinction matters because owning a rental property comes with costs that don’t necessarily show up in the monthly rent figure. You may have periods when the property is vacant, need to make repairs, replace appliances, or pay for routine maintenance. Even with a reliable tenant and a property in good condition, mortgage agencies recognize that gross rent doesn’t always reflect the income available to the owner.
In many situations where the lender is using a lease or appraiser-supported market rent, you’ll hear about using 75% of the gross rental income. The remaining 25% is intended to account for the expenses and risks associated with maintaining a rental property. Rather than calculating every operating expense individually, the applicable guidelines allow the lender to use a percentage of gross rent as the starting point for the qualification calculation.
Let’s see what that looks like with our $2,500 rental.
Rental income calculation
Monthly amount
Gross monthly rent $2,500
25% reduction -$625
Rental income after the reduction $1,875
Instead of starting with $2,500, we’re now working with $1,875. That’s $625 less per month, or $7,500 over a year.
Before you assume that 75% is the magic number for every rental property, though, there is something else to understand. This calculation is common in several rental-income scenarios, but it doesn’t apply the same way to every loan program or property situation. When a borrower has an established rental history reported on tax returns, the lender may use the documented rental activity and make adjustments according to the applicable guidelines. We’ll look at that in more detail later in this article.
For now, the important thing to understand is that the rent your tenant pays is only the beginning of the calculation. The lender still has to determine how to treat that income in relation to the property’s housing expense.
Mortgage Lending Explained is a reader-supported publication. To receive new posts and support my work, consider becoming a free or paid subscriber.
What Happens When We Add the Mortgage Payment?
Let’s use the same example, with $2,500 in monthly rent and $1,875 remaining after the 25% reduction. Now we need to consider the housing expense associated with the rental property, because the lender isn’t looking at the rent in isolation.
For mortgage qualification, the housing expense generally includes principal and interest, property taxes, homeowners insurance, and any applicable HOA dues or other required housing costs. You’ll often hear this referred to as PITIA, which is simply a shorthand way of describing the property’s total monthly housing expense.
Suppose the monthly housing expense on our rental property is $1,800. Here’s how the calculation would look using the 75% method.
Calculation
Monthly amount
Gross rent $2,500
Rent after 25% reduction $1,875
Property housing expense -$1,800
Difference +$75
We started with $2,500 in monthly rent, but after applying the rental-income calculation and accounting for the housing expense, the difference is only $75 a month. That’s quite a change from the number the borrower may have had in mind when looking at the rental income.
What happens to that $75 depends on the mortgage program and the borrower’s circumstances. In some situations, positive net rental income can be added to qualifying income. In others, the rental income may only be used to offset the property’s housing expense. These are two different treatments, and understanding the distinction matters when you’re trying to determine whether a rental property will help you qualify for another mortgage.
When Rental Income Can Increase Your Qualifying Income
Let’s change our example slightly. The property still rents for $2,500 a month, and the lender still uses 75% of the gross rent, leaving $1,875. This time, however, the property’s monthly housing expense is $1,500 rather than $1,800.
Calculation
Monthly amount
Gross rent $2,500
Rent after 25% reduction $1,875
Property housing expense -$1,500
Difference +$375
In this example, the calculation leaves us with $375 a month in positive net rental income. Depending on the applicable guidelines, the lender may be able to use that amount to increase the income considered when qualifying the borrower for a mortgage.
You can see how the numbers can make a difference. A rental property with a lower housing expense relative to its rent may produce positive net rental income, while a property with a higher housing expense may produce very little or none at all. For someone who owns several rental properties, those amounts can add up, but the lender still has to determine whether the borrower is eligible to use the positive net income under the rules for that particular loan.
This is also where rental management history can become important. As we discussed in Part 2, some mortgage programs distinguish between borrowers who have an established history of owning and reporting rental properties and those who are relatively new to being landlords. Depending on the program and situation, a borrower without the required experience may be allowed to use rental income only to offset the property’s housing expense, rather than adding the positive difference to qualifying income.
In other words, having a rental property that produces positive income doesn’t automatically mean that the lender can add that income to your paycheck for qualification purposes. Both the calculation and the rules governing how you can use the result matter.
What If the Rent Doesn’t Cover the Housing Expense?
Of course, not every rental property produces enough income to cover its housing expense under the mortgage qualification calculation. Let’s go back to our original $2,500 rental and assume the monthly housing expense is $2,200.
Calculation
Monthly amount
Gross rent $2,500
Rent after 25% reduction $1,875
Property housing expense -$2,200
Difference -$325
Although the tenant is paying $2,500 every month, the calculation now shows a shortfall of $325. That’s because the lender isn’t comparing the gross rent directly with the mortgage payment. The lender uses the rental income amount permitted under the applicable guidelines and then determines how that amount relates to the property’s housing expense.
For qualification purposes, a negative rental-income calculation may have to be counted as an additional monthly obligation. That can increase the borrower’s debt-to-income ratio and make it more difficult to qualify for another mortgage. The exact treatment depends on the property and the mortgage program, but the key point is that rental income isn’t automatically a benefit just because money comes in every month.
I want borrowers to understand this before they decide to keep a home as a rental or buy an investment property. A property can generate thousands of dollars in monthly rent and still negatively affect mortgage qualification once the lender completes the applicable calculation. The lender needs to look at the entire financial picture, not just the amount shown on the lease.
What Changes When You Have an Established Rental History?
So far, we’ve been using a calculation based on gross rent and a 25% reduction. But what happens when you’ve owned a rental property for several years, collected rent, paid the expenses, and reported the rental activity on your federal income tax returns?
In that situation, the lender may use your tax returns to evaluate the rental income rather than simply applying the 75% method to the current rent. Schedule E, which is part of your federal income tax return, reports rental real estate income and expenses. It provides information about the property’s reported financial performance, and that history may matter when determining the income available for mortgage qualification.
However, the bottom-line figure on Schedule E isn’t necessarily the amount the lender will use. The applicable guidelines may permit certain expenses to be added back or require other adjustments to the reported rental activity. Depreciation is one example of an expense you may add back because it is a noncash expense. Other adjustments depend on the loan program and the circumstances surrounding the rental property.
The lender may also need to review more than one year of tax returns and calculate an average, depending on the applicable requirements. The goal is to determine a qualifying amount based on the documentation and the loan rules, rather than simply taking the current monthly rent at face value.
This is why two borrowers who each collect $2,500 a month in rent can end up with different qualifying rental income. One borrower may have a newly rented property supported by a lease and market-rent documentation, while the other may have several years of rental activity reported on tax returns. Although the gross rent is the same, the documentation and required calculation may differ.
And remember, an established rental history doesn’t mean that every dollar of rent will count. The lender still has to evaluate the rental income and the property’s housing expense under the applicable mortgage guidelines.
What About the Home You’re Moving Out Of?
Converting a property from your primary residence to a rental is another situation where you need to be careful about how the income will be treated. Let’s say you’re buying a new home and plan to rent out the one you’re leaving. You expect to collect $3,000 a month, and you’re counting on that rent to help you qualify for the new mortgage.
It may seem reasonable to subtract the old home’s mortgage payment from the expected rent and use the difference as additional income. Unfortunately, the calculation may not work that way. A departing residence may have specific requirements for documenting market rent and determining how you can use the rental income. Depending on the mortgage program, you may be able to use positive rental income to offset the existing property’s housing expense without adding it to your qualifying income.
The requirements can also differ based on your rental history, the documentation available, and the loan program you’re using. A signed lease, for example, doesn’t necessarily establish the rental income amount the lender can use, and some programs have specific requirements for market-rent documentation.
This is why I recommend talking with your lender before you make an offer on your next home if you plan to keep your current property and rent it out. The lender needs to determine how the departing residence will be treated and what documentation is required, so you can decide based on the qualifying numbers rather than an estimate of what you expect to collect.
Why the 75% Calculation Doesn’t Tell the Whole Story
By now, you can see why the $2,500 example is useful, but also why it doesn’t answer every question about rental income. The 75% calculation is common in several situations, yet it is only one part of the process. Property type, the borrower’s rental history, available documentation, and the mortgage program all affect how the lender evaluates income.
An established investment property may be treated differently from a home you’re converting to a rental or a duplex you’re buying as your primary residence. The lender may use tax returns, a current lease, appraiser-supported market rent, or other documentation permitted by the applicable guidelines. Even when two properties have similar rents and housing expenses, the resulting qualifying income may differ because the rules for those situations aren’t necessarily the same.
FHA, VA, Fannie Mae, and Freddie Mac each have their own requirements, and the details aren’t interchangeable. Mortgage guidelines also change, so a calculation you saw in an older article or used on a previous mortgage may not automatically apply to the loan you’re applying for today. The lender has to evaluate your property and circumstances under the guidelines that apply to your current loan.
That’s why I don’t want you to leave this article thinking you can always take your gross rent, multiply it by 75%, and subtract the mortgage payment. That may be a useful starting point for understanding some rental-income calculations, but it isn’t a substitute for determining which rules apply to your situation.
Before You Count on Rental Income
If you’re planning to buy a home and need rental income to help you qualify, bring it up with your lender early in the process. Explain which properties you own, whether you’re converting your current home to a rental, and whether the property you’re purchasing will have rental units. The lender can then determine what documentation is needed and how the income or loss is likely to be treated.
Realtors, this is a conversation worth having with your buyers before they fall in love with a property. You don’t need to know how to calculate rental income yourself, and please don’t make me turn you into an underwriter. But recognizing that a property’s rent may differ from the qualifying income a lender can use can help prevent surprises when the loan is reviewed.
For borrowers, the same advice applies. Don’t assume the rent will increase your qualifying income, and don’t assume a property that produces a monthly loss will automatically make you ineligible. Have the lender run the calculation using the appropriate guidelines before you decide based on what you expect the rental property to contribute.
Next Up in the Rental Income Series
We’ve now looked at situations where rental income may help you qualify and how lenders calculate the amount you can use. In Part 4, we’ll compare FHA, VA, Fannie Mae, and Freddie Mac, looking at where their rental-income requirements are similar, where they differ, and why the same property may be treated differently depending on the mortgage program.
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.
