In the world of real estate investment strategy, debt to income ratio, or DTI, is a way to compare the amount of debt you have to your overall income.
It is a lender’s way to estimate a potential borrower’s ability to make the monthly payments due on its loan, taking into account the borrower’s income and existing fixed monthly expenses, including debt service. It is generally expressed as a percentage.
Debt to Income Calculation
The DTI ratio calculation is simple, just divide the fixed monthly expenses (rent or mortgage, car payments, student loans, credit card debt, etc) by the borrower’s monthly gross income.
A good DTI ratio in the traditional lending world is considered to be 43%, meaning that your monthly expenses do not exceed 43% of your gross income. In the real estate investing world, that number varies.
Private lenders, like Rehab Financial Group, LP will look at the borrower’s overall income and expenses and review how much “free cash” the borrower has on a monthly basis. The acceptable DTI can vary greatly – generally the higher the income, the higher the DTI can be. It is perhaps easiest to explain it by examples as follows:
DTI Ratio Example A
Borrower A earns $48,000 per year in annual income, meaning $4,000 per month.
His monthly debts, including things like car payments, mortgage or rent, student loans, credit card debt, etc. AND the contemplated rehab loan total $2,800.
His unallocated cash for non-fixed expenses (food, entertainment, taxes, insurance, etc.) is $1,200.
This means his DTI ratio is 70% ($2,800 divided by $4,000).
This DTI is too high for RFG as a lender to feel comfortable with, as the “free cash” per month is only $1,200.
DTI Ratio Example B
Borrower B earns $480,000 per year in annual income, meaning $40,000 per month.
Her monthly debt, including things like car payments, mortgage or rent, student loans, credit card debt, etc. AND the contemplated rehab loan total $28,000.
Her unallocated cash for non-fixed expenses (food, entertainment, taxes, insurance, etc.) is $12,000.
This means her DTI ratio is 70% ($28,000 divided by $40,000).
While her DTI alone is too high for RFG, she has $12,000 per month in “free cash.” This is a DTI that RFG would be comfortable with, as the amount of “free cash” per month is significant.
DTI Ratio and the Real Estate Investment Industry
As a word of caution, however, what is included in the gross income calculation is not necessarily consistent with all lenders. Remember that lenders tend to look at extending loans to borrowers in the most conservative way possible. Many will count only W-2 income (wages paid from a job).
Schedule E income, which is income found on Schedule E of IRS Form 1040, is income earned from rental real estate, partnerships, S corporations and other specific sources. Some lenders will use this income in calculating the DTI ratio, some will disregard it completely, and some will only use it if there is a least a two year history of Schedule E income (this history is often averaged together).
If you are worried about your DTI ratio when applying for a loan, and you have meaningful Schedule E income, you should check with your lender about whether they will use it in determining your DTI and ultimate approvability.
Remember, at RFG we use Schedule E to supplement a borrower’s income in determining approvability.
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