The debt-to-income ratio is an essential concept for any homebuyer, but it’s an even more complicated calculation for real estate investors. Whereas typical homebuyers apply for loans using their personal income and debt, investors must also report the income and expenses of their properties. For lenders, the purpose of requesting the DTI ratio is to verify the buyer’s financial readiness to invest in a property by comparing their income and expenses.
This article breaks down debt-to-income ratios for real estate investors to recognize the benchmarks lenders look for, their calculations, and the strategies any investors can use to improve their DTI ratio to receive better rates and invest in more properties.
What is a Debt-to-Income (DTI) Ratio?
A debt-to-income ratio is a percentage that defines how much of an individual’s gross monthly income goes toward paying off debts each month. The calculation is simple:
Multiplying by 100 results in a percentage, which the lender will compare to industry standards to determine if the borrower is eligible for the loan, the borrowing limit they qualify for, and the interest rates they will be offered.
Before expanding a portfolio with new investment properties, real estate investors should calculate their DTI ratio to view their finances from their lender’s perspective. Unlike single-property homeowners, real estate investors expanding their portfolios will have more complex calculations to consider to calculate their total debts and gross monthly income, including outstanding loans and revenue streams on existing properties.
An accurate DTI ratio calculation helps investors gauge their readiness for new investments without overleveraging. Debt obligations should include individual debts, including credit cards, student loans, car loans, and other mortgages. Gross income should include net rental income from other properties, which is rental income minus expenses such as taxes and insurance.
What is a DTI Cap?
Before issuing a loan and setting an interest rate, lenders use the borrower’s DTI ratio to determine their ability to handle the new loan. A DTI cap is the ratio of debt to income over which the lender could deny the loan application.
To use Fannie Mae as an example, the maximum DTI ratio they accept is 36%, but they can go up to 45% if the borrower meets other criteria, such as a sufficient credit score and reserve (50% if using a Desktop Underwriter). Each lender sets their own DTI cap based on multiple factors, but typical caps sit around 43-50%, meaning the borrower’s total monthly debt payments should not exceed that percentage of their income.
The lender’s type (conventional, private, commercial, etc.) can impact their DTI cap. For real estate investors, the loan-to-value (LTV) ratio works with the DTI ratio to measure the lender’s risk. The LTV ratio compares the risk of the loan to the property’s value, with lower ratios representing a lower risk for the lender.
How to Improve DTI Ratio for Investors
Since the DTI ratio is a simple calculation, real estate investors can enact simple changes to their portfolio to shift the percentage and secure better loan terms. There are five main ways to improve a DTI ratio, based on the factors used to calculate it:
1. Reduce Monthly Debt Obligations
This is one of the primary ways an investor can improve their ratio. As monthly debt obligations decrease while maintaining the same monthly income, the percentage will decrease. High-interest debts should be paid off first to make the most impactful change.
2. Increase Monthly Income
For rental property investors, adding rental income or another income stream can improve the DTI ratio even if the debt remains the same. Reported income can come from multiple sources, including investments, to shift the ratio toward better terms.
3. Optimize Financing
Renegotiating loan terms on new or existing properties can also improve the DTI ratio. Lower interest rates on monthly payments or extended loan terms can reduce the monthly payment obligation.
4. Manage Investment Portfolio
Investors often increase their return on investment by using a mortgage or another loan to purchase a property, but this can also lead to additional payments that shift their DTI ratio. Reducing leverage may delay new acquisitions and prevent additional monthly payments from lowering the buyer’s eligibility.
5. Estimate Costs Accurately
Many investors calculate their DTI ratio using only fixed monthly costs. Underestimating variable expenses such as lost income from vacancies, repair costs, management fees, and more can impact their long-term borrowing capacity, potentially leading to unfavorable loan terms.
Contact an Experienced Lender for Advice on DTI Ratios in Maryland
The debt-to-income ratio is a significant factor in every real estate investor's loan eligibility and terms. Before accepting a lower ROI on a new acquisition, investors should consider these strategies for improving their DTI ratio, from diversifying their income to renegotiating the terms of their new investment.
At Woodsboro Bank, our experienced financial advisors help real estate investors in Maryland understand debt-to-income ratios, how they impact their loan eligibility, and how to optimize the ratio for more favorable terms. Contact our professionals today to learn how the DTI ratio will be calculated in your situation and how simple changes can improve your loan eligibility in Maryland.