How Lenders Calculate Debt Ratios On Rental Properties - MoneySense

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Mortgages

By Romana King on April 29, 2015 Estimated reading time: 2 minutes

How lenders calculate debt ratios on rental properties

By Romana King on April 29, 2015 Estimated reading time: 2 minutes

Not all your rental income is used to lower your debt service ratios

This article is 1 year old. Some details may be outdated.

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In a previous post I talked about the basics of mortgage debt ratios—the calculations lenders use to determine if you qualify for a mortgage. This prompted this reader question:

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Q: If I own a rental property, which debt ratio does that get included in? GDS or TDS or both? In other words, which debt ratio do you add the rental property mortgage payment, rental income, taxes and heat to?

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—Bob

A: Good question. While the short answer is TDS (the total debt service ratio), the mechanics of how a rental property is assessed when applying for a mortgage are important. As such, I thought it would be a good idea to provide a brief explanation of how lenders use rental property income and expenses when you apply for a mortgage.

In general, lenders will apply two calculations when examining a rental property:

Debt Service Coverage ratio

This is calculated by dividing the Net Operating Income (all rental income minus all reasonable operating expenses) by the Debt Service (cash required during a specified time period to cover the payment of interest and principal on a debt). For example, if your property’s rental income is $2,000 each month and it costs you $500 in expenses along with a $1,200 monthly mortgage payment, then your DSCR would equal 1.25 ($2,000 – $500 / $1,200).

Most lenders want to see a minimum 1.1% return on a rental property—so for every dollar you spend on the rental property, you earn at least $1.10 in income.

Rental offset rules

The lender will use 50% to 70% of the rental income to offset the principle, interest and tax mortgage payments (PIT) you make on the property. So if your property earns you $2,000 per month, the lender will only account for $1,000 to $1,400 in income to offset the PIT payment. To see how this works, let’s assume PIT payments equal $1,425. Since you earn $2,000 in income, and the lender uses a 70% rental offset rule, you deduct $1,400 from the $1,425 PIT payment. The remaining $25 shortfall will be added to your debt—thereby increasing the debt portion of your total debt service ratio.

Unfortunately, though, there is no standard. Some lenders use debt service coverage ratio while others use rental offset rules. The best approach is to talk to a mortgage professional to determine your best options.

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  1. We are looking at buying a home with a rental suite. How do we calculate what we will be able to afford?

    Reply

    1. Hi DS, thanks for the question.

      Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.

      Reply

  2. The rental off set used by banks is absurd. TD for example uses 50%. Their thinking is that my units are going to be sitting vacant not collecting rent half the time!

    I have been a landlord for 20 years and own five units. In that period the total time the units sat empty not collecting rent is less than one percent of the time.

    In other words, a rental offset of 99% would have been appropriate. Dump the big banks and go to a credit union like Vancity who uses a 90% rental offset.

    Reply

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