How to Screen a Tenant: Debt Service to Income Ratios

When we were buying properties one thing  which we realized quickly was very important to lenders and mortgage brokers which was our ratio of debt payments to income. It makes sense, of course; if you’re making $100,000 a year but  have $90,000 of mortgage payments, car payments, minimum credit card payments, etc. a year, you’re going to be in trouble. The magic number we were told by most brokers was 40%; meaning if your debt obligations (payments) were more than 40% of your income – when figuring in the new mortgage payment as part of the equation – that the loan was going to be a no go. These days the magic number is probably lower just because of the aftermath of the mortgage crisis the banks created (and we all continue to pay for), and the tighter lending guidelines.

The principal is the same for renting; there is a line somewhere above which it’s very unlikely the tenant is going to be able to pay the rent; they just don’t have enough to live on. For most, rent and car payments are their primary payments, but we also include child support obligations and other debt payments; any money that is basically guaranteed to be unavailable to the tenant to pay rent. We’ve found that a 40% debt service to income ratio still seems to be a good rule of thumb in most cases. So, we incorporated that into our application scoring. Above 40% but below 50% we deduct something from their score (and above 50% is a no go no matter their score), below 40% we credit their score. Often a prospect just isn’t thinking clearly about what they can afford, and this formula helps clear things up. We recently had someone who had $700 a month of income apply for a $500-a-month apartment; and they had a car payment of $150. Explaining to them the 40% guideline and how they were at 93% helped them understand a little (though they still initially illogically claimed they could make it on food stamps and a few odd jobs).

There are exceptions, of course; a student where Mom and Dad are backing them is a good example (with Mom and Dad co-signing, for our protection of course). We have tried taking ratios as high as 55% and can tell you it doesn’t work. In the above 40% up to 50% range, we’re going to ask for extra security – either a co-signer like the student example (and we run credit on the co-signer; if the co-signer is no count, their signature adds nothing), or extra deposit. Even with that, the number of problem situations we’ve seen in the 40%-50% range has us continuing to evaluate that.

Debt Service to Income Ratio is one of the quickest ways to see if an applicant is worth a closer look; in a few seconds that percentage can tell us a lot. If you aren’t looking at applicant’s ratios, you should. Take the rent they will be paying you, add any car payments, child support payments, personal loan payments, etc. and divide that total by their verified income. Income you can’t verify shouldn’t be counted – unless you think applicants and tenants never lie (or grossly exaggerate). For example, (using monthly amounts here) rent of $500, car payment of $200 and income of $1500, the math would look like this: ($500+200)/$1500=.46667 (rounding those infinite “6”‘s up as the calculator will do). As you recall from math class, move the decimal two spots to the right to convert to a percentage and you have 46.667%, or rounding to a whole number 47% – a borderline case in our figuring.

 

 

 

Category: Property Management, Tenant Screening

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