The debt-to-income ratio is a significant determinant for lenders in the mortgage qualification process, it is one of the more meaningful measures of leverage in the real estate industry, and it represents one the top advantages of owning single-family rentals.

This blog post will help you understand what exactly this ratio measures, how to do the calculation, and what an acceptable range looks like. Additionally, and perhaps most importantly, this post will explain how you can use the debt-to-income ratio - leverage - to your advantage as a real estate investor.

Broadly, the debt-to-income ratio is a comparison of total monthly debt payments, and your gross monthly income from all sources.

(your monthly debt obligation)

÷

(your monthly: salary + cash-flow from real estate and all other investments)

As mentioned earlier, this number tells lenders how leveraged you are. And, although lenders do not want this number to be too high, leverage is a wonderful thing if used strategically.

Essentially, financial leverage is the use of borrowed money to purchase assets. In the case of real estate, this is expressed when you can take out a mortgage and pay only a percentage of the home’s value upfront in the form of a down payment. This means you can purchase multiple investment homes for the price of one. At 20% down, you could theoretically buy five homes for the price of one, giving you five sources of cash-flow (as well as appreciation from all five homes), and you can write off the expenses – depreciation, mortgage interest, etc. – from all five homes. 

You would also be more diversified. Yes, you would be more leveraged, but diversification spreads out your risk in the sense that you are not reliant on the cash-flow from a single home.

Here’s a real-life example that demonstrates the power of leverage. Let’s say Joanne (Joe) purchases…

$100,000 of gold = $100,000 value

$100,000 of shares on margin = $200,000 value

$100,000 of investment homes (five $20,000 down payments at 20% down) = $500,000 value

And that does not include the monthly cash flow you receive from the five homes, which will be used to pay down the mortgages while the homes appreciate.

Importance in the mortgage process

As mentioned earlier, debt-to-income is a key ratio used by lenders when financing a home. Lenders want to know how leveraged you are before they sign off on a mortgage.

Typically, they look for a debt-to-income ratio below 43-45%.

With that said, common questions we get asked are: should I (or can I) buy multiple homes if I currently have debt obligations? Wouldn’t more debt negatively impact my debt-to-income ratio? Will investment homes impact my ability to purchase my own personal residence?

The answer lies in the nature of the debt.

Financing a car will increase your debt and it does not provide any income. This will negatively affect your debt-to-income ratio. However, continuing with our example above; five rental homes will increase your debt, but will also give you five sources of cash-flow – all of which will be used to pay down your mortgage expenses. In fact, all of our homes here at Doorvest have positive cash flow, which will increase your monthly income and positively impact your debt-to-income ratio.

Deciding on your degree of leverage is not a trivial matter. Everyone’s situation is different, and you should take into consideration all aspects of your particular circumstances when making an investment decision.

Leverage is a powerful tool. Used strategically, it can help you reach your investment goals.