In a previous blog, I covered the basics on the GDS (gross debt service) and TDS (Total debt service) ratios.  Rental income is treated differently from your regular gross income earnings. How rental income is calculated varies between lenders and within the last year or so, the lenders’ policies have tighten up.  However, there are still great lenders out there that are more flexible on how rental income is accounted for.  The key is to know  when to reserve the use  of those lenders and what order to use those lenders. That is why mortgage planning with a broker who understands rental mortgage policies is so important.

Lenders look at rental income in several ways.  Bottom line, don’t count on 100% of the rental income being used and expect a buffer beyond just your rent simply covering your basic rental expenses .   Expenses related to property is typical expressed as PITH (principle and interest (ie. your mortgage), property taxes, heat).  Condo fees are also included, where applicable, lenders usually use 50% of condo fee.

The most common sense approach is to add your basic rental expense: PITH (for heat, use $75/m as a rule of thumb) and deduct that from rental income .  You should at least have a positive number, if you want to increase your chances of getting subsequent rental mortgages.  Lenders sometimes use a ‘debt coverage ratio’ or DCR: (rental expense / rental income) .  Keep it above 1.1,  a safer bet is 1.2.  Usually these calculations are done on a spreadsheet provided by the lender with their specific formulas programmed into the sheet, there are some variations between lenders.   If you have a portfolio with some not so stellar DCR’s, those can be neutralized by one of your higher DCR properties.  Many lenders look at the grand total, but some may nitpick and want all properties at some minimum DCR.   With the completed spreadsheet, all the cashflows are added and if positive, the amount is added as an income; if negative, it is added to your liabilities.

There are other rental calculations lenders may  use.    ‘Rental offset’  is a percentage of rental income that is deducted from your debts, then that balance is added to gross income.  Currently lenders are using 50% to 80% range.

Example:
$1000 rent – $500 rental expenses (PITH) = $500; $500 x  80% offset = $400
Do not include the PITH of this property in the TDS.  Offset amount is added to the ‘gross income’
TDS = {PITH + other debt} / {gross income + rental offset amount}  ‘Rental addback’ is when a percentage or your rental income is added to your gross income.  Currently lenders are using about 50% to 80% range. CHMC is using 50%, hence many lenders just follow suit.

Example:
$1000 rent x 80% addback = $800
Include the PITH of this property in the TDS.  Rental income is added to the ‘gross income’
TDS = {PITH + other debt} / {gross income + rental addback amount}

If you do the math, you will see that the ‘offset’ approach is much better and much more flexible than ‘addback’.  It is much harder to qualify with ‘addback’.  To illustrate this further, let us look at this simplified example, using the 80% ratio calculations stated above.

Gross Income = $5000
Other debt = $1500
Rental Income = $1000
Rental expenses (PITH) = $500
Other PITH = $0  (assume no other properties)

Offset:
TDS = {PITH + other debt} / {gross income + rental offset amount}
TDS = {$0 + $1500} / {$5000 + $400} = 28%

Addback:
TDS = {PITH + other debt} / {gross income + rental addback amount}
TDS = {$0 + $500 + $1500} / {$5000 + $800} = 34%

Debt Coverage Ratio:
DCR = Rental Income – (PITH + % of rent to factor in miscellaneous expenses) …..  (assume  15% factor)
DCR = $1000 – ($500 + 15% of $1000) = $350, add to income
DCR = $1000 / ($500 + 15% of $1000) = 1.53
TDS = {PITH + other debt} / {gross income + DCR amount}
TDS = {0$ + $1500} / {$5000 + $350} = 28%

Another way some lenders count rental income is simply looking at the ‘net rental income’ reported on your T1 General. If is a positive number, it is added to your income, if is a negative number it is added to your liabilities. So often it turns out to ‘be a wash’ and neutral impact to your overall debt ratio.  It is a simplistic approach at counting rentals, without having to go into detailed numbers and documents for PITH expenses or leases.  However, this approach sometimes does not work because one may have recently acquired property and the most recent year reported does not cover full year of rental income, putting you in the negative. Or, another example is loss reported due to large scale expense such as a renovation.  With this simplistic approach, lenders usually will not readjust the numbers to incorporate your explanations why the number was negative, better to revert back to the other calculation options, described above.

It is important to stress again, have healthy cashflowing properties, beyond just the breakeven point of the basic expenses (PITH).  With multiple marginally cashflowing properties, you can see why your debt ratio can quickly explode.

To complicate things a bit more, how the lender treats the subject and existing portfolio properties depends on a number of thing .  The lender can use different calculations or percentages if the subject property is a rental, rental plus owner-occupied, or owner-occupied.  It may also depend on the mortgage product you are applying for (for example, fixed, variable, 3yr term, 5yr term).  Remember my quote: “He who holds the gold, makes all the rules.”  It is not all doom and gloom though, there are lenders out there that understand rental portfolios and have reasonable approaches to your application.  It is all how the deal is packaged and your mortgage broker’s understanding of the lenders’ policies.

To sum up, my advice is for you to be generally cognizant of these rules and calculations, but don’t obsess over trying to figure it all out and pre-qualify the deal yourself.  You may not be aware of the ongoing changes of lenders’ policies or you can make incorrect assumptions.  That is when you can leverage off the expertise of your mortgage broker, such as yours truly; it can save you a lot of time and stress.

The math lesson for today is over, you can now put away your calculator :o)