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Buy Income Property |
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The Financial Aspect of Investing in Real Estate
Knowing how to look at an investment property's financial implications is important. The first thing to think about is how to finance the property. You should have a basic understanding of how a bank or mortgage lender will look at your loan. Here are some guidelines: Generally, a lender will want your monthly mortgage payment to total no more than 28% of your monthly gross income (that's your monthly income before taxes and other paycheck deductions are taken out). This calculation is also known as your debt ratio. Here's how to calculate your debt ratio. Debt Ratio - Calculate your total gross monthly income. Include your gross salary, any other documented income (alimony, child support, etc.), add in any rental income from the property you are buying. This is your total gross monthly income. Now, calculate the basic debt amount, also known as PITI (principal, interest, taxes and insurance). Add up the amount of principal and interest payments (this is the same as your mortgage payment), then add the estimated monthly taxes and insurance amounts (this is usually what an escrow account is composed of). To estimate taxes and insurance, find the annual tax rate for the city you are looking to buy in and multiply it by the estimated purchase price. To get an estimate of insurance, you can call any insurance agent and get an estimate, or you can ask your real estate agent or friends to help you guess. So for example, if you were buying a property for $100,000 and put down $20,000 and could get an interest rate of 5.5% on a 30 year loan, then your mortgage (principal plus interest) on the $80,000 would be $454 per month. If property taxes were 2.0%, then your monthly taxes would be $167 ($100,000 x 2.0% / 12 months) and your monthly insurance would be about $83 (assuming $1,000 per year). If you add these numbers up, your PITI would be $704 ($454 + $167 + $83). Now, assume that your gross monthly income was $3,000 ($36,000 per year). Divide the $704 in PITI by the $3,000 and your debt ratio would be 23.5%. Since the loan requirement is typically 28%, it looks at first glance like you should be able to get approved for your purchase. Next, you should look at your total debt ratio, which includes the rest of your long-term debt. A lender will not want the payments on all of your debt (auto loans, credit cards, mortgages, etc.) to exceed 34% (36% for some lenders) of your total gross income. Here's how to calculate this ratio: Total Debt Ratio - Take the PITI number from the example above ($704) and add to it the estimated monthly payments to all of your other debt. Include any long-term monthly obligation such as car payments, student loans, personal loans and credit cards. To estimate your monthly credit card payments, use a mortgage calculator (or the payment function in Excel) to calculate the principal and interest payment for the total credit card balance at 15% and for a 10 year payback period. I'm not sure exactly how the banks calculate minimum credit card payments, but using this methodology should be conservative. Let's assume that you had $300 in monthly long-term debt obligations. Add the $300 to the $704 PITI and you have $1004 in total monthly obligations. Now divide this by your gross monthly income ($3,000) and your total debt ratio is 33.5%, which falls below the 34% requirement for most lenders. Note that if you want to borrow 90-95% of the total purchase price,
your total debt ratio will have to be closer to 33%. To get more
information about what you need to qualify for the loan you want, you
should talk to one of your local lenders or find a smart mortgage
broker that will work hard and will push the envelope with potential
lenders. The next, and more important financial aspect of buying an investment property is to analyze your expected cash flow, which is addressed in the next section.
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