In follow-up to Debt Ratios 101 which covered the GDS, TDS and DCR ratios, we’ll be looking at the differences between “Rental Add-Back” and “Rental Offset” and the impact of some recent changes on qualifying for financing.
Unless you’ve attempted to plan out the financing for your first few purchases, rental add-back or rental offset calculations are rarely a concern when purchasing your first property. Many first time investors have enough income to qualify for a first rental property without having to worry about how rental income will impact their personal debt ratios. When considering the purchase of second, third and fourth properties, most investors will appreciate the ability to include some rental income when calculating debt ratios.
When it comes to qualifying for mortgage financing on multiple properties, lenders will evaluate your ability to service debt by calculating your GDS and TDS ratios using one of two methods. Most now use rental add-back due to some government intervention in early 2010, but some lenders do offer programs based on rental offset.
Method #1: Rental Offset
Rental offset is the percentage of rental income that a lender will allow a borrower to deduct from their housing expenses to help them qualify for a mortgage. Typically the offset is in the range of 50-80% with a few lenders allowing up to 100% on conventional mortgages.
Here is how rental offset comes into play when calculating the Gross Debt Service (GDS) ratio:
GDS (with Rental Offset) = [PITH – (Rental Offset x Rental Income)] / Borrower’s Income
Method #2: Rental Add-Back
Rental add-back is also defined as the percentage of rental income that a lender will allow a borrower use to help them qualify for a mortgage. Add-back ranges from 50-100% on conventional mortgages but rather than deducting this amount from housing costs, it is added to the borrower’s income.
Here is how rental add-back is used to calculate the Gross Debt Service (GDS) ratio:
GDS (with Rental Add-Back) = PITH / [Borrower’s Income + (Rental Add-Back x Rental Income)]
In February 2010 the Canadian government announced some changes to mortgage financing rules in Canada which came into effect April 19th, 2010. The change which got most of the attention was the increased down payment requirement for non-owner occupied properties which increased sharply from 5% to 20%. What most people never heard about was a change in the way debt ratios were calculated. At the same time the down payment requirements were increased, we went from most lenders calculating ratios using an 80% offset to lenders using the government mandated 50% add-back method.
To make these theoretical changes more real, let’s consider a real life example of an investor with an annual income of $48,000 ($4,000/mth) who owns one property worth $200,000 which rents for $1,250 per month. If this investor put 20% down and has a mortgage balance of $160,000, an interest rate of 4%, and a 35 year amortization, P&I would be $705 per month. Adding 20% of rent ($250) to cover property taxes and insurance, PITH on this property comes to $955. For our example lets assume the investor wants to buy another identical property.
GDS with 80% Offset
Calculating things the “good old way” with an 80% rental offset, the GDS for this investor with 2 of these properties would be:
GDS = [$1,910 – (80% x $2,500)] / $4,000
GDS = [$1,910 – $2,000] / $4,000
GDS = -$90 / $4,000
GDS = -2.25%
In the case of an 80% rental offset, these cash flowing properties actually improve this investors GDS ratio, so he could happily carry on purchasing additional properties so long as he could find the deals and come up with the down payment money.
GDS with 50% Add-Back
Now, lets see what happens if we calculate things the new way, using a 50% rental add-back. The GDS for this investor with 2 of these properties would be:
GDS = $1,910 / [$4,000 + (50% x $2,500)]
GDS = $1,910 / [$4,000 + $1,250]
GDS = $1,910 / $5,250
GDS = 36.4%
With a 50% rental add-back this investor is now hitting the 30-32% GDS wall and will struggle to qualify for mortgage financing beginning with just his 2nd purchase.
The Rental Add-Back Impact
The bottom line is that it is now very difficult to qualify for financing on multiple properties using the 50% add-back rule, especially in areas like Toronto or Vancouver which have higher home prices. To overcome this financing obstacle, you’ll need to conduct some careful planning with your mortgage broker to manage your ratios well, consider using joint venture partners, or start looking at multi-family investing earlier on in your investing career.
photo credit: faungg
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