The rent-to-income ratio is a formula used to measure a renter’s ability to pay rent, and is calculated by dividing rent by the renter’s income (stated as a percentage). For example, if the rent is $500/month, and the renter earns $2,000/month, their rent to income ratio would be 25%.
Table of Contents:
- Importance of Rent-to-Income Ratio – why it’s used, its benefits and its drawbacks.
- How Much to Charge – the 30% Rule and whether you should use it.
- How to Calculate – all 3 possible ways to calculate the ratio.
- Simple Calculator – enter the monthly rent and the renter’s income to calculate.
Importance of Rent-to-Income Ratio
The goal of the screening process is to weed out potential problem tenants. Given that the most common reason for an eviction is the tenant’s inability to pay rent, whether or not that might happen is arguably the most important thing a landlord will screen for.
That’s also because evictions aren’t cheap. Taking into account court costs, legal fees and lost income, it’s been estimated that an eviction costs the average landlord around $5,000.
Trying to predict a tenant’s ability to pay rent is not straightforward, and no single method will do the job. While credit scores and verifications around finances beyond income can aid in the process, the rent-to-income ratio is undoubtedly the best tool in the toolbox for easily (and scalably) predicting a tenant’s ability to pay rent.
Once the income that the tenant provides is able to be verified, this ratio is quick to calculate, easy to compare and generally does a good job assessing whether the tenant is making a financially responsible decision to take on that level of obligation.
Following the 30% Rule, as detailed below, can save the landlord a lot of time and money, as well as effort. If they choose not to screen anyone who doesn’t pass this preliminary ratio examination, they can quickly narrow down the pool of prospective tenants to those that can afford the amount.
Benefits of Using Rent to Income Ratio
Whether the landlord chooses to adhere to the 30% Rule or not, there are certain benefits to using rent-to-income ratio as part of the screening and rental process, for both the landlord and the tenant.
For one, it gives the landlord and the tenant common ground. Using this figure, both parties can see if the tenant has the ability to pay the rent. The landlord can save time and screening costs by refusing to screen tenants who would be paying more than 30% of their income for housing costs.
On the other hand, tenants can take this information into their housing search. By having this on hand, they can understand what rent they may be able to afford and work towards finding housing that fits into their budget a bit better. They can also save time by eliminating housing that they can’t afford or will not be approved for.
Drawbacks of Using Rent to Income Ratio
Unfortunately, the rent to income ratio doesn’t tell the whole story. Often, the tenant may have other monthly obligations that require payment, including child support, student loans, car loans, and other high-price payments. If they have too many of these, the rent-to-income ratio won’t present an accurate model of how much the tenant can afford.
Tenants may also have different sources of income that are not factored into taxes, such as small payments from a side business or other income that is not reflected by pay stubs. In this case, the rent-to-income ratio is similarly inaccurate.
Using gross annual income may also be a pitfall when it comes to determining if the tenant can afford the rental. That’s because gross income is what the tenant earns before deductions, insurance payments, and taxes are taken out of their wages. If a tenant has various insurance payments that come out of their paychecks for their job, or they pay a lot in taxes up front, the gross annual income will not accurately reflect the funds that the tenant has available. In this case, the net annual income is a better estimation, but this is not widely available in tax information.
For those reasons, using the rent-to-income ratio alone may not be a great idea.
How Much to Charge (30% Rule)
When a landlord applies a rent-to-income ratio to a tenant’s application, they are generally looking for the information to fall under the guidelines of the 30% Rule.
The industry standard states that prospective tenants should only spend 30% of their annual income on rent. Spending more than 30% of their income means that they are financially burdened by housing and may not be able to afford the rent, even if they are budgeting carefully.
There are factors that can influence this rule and reasons why it might not appeal broadly to all prospective tenants. However, most consider it a solid rule of thumb to adhere to when screening or before screening prospective tenants.
It’s important to note that while this ratio is the industry standard, it will not work in all markets, particularly in more expensive places such as San Francisco or New York. Use these figures with caution.
Accepting Tenants Outside of the 30% Rule
Each individual tenant and situation is different. There is no one rule that will fit every applicant or every property, especially in higher-cost cities such as New York, San Francisco, and Los Angeles.
For that reason, it’s a good idea to examine each applicant on an individual basis. A rent-to-income ratio is only a tool, and while it can help determine if a tenant is right for a property, it can also be limiting.
Choosing to rent to a tenant with a lower rent-to-income ratio is entirely up to the landlord, but there are some factors to be considered and some precautions that a landlord can take. As mentioned above, tenants often pay up to 50-60% of their income for rent in cities where rental rates are higher.
On the other hand, tenants who are within the 30% Rule still may not make good rental candidates. However, there are things that the landlord can do to prevent any loss of income or damage, as well as to make sure that the rent is paid no matter what the tenant’s rent-to-income ratio looks like.
- Automatic Payments. Landlords can work with rental management software to set up automatically recurring rental payments. The rent will come out of the tenant’s bank account on the same day every month, taking the initiative to pay out of the renter’s hands.
- Rental Insurance. There are certain services, such as LeaseGuarantee, that the landlord or tenant can purchase. These insurance services make sure that the landlord will continue to get paid the amount that was agreed upon, even if the tenant doesn’t pay or skips out on the rent.
- Security Deposits. Most rentals already have a security deposit, but requiring more money from the tenant up front will help make sure that the landlord doesn’t lose out on any income. Some landlords require tenants to pay a deposit in addition to the first and last months’ rent in order to move into the home, which can be a viable strategy.
- Require a Co-signer. A co-signer will also sign the lease and will take over the financial responsibility of the rent if the tenant fails to pay. Requiring a co-signer can be one way to make sure that the rent is always paid, regardless of whether the tenant takes the initiative or not.
Renting to a tenant or tenants who fall outside of the industry standard can be a risk, but each individual case is different and should be carefully considered.
How to Calculate Rent to Income Ratio
There are a few ways that landlords can calculate this ratio on their own, and it doesn’t take a mathematical genius to figure out. We’ll look at three main models and formulas to use in order to calculate the ratio and determine if the tenant makes enough to afford the rent based on the industry standard.
Model 1 – Gross Annual Income
This model uses the tenant’s gross annual income to determine the rent to income ratio. The following formula can be used.
Gross Annual Income x 0.30 = 30% of Annual Income
30% of Annual Income / 12 = Affordable Rent Amount
This formula uses the confirmed gross annual income from the tenant, determines what 30% of that is, and then divides it by the number of months in the year to figure out how much rent per month the tenant can afford. Here is an example, using a prospective tenant or tenants whose gross annual income is about $60,000.
60,000 x 0.30 = 18,000
18,000 / 12 = 1,500
Therefore, this prospective tenant could not afford the rent on a unit or property that exceeds $1,500 per month. If the landlord has set the rent at $1,700 per month, this tenant would not be a likely candidate (if the landlord chooses to follow this model).
Model 2 – Amount of Rent
This model is a bit simpler and uses the amount of rent that the landlord has set for the unit or property. The following formula can be used in this instance.
Amount of Monthly Rent x 3 = Monthly Income of Ideal Tenant
This formula can be used to determine how much income a landlord should look for when determining if it’s worth screening a prospective tenant. For example, if the monthly rent is $900 on the unit:
900 x 3 = $2700
The ideal potential tenant or tenants should make $2,700 per month (combined if more than one adult that is applying has an income).
Model 3 – Amount of Rent and Gross Annual Income
This formula is a bit more confusing, but it combines a bit of both prior models to determine if the tenant or tenants can afford the rent.
Amount of Monthly Rent x 40 = Combined Annual Income of Tenant(s)
This gives the landlord a marker for annual incomes they should require when screening tenants. Here’s an example from a property with a monthly rent of $1,100.
1,100 x 40 = $44,000 required annual income(s)
This formula can be more useful when the tenant enters an annual income, as it requires less math to reach the same conclusion as the other models. However, if the tenant enters a monthly income instead, it can become more difficult to determine the results from this formula.
Any one of these formulas can serve landlords by giving them an ideal rent-to-income ratio amount, or by determining if the tenant makes enough money overall. Note that if more than one adult with an income is going to be renting the property, all incomes should be considered and added together.
Don’t feel like calculating the ratio yourself? The following tenant screening services offer a rent-to-income ratio report.
- TransUnion SmartMove
- National Tenant Network
Rent to Income Ratio Calculator
If you want to calculate the rent to income ratio in its simplest form, use the calculator below.
Additional Income Requirements
Because the rent-to-income ratio may not be an accurate representation of a tenant’s ability to pay the rent, it is useful to use additional screening tools. Other financial information is key to the understanding of the tenant’s financial situation as a whole.
Income verification can prove to be an important step in understanding how a tenant makes their money and how much they make before and after taxes. This verification comes from the tenant’s employer, though it won’t work in the case of tenants who are self-employed.
To verify the income of any potential tenant, landlords may request paystubs from the most recent three months, bank statements going back as far as six months, a W2 tax form from the most recent tax year, and more.
Landlords can even request that self-employed applicants provide a 4506-T tax form. This form can be processed in a single business day and provides the landlord with a copy of the tenant’s tax return.
Running a credit report can help further. A credit report will inform the landlord if the tenant has any late payments, as well as adding details about required payments, loans, liens, and other financial information. Credit reports also help landlords determine if the tenant has a habit of paying their bills on time or not and may include basic information about past evictions.
Income verification and credit reports can both be used in addition to the rent-to-income ratio to help determine if a tenant can pay the rent.