The number one reason for eviction is when a tenant stops making their monthly payments. While there are a lot of factors that go into determining if an applicant can pay the rent each month, the most common metric that landlords use is to calculate rent-to-income ratio.
How to Calculate Rent-to-Income Ratio
Rent-to-income ratio is the percentage of a renter’s gross income that goes towards paying the rent. It’s a limited metric, but many landlords use it as a quick way to identify applicants who are worth additional screening.
Trying to predict a tenant’s ability to pay rent is not straightforward, and no single method will do the job. While credit scores, rental histories, and income verifications can help, the rent-to-income ratio is undoubtedly the quickest and easiest way to provide a first-glance view into an applicant’s financial health.
There are two common ways to calculate rent-to-income ratio:
1. Percent of Income That Will Go Towards Rent
The formula looks like this:
Monthly rent payment / gross monthly income
In other words, let’s say someone earns $100,000. That comes out to $8,333 in gross monthly income.
If rent is $2,000 per month, then you get:
$2,000 / $8,333 = 24% rent-to-income ratio
A lower rent-to-income ratio means an applicant should have an easier time making rental payments each month. This rental payment would be a smaller burden on the applicant than for someone else with a rent-to-income ratio higher than 24%.
Try out this rent-to-income calculator:
2. Multiply Monthly Rent By 3
The formula here looks like:
Monthly gross income x 3 = maximum rent payment
This means that if the monthly rent comes out to $2,000 per month, the applicant should earn a minimum of $6,000 per month ($2,000 x 3 = $6,000).
Our hypothetical example of someone earning $100,000 per year would be well above this threshold.
This formula essentially means we’re using a rent-to-income ratio of 33%.
Only use the “times 3 method” as a quick mental calculation. Any real analysis of a tenant’s ability to pay rent should use the first method above and also include the applicant’s other debt as well.
What Is an Acceptable Rent-to-Income Ratio?
The simple rule that many landlords follow is that rent-to-income should be no higher than 30%. The logic is that a tenant would be able to pay rent each month and still have more than enough left over to pay for their other living costs (food, car, insurance, etc.).
A tenant who falls in a worse rent-to-income ratio is more likely to:
- Pay rent late
- Miss rent payment
- Pay in installments
- Plead for leniency
Any of these is less than ideal for a property owner.
However, setting a hard line at 30% for rent-to-income ratio would ignore other important factors, such as debt and location.
How Much Debt Does the Applicant Have?
Another important calculation that many landlords use when screening is debt-to-income (DTI) ratio.
Take these two scenarios:
- Applicant A has a rent-to-income ratio of 25%, but has two car payments, some credit card debt, and pays child support.
- Applicant B has a rent-to-income ratio of 32%, but has no significant monthly debt payments.
Simply looking at rent-to-income ratio tells you that Applicant A is better. In reality, Applicant B is likely to have more income to devote towards monthly rent payments.
Debt-to-income is calculated like this:
Monthly debts (including rent) / gross monthly income
If rent is $2,000 and the applicant owes another $2,000 in monthly financial obligations, then our theoretical $100k earner has a DTI that looks like this:
$4,000 / $8,333 = 48% DTI
When it comes to housing, 43% DTI is a commonly used standard.
Having many children can be expensive, and could hurt a renter’s ability to make monthly payments. However, an owner cannot deny an applicant for family size based on the Fair Housing Act.
30% Rent-to-Income Ratio Isn’t Feasible in High-Cost Cities
Let’s take San Francisco for example. Currently, the average rent is $3,397 for a 740 square foot apartment. This means that to hit a rent-to-income ratio of 30%, the applicant would need to earn $11,323 per month, or $135,880 per year!
However in this case, the renter would still have $7,926 left over for the rest of their living expenses (of course it’s actually a bit less because that’s a gross income figure). Provided the applicant doesn’t have a lot of debt, someone with a rent-to-income figure in the 35%-40% range could probably make the payment just fine. They’d still have plenty of money left over for the rest of their expenses.
Across the U.S., average rent has passed $2,000 per month, while the median household income sits at $62k.
In other words, an average family in an average rental unit would have a rent-to-income ratio of nearly 39%! That number is only getting worse as rental prices increase 4 times faster than wages.
In other words, while setting a standard of 30% for rent-to-income ratio can be an optimistic benchmark, it’s becoming more unrealistic for renters to qualify.
This is why many landlords turn to DTI as a better metric. Applicants with a worse rent-to-income ratio may turn out to be better tenants because they have less overall debt.
Benefits of Rent-to-Income Ratio
While rent-to-income ratio isn’t a perfect metric, there certainly are benefits to using it as a baseline for screening.
- Extremely Simple to Calculate – All a landlord needs to know is how much rent he’ll be charging, and how much money the applicant makes. For their first pass through the applicants, verifying the income number isn’t even essential yet. That will come later.
- Quick Weed Out Applicants – Landlords with in-demand properties can get swamped with applicants. Since income is usually the first qualifier looked at, a landlord can set a baseline rent-to-income ratio (perhaps 40%) and discard anyone that’s below that standard.
Drawbacks of Rent-to-Income Ratio
While rent-to-income ratio can be helpful, it should by no means be the only reason for accepting an applicant, especially as it can be a flawed indicator.
- DTI is More Accurate – Rent-to-income doesn’t look at debt. Applicants with high monthly financial requirements may find themselves having trouble making rent payments even if they have a high gross income.
- Saved Money Isn’t Considered – If someone recently won a settlement, has saved up a lot of money, or is recently divorced and received a large sum of money, then their income may be zero. These people would be excellent renters as far as their ability to make payments each month.
- Doesn’t Take Into Account Net Income – This may be a smaller one, but a landlord should take a look at net income as well. For example, the applicant may be putting a huge percentage straight into a 401(k) or is having their wages garnished for a debt owed.
- Their Income May Be Temporary – In addition to calculating income, a landlord should check an applicant’s employment history. For example, maybe they have a good job now, but their employment history indicates they may not last long at the job.
Rent-to-income is a good initial indicator to look at, but it’s by no means the only financial number that a landlord should consider.
How to Handle Applicants Who Don’t Meet Your Rent-to-Income Requirements
Landlords can legally reject any applicant that doesn’t meet their rent-to-income requirements, regardless of how qualified they are in other areas. As long as they keep the same standards for every applicant, they can require 20% rent-to-income if they’d like.
Here’s a common process a landlord may take for looking at applicants who have rent-to-income ratios worse than the standard 30%:
- Reject Anyone Who’s Not Even Close – Perhaps you like to shoot for a rent-to-income around 30% – 32%. You can make it a policy of yours to reject everyone who’s above 40% without even considering anything else.
- Pull Their Credit Report – A credit report will give you insight into their debts. Consider their monthly payments and calculate a DTI for everyone. Now, you can reject more applicants with a baseline DTI that you find acceptable (perhaps 43% or 45%).
- Verify Their Income – At this point, it’s time to do some legwork. If it looks like they have acceptable rent-to-income and DTI ratios, then it’s time to verify that the income numbers they put on their applications are legitimate. You can do this by talking to their employer, asking for W-2s, checking pay stubs, and/or looking at bank statements.
- Establish a Rental History – Let’s say now that you have an applicant with a rent-to-income ratio of 32%. However, their DTI falls under 43% and you’ve verified their income. On paper, they look like a good enough candidate to overlook their high rent-to-income ratio. Next, you can talk to previous landlords to ask about missed or late payments to find out if they have a good history of handling rent payments.
Protect Against Unqualified Applicants
Now, perhaps the landlord has decided that there’s one applicant that they’d like to give the lease to, but the person doesn’t have a stellar rent-to-income ratio. In these cases, the landlord can take a few different actions:
- Lower Rent – This may sound counterintuitive to a landlord who’s trying to maximize their business, but this is a great option if there’s a truly standout applicant. Keeping great tenants in the property for as long as possible is the best way to make money in the long run. A landlord could lower rent by $50 in order to get a good applicant into the property and make it easier for them to pay each month.
- Set up 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.
- Require 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.
- Ask for a Higher Security Deposit – Requiring a higher security deposit can help protect the landlord from missed payments, an unplanned vacancy, or an eviction.
- Require a Co-signer – A co-signer is someone who signs 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.