It’s essential for landlords to consistently collect rent on-time. These payments create a steady flow of income that landlords use to manage rental property, pay their mortgage, and keep staff. It may even be their primary source of income.
That said, it’s important to set a standard for tenant screening. This will help to ensure they will be able to fulfill their duty of consistently paying the rent on time. That’s where the rent-to-income ratio comes in.
The rent-to-income ratio is a tool that is used to measure a prospective tenant’s income against their rent payment. It helps to determine whether a tenant will be able to afford to pay rent.
Looking at rent as a percentage of income can help establish a standard for qualifying tenants. Here’s everything landlords and property managers need to know about the rent-to-income ratio and how they can use it to protect their cash flow.
What is a Rent to Income Ratio?
A rent-to-income ratio is a formula that landlords and property managers use to gauge whether a tenant will be able to comfortably afford rent payments with respect to their current income. The ratio uses the tenant’s current income and the asking price for rent.
When calculated, it determines whether a tenant is within the standard guideline of 30% of income going toward housing costs. If a tenant’s rent far exceeds the desired rent-to-income ratio of 30%, they would be considered “rent-burdened.” This means that it will be harder for them to pay rent and all other living costs, making it likely that they will default on rent.
The ratio is used to answer the question of whether a tenant will be able to pay rent, but doesn’t guarantee that a tenant will pay rent. That’s why it’s imperative to perform a thorough tenant background check, including credit checks, on every potential applicant.
Why Consider Rent as a Percentage of Income?
There are many benefits of using the rent-to-income ratio for both landlords and tenants alike. The ratio can help tenants determine their budget when they are shopping for an apartment. Tenants who view their rent as a percentage of their income that is taken out are more likely to look for apartments that fit their budget.
Having a measurement that determines an applicant’s financial eligibility can help during the screening process. Landlords can use it to weed out tenants who don’t have an income that will allow them to afford the rent.
How to Calculate the Rent to Income Ratio
There are a few different ways to calculate the rent-to-income ratio to find out just how much a tenant can afford on rent as a percentage of income. However, the simplest method is the one we’ll focus on as it will save you time. Here’s what the equation looks like:
(Cost of Rent) x 3 = The Min. Monthly Income for Tenants
Ideally, a tenant should earn at minimum three times the cost of their rent to live comfortably. However, there are landlords who choose to increase or lower this amount based on their own preferences and risk tolerance. Regardless, three times is the industry standard.
If you would like to figure out the yearly income that a tenant must meet under this ratio, simply multiply the minimum monthly income for tenants by 12. Using a unit with a 1,000 rent cost as an example, the equation would look like this:
$1,000 (cost of rent) x 3 = $3,000
$3,000 x 12 = $36,000
In short, a tenant should earn at minimum $36,000 a year or $3,000 monthly to comfortably afford a rental unit with a monthly rent cost of $1,000.
Protect Your Income as a Landlord
The rent to income ratio isn’t a completely failsafe way to ensure that you are consistently receiving rent payments on-time. Landlords have to contend with job losses, poor money management, and tenants who simply refuse to pay rent on time.
All of this is possible even after going through the process of thoroughly screening your tenants.
It’s possible that you may find a very qualified tenant who doesn’t meet the ratio, However, that doesn’t mean that you should automatically toss out their application. If you find yourself considering a tenant that doesn’t meet your preferred ratio, you have options.
Here are some ways to protect your income when you’re considering a lower-income applicant.
An Effective Rent Payment Method
Landlords should offer multiple rent payment methods. They should also ensure that automatic payments are supported on whichever method they choose. A tenant that doesn’t meet the rent to income ratio should have recurring automatic rent payment set up. This provides extra assurance that they won’t miss out on paying the rent.
Mitigate Any Rent Slips Upfront
Here’s the thing — there is no way to completely prevent missed or late rent payments. However, that doesn’t mean that you can’t be proactive. Here’s how to be proactive when it comes to having a tenant that doesn’t meet your rent to income ratio requirements.
- Require a Co-signer – A cosigner provides additional security for landlords. They assume the responsibility of covering rent payments if the tenant is unable to pay them. A co-signer should be in a better financial position than the tenant. They need to be able to cover the cost of the rent with no trouble. Don’t forget, you’ll have to verify their financials, as well.
- Require a Guarantor – A co-signer is usually someone who will live in the apartment with the applicant. A guarantor is usually someone related to the applicant that is willing to guarantee their rent payments. Like an applicant, a guarantor’s income and credit needs to be verified. It’s important to make sure the guarantors monthly income is six times the monthly rent (2x the rent-to-income ratio for an applicant). The reason for the higher rent-to-income ratio is because the Guarantor has to be capable of paying for their own housing and the applicant’s housing in the event of default.
- Get Rent Default Insurance Coverage – A rent default insurance policy provides landlords with a steady flow of income if a tenant defaults on their rent payments. Two companies that offer this are Insurent and The Guarantors.
- Require a Security Deposit – Security deposits are normal. The amount you charge (within the legal limit) is up to you. If a tenant is at the lower end of the rent to income ratio, consider requiring a larger security deposit.
Above all, utilizing the rent-to-income ratio is a way to determine how much rent as a percentage of income a tenant can afford to pay. However, this method is not without its drawbacks. If a prospective tenant has outside sources of income that aren’t reflected on their tax returns or if they have outstanding debts, the rent-to-income ratio may be inaccurate.
Therefore, it’s crucial to perform a thorough tenant screening on all applicants. You want to get a complete view of their entire financial situation before coming to a final decision.
PreApproved Renter can help you get all the information you need to conduct an effective tenant screen. This tool helps landlords and property managers customize their tenant rental applications. PreApproved Renter makes it easy for you to ask the questions you need to ask, so there won’t be any surprises on your end. Get the most out of your tenant screening process with PreApproved Renter.