Claiming Rental Income to Qualify for a Mortgage: How Do Lenders View It?

Claiming Rental Income to Qualify for a Mortgage: How Do Lenders View It?

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As a landlord or aspiring real estate investor, it’s possible that a lender will let you use rental income to qualify for a mortgage. Whether they actually do so will depend on your ability to provide proof of income, or if it's for a new rental, proof of the earnings potential of the property. Lenders have to adhere to specialized guidelines when making their decision. Read on to learn more about these stipulations, as well as how they may impact your eligibility.

Does rental income count when applying for a mortgage?

Generally, rental income can be counted when you’re applying for a mortgage or refinancing an investment property. However, like all other sources of income, it must be properly documented and meet specific qualifying guidelines.

According to Fannie Mae’s rental income guidelines — one of the largest buyers of conforming loans in the U.S. — the following criteria must be met:

  • You must establish that the rental income is likely to continue
  • The property must be a two- to four-unit principal residence property in which the borrower occupies one of the units, or a one- to four-unit investment property

Rental income from a commercial property owned by the borrower, for example, is acceptable if it’s not from the property being financed.

  • Income from the borrower’s principal residence, whether it’s from a stand-alone property or from a particular unit in a multiunit structure
  • Income from vacation homes

Provided that your property falls in line with those stipulations, getting your rental income counted is mostly a matter of filling out the right forms and providing the lender with the proper documents. What you’ll need to provide depends on whether the property already has an established rental history.

When is rental income accepted for underwriting?

If you already own the rental and can document the income that came from it, your income is considered real — rather than projected — by the lender. Real rental income will be considered by underwriters.

A bank could look at two years of your tax returns to see how much proven income has been generated from your leases.

For your personal tax returns to be sufficient — per Fannie Mae — you’ll need to file IRS Form 1040, Schedule E. If you file a business tax return, you’d fill out the Rental Real Estate Income and Expenses of a Partnership or an S Corporation form, which is also known as IRS Form 8825.

Fannie Mae will also likely require that an appraisal report is conducted to estimate the property’s market value. If you have a one-unit rental property, this will require having an appraiser fill out a Single-Family Comparable Rent Schedule (Form 1007). For two- to four-unit properties, the appraiser should fill out Form 1025 — the Small Residential Income Property Appraisal Report.

When is predicted rental income accepted for underwriting?

Sometimes, rental income can’t be proven via a tax return. Say, for example, you’ve just purchased the property, or you purchased the property in the middle of the year and only show a portion of the rental income on your tax return.

In that case, the rental income would be considered predicted and may be used — under certain circumstances — for underwriting purposes. Again, it’s a matter of being able to show proof of the property’s income potential.

If the renter has a tenant, lenders will take a percentage of the income that’s outlined on a lease and use that to determine projected rental income. They usually use 75% of your total reported income — 25% is subtracted to account for potential vacancies and ongoing maintenance.

If there’s no tenant, the lender will have an appraiser do an audit of the property and use comparables of rental prices for similar properties in the area to estimate the potential rental income.

When is predicted rental income not acceptable?

Predicted rental income is not always acceptable for underwriting, though. First and foremost, you may have a problem getting it counted if it cannot be documented (for example, if the rent has been paid in cash). This is because lenders sometimes request copies of checks as proof that the rent is regularly being paid on time.

Also, predicted rental income can be hard to justify if the lease is worth less than market value. Let’s say you decided to provide a friend or family member with preferential rent. If it is accepted, you may not get as much value out of it as you’d hoped. In this case, you’d have to use the rental values outlined in the lease as your projected income, rather than the market value for which the unit can appraise.

How is rental income calculated for a mortgage application?

The way in which your rental income will be calculated when you’re trying to qualify for a mortgage will depend on the documentation being used to justify it.

How is rental income calculated with federal tax returns?

When federal tax returns are used to calculate qualifying rental income, the lender must add back in any deducted expenses — depreciation, interest, homeowners association dues, taxes or insurance — to the borrower’s cash flow before doing any calculations. Any nonrecurring property expenses may be added back in, provided that they were documented accordingly.

The income is then averaged over however many months that the potential borrower used the property as a rental unit during the last tax year.

How is rental income calculated with leases and appraisals?

For leases and appraisals, the lender will take a portion of the projected income and use it for their calculations. They usually use 75%, with the other 25% accounting for projected vacancies.

How does rental income factor into DTI?

Your debt-to-income (DTI) ratio is an important factor that lenders look at when deciding whether to approve your loan application. It’s essentially the sum of your recurring monthly debt divided by your total monthly income. Typically, lenders look for a ratio that’s less than or equal to 43%. Though, the lower your ratio is, the better.

For example, let’s say you have a gross monthly income of $5,000. Meanwhile, your mortgage payment is $1,000, you have a monthly student loan payment of $300, a car payment of $300 and a minimum credit card payment of $200.

The math would look like this:

($1,000 + $300 + $300 + $200)/ $5,000 = 0.36

In this case, your debt-to-income ratio would be 36%.

However, when doing this calculation, there’s a few more details to consider, particularly if the rental income you’re hoping to use comes from your primary residence or a separate investment property.

If your calculated rental income — which has been averaged over the number of months it was used as a rental during the last tax year — comes from your primary residence, you should add it to your gross monthly income calculation. Meanwhile, the full amount of your monthly mortgage payment should be included in your monthly debts.

If that calculated income is not from your primary residence, it would only count toward your gross monthly income if it’s more than your monthly mortgage payment. If calculating it puts you in the negative, it would count toward your monthly debts instead.

How does rental income affect your net cash flow?

For rental properties, the lender will also look at your net cash flow. In most financial situations, net cash flow is represented by subtracting your expenses from your income. However, in rental scenarios, it’s a bit more complicated. Here, lenders again use 75% of your total rental income before subtracting expenses.

If the resulting number is positive, you’re in luck. That number is then added to your income. If not, however, it will be counted as a loss and you’ll need to make it up from some other source.

Rental income calculation worksheets

Fannie Mae provides worksheets so that you can get a sense of what your rental income may be before bringing your paperwork to a lender. Which worksheet will be appropriate for you depends on whether your property is a principal residence, investment property or commercial holding, as well as how many rental units you have:

  • Form 1037: For principal residents with two to four units
  • Form 1038: For investment properties (up to four properties)
  • Form 1038A: For investment properties (up to 10 properties)
  • Form 1039: For business rental income from investment properties

How do I use rental income to qualify for a mortgage?

For the most part, the process of applying for a mortgage using rental income will be the same as it would be without it. However, you should be ready to provide additional documentation to prove your real or predicted rental income — and you may go through some additional vetting.

Introducing rental income in your application

You’ll want to introduce your rental income at the same time as you provide your lender with the other financial information needed for your application. In general, you should be prepared to provide copies of the following:

  • Two years of W-2s or 1099s
  • Two years of tax returns
  • Pay stubs from the past 30 days
  • Monthly (at least two) or quarterly bank statements for all your financial accounts, including investments
  • A profit and loss statement if you’re self-employed
  • A signed copy of your real estate purchase agreement

As for what you need specifically to prove your rental income, if you already have a tenant, your tax returns should provide sufficient information. If not, you’ll likely be asked to provide an estimate of what you expect the rental income to be.

How do lenders verify rental income in your application?

That said, an estimate is not going to be enough to get you approved for a loan. The lender will go through and verify your income, by most likely conducting an appraisal. The appraisal will look at what similar properties are renting for in your area to come up with a projected rental value.

However, your lender may ask for more specifics. If you already have a tenant, your lender may want a copy of the lease, as well as copies of your recent rent checks, to verify that the rent is being paid on time regularly.

In all likelihood, the income from your rental property may indeed be shown as income. You just need to be prepared to prove it by providing the correct documentation. Talk to a lender to get a sense of the specific documentation to be included for your unique rental scenario. Be sure to make copies before you provide documents to the lender.

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