What is Rent to Income Ratio and How To Calculate It?
Whether you are renting your first apartment or considering a move, there’s one question you perhaps have on your mind: “What percentage of my income should go to rent?” Spending a large portion of your paycheck on monthly rental payments could mean coming up short for other expenses like, paying off debt, bills, or even advancing your financial goals.
So, how do you determine the amount of rent you can pay based on income? And, as a landlord, what exactly should be your income requirements for renting an apartment? That’s where a rent to income ratio comes in handy.
The Importance of Rent to Income Ratio
A rent to income ratio determines the monthly or annual gross income a tenant must earn to be able to afford rent each month. This ratio is a useful and simple tool that helps tenants as well as landlords enter into a smooth rental agreement.
Using an income to rent calculator, landlords can analyze the ability of tenants to pay rent each month. As a result, it simplifies the process of tenant screening and shortlisting applicants. Not to mention, it also helps landlords determine the applicant’s income requirement for renting an apartment.
On the other hand, it helps people seeking a rental property pursue options that fall within their budget. Before you start looking for a rental apartment, you should know how much rent you can afford. This ratio will help you set a budget and better ensure approval when you apply for a rental property.
Calculating Rent to Income Ratio
Calculating income to rent ratio involves some simple math. Here are two commonly used ways to calculate this ratio:
Calculate gross income against a fixed rent percentage
This will help you determine the maximum amount you can afford to pay in rent each month. The industry standard is 30% of your income. In other words, no more than 30% of your annual income should go toward housing costs.
Its mathematical representation looks like this:
(Gross earnings per year ➗ 12) X 0.3 = Maximum monthly rental income
For example, suppose an applicant earns $150,000 per year. The income to rent ratio will be:
(150,000/12) X 0.3 = $3,750
Now, if the rental site asks for $4,000 per month, the applicant would fail to meet this condition. This is because their maximum monthly rental income does not reach the required limit. Therefore, the landlord might not find the candidate eligible for renting.
Use a ratio multiplier
Another method to calculate the rent to income ratio is to multiply the monthly rent value with a ratio multiplier. In this method, the standard multiplier is 3. This means that the applicant should make at least three times their gross monthly income to cover rental expenses. The math would look like this:
Monthly Rent X 3 = Minimum monthly rental income
Let’s consider an example to better understand. Suppose you are interested in renting an apartment that asks for $3,000 per month. Three times this rent amount becomes $9,000. This means you must gross a minimum of $9,000 per month in income to be eligible for consideration.
Pros & Cons of Rent to Income Calculations
Each month, a tenant’s paycheck likely goes toward many different bills and obligations. By gaining an understanding on how much monthly income is remaining, you’ll get a better idea of the ability to pay.
When landlords are recruiting good tenants, the rent to income ratio plays a very important role. It is the primary way to determine income requirements to rent properties based on monthly or annual earnings. This helps ensure that the tenant is able to afford rent each month.
As a landlord, you might not want to invest your time on ineligible tenants for your property. Calculating the gross income to rent ratio is an important step toward securing the right people for your rentals. Rather than going through the hassle of the screening process, use the rent-to-income ratio as your simple criteria instead.
However, ideal rent to salary ratio situations are not always as favorable as they sound. We know a lot of people aren’t that consistent in paying rents. Whereas, applicants who may not satisfy the income to rent ratio could be more responsible when it comes to paying rent on time.
Plus, some complexes make their income to rent apartment policies 3:1 . This might look like a lucrative option but in actuality, it prompts to a significant decline. Some tenants demonstrate a consistent ability to pay rent while others, with higher rent to income ratio, fail to provide steady deposits.
On the other hand, the 30% rule is a popular guideline for determining what percentage of income should go to rent. However, there are two big flaws associated with this rule. First, it doesn’t account for inflation and rising rental prices. Although rent prices are climbing more rapidly in some areas than others, average wage growth has been relatively flat since 2007. So, while rental rates are climbing, incomes aren’t necessarily keeping pace.
The second problem with the 30% rule is that it’s not personalized to your situation. It doesn’t take into account, for instance, how much student loan or credit card debt you might be paying off. Moreover, it also does not consider how much money you’re earning, your financial goals, or the condition of the real estate market where you are planning to rent.
Alternative ways to calculate rent to income ratio
As a rule of thumb, your income should be 40 times your rent, which is basically the same as 30% of your total salary. Almost every rent to income ratio calculator you find online uses this alternative way to calculate the ratio.
For example, suppose your income is $100,000 per year, the amount of rent you can afford each month can easily be evaluated as 30% of your total income divided by 12.
The math will look like this:
(0.3 * 100,000) / 12 = $2,500
Alternatively, you can divide the gross amount by simply 40.
( 100,000 / 40) = $2,500
How Landlords Can Protect Themselves?
Calculating rent to income ratio might seem quite effortless and manageable, but it might partly hold a deficit for the landlord. Why? Because the landlord is not able to acknowledge the total worth of the tenant because of unspecified sources of income. The potential tenant may seem to have other financial obligations like loan percentage, fixed rate for insurance, and indemnification.
Even after thorough screening, some people may delude and provide false income documentation. In any case mentioned above, the landlord is fully granted the right to access all additional financial information of an applicant. Tenants should likely provide all credit card details with a proper financial report.
Before letting in a tenant, make sure that all the certified funds, cashiers’ checks, money orders, and records of all previous taxes of a year are officially provided. Even if your tenant qualifies as per the 30% rule, they may be overburdened with extra expenditures. In such cases, landlords need to assure ways to protect themselves.
Here’s how landlords can protect themselves:
- Set up recurring rent payments
Auto-pay services provide a convenient method of direct deposit with rent deduction on a specified date. It also provides more assurance of getting paid on-time each month if payments are set up to recur.
- Request a large deposit as a backup provision from any uncertainty or loss
A larger security deposit offers greater security because it can cover the landlord’s losses in case of damages or missed rent. Also, introduce several methods of rent payment. Get rent default insurance coverage to keep your income stable and regular.
- Specify a co-signer on the lease
The co-signer is responsible to pay the dues in case the primary leaseholder cannot. The landlord should vet the co-signer as thoroughly as the tenant.
- Run a thorough background check
Check the tenant’s background and inquire about past rental history. Also, check what your tenant presents as evidence. Cross-check all the references provided. Verify and validate all means of income sources. Gather data regarding any individual or collective payments or transactions. Once the property is rented, conduct routine inspections to prevent huge problems.
Get Help With AAOA
Rent to income ratio can benefit the landlord and tenant in many ways. It can help with budget planning for tenants looking to comfortably afford their rent. Whereas, it can prevent landlords from having tenants who may have difficulties paying their rent.
However, when it comes to screening and shortlisting a tenant, the rent to income ratio may not reveal enough about the tenant, their level of responsibility, or honesty. Therefore, all landlords should be running tenant credit checks, in addition to, calculating rent to income ratios.
At AAOA, we help you identify qualified tenants with our tenant screening services for landlords. We offer a variety of rental background checks, many with tenant credit checks, providing you with the best data and value in screening packages anywhere. Check out our sample tenant screening report here.