Non-payment of rent is the number one concern of landlords in America. In extreme examples it can lead to lengthy and costly evictions. Even in more normal circ*mstances it can cause problems, from cash flow issues to a breakdown of relationships and potential communication complications.
The rent to income ratio is one calculation that landlords can use to help them assess tenants and a calculation that tenants can use to determine if they can feasibly afford a particular property. In this article, we take a look at what the rent-to-income ratio is, how it can be used, and the formulas for calculating it.
About Rent to Income Ratio and Why it’s Important
The rent to income ratio is a calculation used by landlords to determine if a prospective tenant is suitable for their rental. Essentially, the ratio calculates how much income the tenant makes in relation to the rent. Landlords can then quickly assess how affordable the rent for a particular property is for that tenant.
As a general rule of thumb, landlords should aim for a rent-to-income ratio of no more than 30%. Meaning the tenant should earn at least three times the rent amount. A higher rent-to-income ratio means the tenant will have less money to live off and should they come under hard times, they may have to sacrifice paying for certain essentials to continue covering living expenses. With rent taking so much of their paycheck, it is often the first payment that is sacrificed.
Calculating Rent to Income Ratio
There are two ways to use the rent to income ratio. The first is to use the tenant’s gross income to calculate whether it meets your minimum requirements. The second is to calculate how much gross income a tenant needs to meet your target.
(Tenant gross income / rent amount) x 100 = Rent to income ratio
Eg. the tenant earns $5,000 per month gross income and the rent amount is $2,000.
($2,000/ $5,000) x 100 = a rent to income ratio of 40%.
Rent amount / Target rent to income ratio = minimum tenant income
$2,000 / 30% = minimum tenant income of $6,666
Alternatively you can set a minimum ratio of, for example, 3 times the rent to make the calculation simpler. In this example that would make the minimum gross income of $2,000 x 3 = $6,000.
Pros and cons of using the rent-to-income ratio
The rent to income ratio is a simple way for both landlords and tenants to guage the financial feasibility of a tenant signing the lease agreement.
If a tenant does not have enough income to afford the rent and all their additional living expenses, landlords can expect a high probability of late and missed rent payments. For applicants, by realistically understanding how much rent they can afford, they can better tailor their search for a new home saving both themselves and the landlord time.
With that being said, the rent to income ratio doesn’t tell the whole story. For example the tenant might have other sources of income that are not reflected on the W2 or pay stubs such as:
- Child support payments
- Additional freelance work
- Other sources of income
And of course, this works the other way around too. The tenant might have additional expenses and financial burdens that will mean they need to target a lower rent to income ratio.
Because of this, the rent to income ratio is just a starting point. Landlords should seek out additional financial information such as a tenant credit report, to get a better picture of the applicant’s overall financial situation.
Mitigating the risk of late payments
In order to reduce the chance that a tenant is late with the rent or misses a payment, you need to first of all do everything you can to ensure they have the ability and wherewithal to pay the rent on time and in full every single month. This means first and foremost setting your minimum criteria with a strict rent to income ratio. You then need to ensure you do a thorough tenant screening on all tenants with a full, credit, background, and rental history.
However, you won’t always find a perfect tenant, and sometimes you need to fill vacancies fast. On top of this, there are always exceptions to any rule. Perhaps, as mentioned above, the tenant has additional sources of revenue that qualify them but are unstable. Or you may be renting to students who don’t have a rental history and may be entirely supported by parents or loans.
In order to protect yourself and your rental uner these circ*mstances there are a few things that you can do to mitigate risk.
Get a lease guarantor / co-signer
The co-signer agrees to take on the financial responsibilities of the rent in case the primary leaseholder cannot. The landlord should vet the co-signer as thoroughly as the tenant, including a comprehensive screening.
Request a larger deposit (if legal)
A simple approach is to request a larger deposit. This will cover unpaid rent should the tenant fall behind, and also act as proof that the tenant has financial reserves they can call upon. However, several states have limits on the amount you can charge as the deposit so make sure to check your local and state deposit laws first.
Have a fair late fee and grace period policy
Late fees are one way that landlords encourage on-time payments. This late fee should be fair and have a reasonable grace period (usually about five days). A fair late fee acts as an incentive for tenants to make sure they get the rent in on time. However, large late fees can hinder an already struggling tenant’s ability to pay further resulting in a breakdown of relationships and increased likelihood that you wil have to pursue an eviction (something neither of you want).
Use Landlord Studio online rent collection with auto-pay
Landlord Studio offers one of the best rent collection tools on the market built into our award winning real estate accounting tools. Set the rent amount and invite your tenant. Your tenant can then log in to view upcoming and historical payments, and also set their rent to be paid automatically each month. This is proven to dramatically reduce the chance of late payments.
On top of this, income paid through this tool is automatically tracked in our income tracker, meaning all you have to do at the end of the month is run a financial report.
Automate rent reminders and late fees
As part of Landlord Studio’s suite of property management tools you can also set automated rent reminder emails to go out before and after the rent due date. You can even automatically apply late fees should the tenant not initiate their payment on time. These late fees will be applied in the tenant portal so that tenants have comprehensive breakdown of how much and when they paid.
Final Words
Having a streamlined process and the right tools to manage tenant applicants is essential if you want to fill vacancies fast, and mitigate the risk of late and missed rent payments.
The rent to income ratio is one way to assess a tenant’s financial viability. However, it doesn’t tell the whole picture. As such, while it makes a good starting point especially if you have a lot of applicants, landlords should do additional, in depth research to ensure the tenant meets all of their minimum criteria.
With Landlord Studio, we make this as easy as possible. You can collect tenant applicants using the software and even set a selection of prescreening questions to quickly filter unqualified tenants. After tenants have seen the property, easily run a comprehensive tenant screening report from inside the app at no additional cost to yourself.
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As a seasoned real estate professional with extensive experience in property management and landlord-tenant relations, I can attest to the critical role that the rent-to-income ratio plays in the decision-making process for both landlords and tenants. Over the years, I have encountered various scenarios, from successful lease agreements to challenging evictions, providing me with a comprehensive understanding of the complexities involved in the rental market.
Now, delving into the concepts presented in the article, the rent to income ratio serves as a pivotal tool for landlords to assess the financial suitability of prospective tenants. The ratio, expressed as a percentage, illuminates the relationship between a tenant's income and the cost of rent. The widely accepted benchmark suggests that landlords should aim for a rent-to-income ratio of no more than 30%, indicating that tenants ideally should earn at least three times the rent amount.
The article provides two distinct methods for calculating the rent to income ratio. The first method involves using the tenant's gross income to determine if it meets the landlord's minimum requirements, while the second method calculates the minimum gross income needed to meet a specified target ratio. The formulas provided offer a straightforward approach:
- (Tenant gross income / rent amount) x 100 = Rent to income ratio
- Rent amount / Target rent to income ratio = Minimum tenant income
Additionally, the article highlights the pros and cons of relying solely on the rent-to-income ratio. While it offers a quick assessment of financial feasibility, it may not capture the full financial picture. Tenants may have additional sources of income not reflected in traditional documents like W2 or pay stubs, and they may also have undisclosed expenses that affect their ability to afford rent comfortably.
To mitigate the risk of late payments, the article suggests several strategies for landlords, such as thorough tenant screening, requesting a larger deposit within legal limits, and implementing fair late fees with a reasonable grace period. It emphasizes the importance of leveraging technology, such as Landlord Studio's online rent collection tool, to streamline the process and reduce the likelihood of payment delays.
In conclusion, the rent to income ratio serves as a valuable initial assessment tool, but landlords should complement it with in-depth research, including tenant credit reports, to gain a comprehensive understanding of an applicant's financial situation. As a seasoned expert in the field, I endorse the proactive measures outlined in the article to mitigate risks and foster successful landlord-tenant relationships.
