Your income plays a vital role in your ability to refinance. Without it, you probably would not get a loan. Even with certain types of income, you might not be eligible. Many lenders increased their restrictions greatly after the housing crisis. Everything has to be proven several different ways before a lender can accept it. This is especially true for rental income. If you want to use it as your qualifying income, you may have some hoops to jump through, especially if you don’t report the income on your taxes. In any case, you have to provide your bank deposits and a signed lease, although many lenders require more.
Lenders Want Proof on your Tax Returns
The ultimate proof of income is your tax returns. This is the final word for any lender. The income on your tax returns is how they qualify you for a loan. This is because your tax returns show the bottom line after your expenses. As a general rule, you need 2 years of reporting rental income on your tax returns to use it for qualification purposes. Of course, there are loopholes to this rule, even for conforming loans. You have to meet one of the following exceptions in order to qualify:
- You purchased the home within the current tax year, but taxes were not filed yet. For example, if you bought the home on February 1st and need to refinance on December 15th of that same year, you did not complete a full tax year yet.
- The property was not suitable for renting because you made renovations or repairs to it. You will need to prove the repairs/renovations in order for this to work.
If you meet one of these situations or you have a unique situation, you may be able to find a lender willing to work with other documentation.
How Bank Deposits Verify Rental Income
The best way to prove your rental income is with bank deposits. However, this requires you to be very consistent with your deposits. The best way to go about it is to open a bank account specifically for your rental income. This way there is no confusion regarding where your income came from and what expenses you have for the home. Any money exchanging hands pertaining to your rental home should be handled with the same account.
If you don’t have a separate account, you have to be able to prove the bank deposits you made as a result of the rent you collected. Try to make the deposits at the same time each month and keep the deposit tickets to show the actual deposit. The deposits need to be as consistent as possible, meaning for the same amount and put in the bank at the same time.
A Signed Lease is Necessary
You have to make the rent official, whether you claim it on your taxes or not. The only way to go about this is with a signed lease. The sooner you have your tenants sign one, the better off you will be. The lease gives the lender peace of mind that the income will continue. If you don’t have a signed lease, what stops the tenants from just picking up and moving somewhere else? This could leave you in the lurches for the mortgage on that property. In the lender’s eyes, this increases your debt ratio and your chance at defaulting on the loan you wish to refinance. Without the signed lease, your rental income may mean nothing, even if you have proof with bank deposits.
Calculating Rental Income Without Tax Returns
Keep in mind, most lenders will not use your rental income at face value if you don’t claim it on your tax returns. The difference between rent claimed on taxes and income not claimed is the expenses. Chances are, on your income taxes, you claim all of your expenses. It just makes sense since it decreases your tax liability. If you have not claimed your rental income yet, you don’t have any official proof of your expenses. This means the lender has to determine your expenses based on what you provide. If you are not forthcoming about the full extent of what the rental property costs you, your income could be inflated.
In order to side step this issue, lenders often take 75% of the rental income you prove with bank deposits and a signed lease. This gives them a cushion regarding the expenses you do or do not claim. For example, if you show a lender you bring in $1,500 per month in rent, they will likely use $1,125 as your income. This allows a $375 cushion per month in expenses. The standard in the housing industry has lenders believe that 25% of the rental income covers standard expenses including taxes, insurance, and maintenance.
Have Compensating Factors
It is always a good idea to have compensating factors to help yourself look better to a lender. The best way to do this is with a large bank account. You can show the lender that you have adequate reserves on hand. This serves to protect you in the event that your renter picks up and leaves. Without a current tenant, how will you cover the mortgage? This is especially important if you have a mortgage on your owner occupied property. The lender needs to see that you will not suffer financial issues as a result of a faulty tenant. If you don’t have the reserves, you are a higher risk for the lender.
Another great compensating factor is a low debt ratio. The fewer debts you have, the less risk you pose. Your debt ratio will already be pretty high if you have two mortgages on two different properties. If you add multiple credit card debts and miscellaneous loans to it, a lender will not look at your application favorably. Trying to decrease your debts before you apply for a refinance with rental income will definitely help your situation.
The bottom line is that you need to make your financial situation as attractive as possible. If you use rental income for qualification purposes and you don’t have tax returns, be prepared to provide bank deposits and a signed lease, among other things. The lender will likely pick through your application with more precision than they would with an applicant with rental income reporting on their tax returns. Always make sure to have good reasons for not reporting your income on your taxes as well as not every lender will accept this situation in the first place.