Does Rental Income Count as Earned Income for Mortgage?

Understanding Rental Income for Mortgage Qualification

When seeking a mortgage, applicants often wonder if income from rental properties can contribute to their eligibility. While rental income is not considered “earned income” in the same way as wages or a salary, it can indeed be a significant factor in a lender’s assessment. Lenders evaluate this income source differently due to its unique characteristics, and understanding these nuances is important for mortgage qualification. This article explores how lenders assess rental income, the calculations involved, and the documentation required for its consideration.

Lenders differentiate traditional “earned income,” such as salary or wages, from “rental income” due to inherent differences in their nature and stability. Earned income is generally consistent and directly tied to an individual’s labor, offering a predictable stream of funds. Rental income, conversely, can fluctuate due to factors like vacancies, tenant turnover, and unexpected maintenance costs.

Because of these variables, lenders view rental income as a supplemental source rather than a primary, guaranteed form of income for qualification purposes. They recognize that owning rental property involves ongoing expenses and potential periods without tenants. To account for this, lenders apply specific criteria to determine how much of this income can be reliably counted towards an applicant’s ability to repay a mortgage.

The primary concern for lenders is the stability and reliability of the rental income over time. They typically require evidence of a consistent rental history to mitigate risks associated with potential vacancies or inconsistent payments. Furthermore, lenders consider the property’s own debt obligations, such as its existing mortgage, property taxes, and insurance, when assessing the net financial benefit it provides.

Calculating Qualifying Rental Income

Lenders employ specific methodologies to determine the portion of rental income that can be used for mortgage qualification. A common approach involves taking a percentage of the gross rental income, typically ranging from 75% to 80%. This reduction is applied to account for potential vacancies, ongoing maintenance, and other operating expenses, even before actual expenses are itemized. For example, if a property generates $2,000 in gross monthly rent, a lender might only consider $1,500 to $1,600 as the effective monthly income.

From this adjusted gross rental income, lenders then factor in the property’s own recurring expenses. These typically include the existing mortgage payment, which comprises principal and interest, as well as property taxes and hazard insurance premiums. Any homeowners association (HOA) dues associated with the rental property are also subtracted from the calculated income.

If the calculated net income from the rental property is positive, that amount can be added to the borrower’s total qualifying income. For instance, if the effective monthly rental income is $1,500 and the property’s monthly expenses (mortgage, taxes, insurance, HOA) total $1,200, the resulting positive $300 would contribute to the borrower’s income for debt-to-income ratio calculations.

Conversely, if the property’s expenses exceed the adjusted rental income, the resulting negative cash flow is treated as a debt for the borrower. Using the previous example, if the effective rental income was $1,500 but the property’s expenses were $1,700, the negative $200 would be added to the borrower’s monthly debt obligations. This negative amount increases the borrower’s debt burden, potentially impacting their ability to qualify for a new mortgage.

Lenders apply these calculations consistently across various property types to ensure a standardized evaluation of rental income. The resulting net figure provides a clear picture of how the rental property contributes to, or detracts from, the borrower’s qualifying income.

Documentation and Lender Requirements

To verify rental income and assess its eligibility for mortgage qualification, lenders require specific documentation from applicants. A primary document is the federal tax return, specifically Schedule E, “Supplemental Income and Loss,” which is part of Form 1040. This schedule details income and expenses from rental real estate, royalties, partnerships, S corporations, and trusts, providing a comprehensive historical record of the property’s financial performance over the past one to two years.

Lenders typically request copies of the applicant’s federal tax returns for the most recent one or two tax years to review the reported rental income and associated expenses. The information on Schedule E allows lenders to independently calculate the net rental income based on the reported figures, aligning with their own qualification methodologies.

In addition to tax returns, current lease agreements for the rental property are often required. These agreements confirm the current rental amount, the lease term, and the names of the tenants. Bank statements showing consistent rental deposits from tenants can also be requested to corroborate the income reported on tax documents and lease agreements, providing further evidence of regular cash flow.

Many lenders have “seasoning” requirements for rental income, meaning they require a minimum period of established rental history. This typically ranges from one to two years, demonstrating the stability and reliability of the income stream.

For properties that are newly acquired, recently rented, or being purchased as an investment property without an existing lease, lenders may still consider projected rental income. In such cases, an appraisal that includes a rent schedule is often necessary. The appraiser will assess the property’s market rent based on comparable rental properties in the area, providing an estimate of its potential rental income.