As a landlord, you know steady rent payments are vital to running a profitable rental business. You need a tenant who’ll pay on time consistently—and to do that, they’ll need to earn enough income to handle your monthly rent.
One way to determine the health and reliability of a tenant’s income is to calculate their rent-to-income ratio. A ratio that falls into the high-risk range (which we’ll explain) signifies that a tenant is more likely to miss payments, hurting your bottom line.
In this article, we’ll show you how to calculate it and how to use it to reduce your risk of signing a lease with the wrong tenant.
What is the rent-to-income ratio?
The rent-to-income ratio is a financial metric that measures the percentage of income a tenant will use to cover their monthly rent. The formula for calculating the ratio is straightforward:
For example, let’s assume a tenant earns a gross monthly income of $4,000, and their monthly rent is $1,000. In that case, their rent-to-income ratio is 25%.
Analyzing different rent-to-income ratios
Here’s the general rule of thumb for analyzing rent-to-income ratios: the higher a tenant’s ratio, the more likely they are to miss their rent payments. Conversely, the lower the ratio, the more capable they are of meeting their rent payment deadlines.
There’s no one answer to what constitutes a good rent-to-income ratio. However, a widely used guideline is 30%. At this level, a tenant will likely have few issues making timely rent payments while still being able to cover their other everyday expenses.
However, the 30% figure is too conservative in most cases – relatively few tenants will be able to hit this target, especially in Canada’s more expensive cities. A more realistic, but still acceptable, figure used in practice is 35%. Tenants whose ratios reach this percentage are still considered “safe” – they usually have sufficient room in their budget to cover rent and other day-to-day costs comfortably.
Tenants with ratios that fall between 40% and 50% pose a higher risk of non-payment of rent. They may face more challenges in juggling rent, food, transportation, utilities, and other costs. As a landlord, you can anticipate a lower profit margin in the long run if you offer lease agreements to this group of renters. However, these tenants can still cover their monthly rent if they have a stable income, ample savings, and low expenses.
Tenants with ratios above 50% are at elevated risk of defaulting on their payments. A job loss or an unforeseen financial emergency can easily result in them falling behind on rent. As such, you ideally want to avoid renting to this category of tenants. However,ratios above 50% are becoming more common across Canada.
Considering other factors with the rent-to-income ratio
While the rent-to-income ratio is valuable, you should never analyze it in isolation when evaluating tenants. It’s important to assess other equally crucial factors to obtain a holistic view of a tenant’s finances.
A notable limitation of the rent-to-income ratio is that it doesn’t account for debts.
For some tenants, debt payments comprise a sizable chunk of their budget. Not surprisingly, it’ll be much more challenging for them to pay rent on time compared to someone with a light debt load. For this reason, consider adding the tenant’s total monthly debt commitments to the ratio. You’ll get a far more accurate assessment of their ability to handle rent payments.
In addition, never choose your ideal rent-to-income ratio based solely on rules of thumb or industry guidelines. While 30% is a good starting point, you should tweak your desired percentage based on other relevant factors, such as current economic conditions and location.
For example, incomes during a recession tend to decrease, which means more renters than usual will have a higher rent-to-income ratio. Therefore, you may have to lower your standards to accommodate them. Otherwise, you risk losing them to your competition.
Regarding location, renters who live in urban areas tend to have higher rent-to-income ratios. The reason is that real estate in cities is typically more competitive, and living costs are higher.
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Pro Tip:Never rely on the rent-to-income ratio exclusively to decide whether to approve or decline a rental application. You could get into legal trouble if you do, as somecourts may view it as a form of discrimination, depending on the laws in your jurisdiction.
The key to understanding rent-to-income ratios
The biggest risk you face as a landlord is your tenant defaulting on their rent. By calculating the rent-to-income ratio for each candidate, you can quickly narrow the field to those most likely to pay you on time.
Renting to someone with an excessively high rent-to-income ratio, say 60%, is risky. This type of tenant is more likely to struggle financially, as they’ll be juggling multiple bills in addition to their rent. With a tight budget, it’ll be more challenging for them to cover unexpected expenses. And should they lose their job, their day-to-day spending will rapidly drain their bank account. Eventually, they’ll have little or nothing left for rent payments.
Should your tenant consistently miss their rent, you may have no choice but to evict them. Unfortunately, evictions come with a steep price tagand can take a long time to resolve.
On the other hand, a tenant with a low rent-to-income ratio poses much less risk for you. They’ll be far more capable of paying their rent on time, even when they experience financial setbacks.
Our final thoughts
A rent-to-income ratio measures a renter’s ability to pay timely rent. It tells you what percentage of their income they will dedicate to rent, allowing you to determine their financial stability. A higher ratio increases the risk of missed payments, while a lower ratio decreases it.
Industry guidelines typically quote 30% as an “acceptable” ratio, but 35% is a more realistic figure to target in practice. However, when choosing your ideal ratio, adjust it where necessary based on what’s reasonable according to your location and economic trends.
While the rent-to-income ratio is a valuable tool for screening tenants, it doesn’t accurately depict their suitability alone. Always review other relevant financial and non-financial factors, like debt obligations, past rental history, and job stability, before arriving at your decision.
