Part 1: Screening Tenants’ Finances
How to Qualify a Tenant’s Financials:
The importance of putting a qualified tenant into your rental properties is pretty high. Having the properly screened tenant that will pay rent on time is going to make or break you for the next year that you have the lease with them.
Before we get into “How do I screen tenants?” we want to look at what happens if we don’t screen them properly.
What Can Happen to My Rental Properties With a Poorly Screened Tenant?
Let’s imagine that you go all willy nilly with screening your tenants and you just place one in there without verifying their incomes, references, and background checks. You may get lucky, or you may get what you’d expect – a living, breathing nightmare. Be aware that even tenants with perfect records can turn out to be horrible in the long run.
This nightmare could come in the form of someone not paying rents on time, making you have to fork out the money for the mortgage from your own paycheck for a couple of weeks while you spend time and energy chasing them down to get the rents. Yes, you get extra money for them being late, but is the $20 worth the energy that you put into chasing them down?
Then, what if you only can get partial rents out of them because they don’t make enough money, or can’t manage it correctly, causing you to only receive half of the rent. If you don’t have a strong lease agreement with a partial rent clause, then the judge is most likely going to view partial payments of rent to be sufficient to not favor you during an eviction since you accepted a form of payment. Check out the partial payment clause that we use here.
“PARTIAL PAYMENT: Landlord’s acceptance of any partial rent payment shall not waive Landlord’s right to require immediate payment of the unpaid balance of rent, or waive or affect Landlord’s rights with respect to any remaining unpaid rent.”
Note: You should verify with your local attorney that this is applicable to your state. We are not giving legal advice.
So now you are trying to go through an eviction due to your tenant not being able to afford the rents, but the process is drawn out because court systems are amazingly fast. You spend 5 months without receiving rents since your tenants is pissed while you are evicting them and is ‘sticking it to you.’
You’ve been stressing for 5 months about your tenants potentially trashing your rental properties, the legal fees associated with the evictions, paying mortgages for the property out of pocket, considering how the security deposit won’t even touch the damages and late rents due. Basically, you’ll never see your money again, and what you thought was going to be a great investment is turning into a money pit.
Not only does this ruin your financials, it beats you down mentally, making you hesitate about even keeping the rental properties, let alone buying any more properties and securing your future.
How to Avoid Non Paying Tenants
The rule of thumb used to verify that someone can pay rent is whether or not the household income is three times the rent. For us, this income is household income. This is relevant because we went to couples, students, and friends. Not everyone is structured on a single income that will cover rent and we get the question from tenants a lot to clarify if we consider everyone’s income within the house.
The issue with the three times the rent rule is that it doesn’t show the entire financial picture for an applicant. We haven’t taken into consideration their car payments, their phones, their utilities, their food, their gas, their college debt, etc. For this reason, we only use the three times the rent rule to do a preliminary screening, not as a hard and fast rule.
Most renters (most – not all) are a bad judge of how much they can afford. Let’s be honest, most of America is a bad judge on what they can afford. As investors and property managers, we need to manage our rental properties accordingly. This means that we need to dig deeper into our prospective tenants’ finances and run some quick calculations to see if we are comfortable betting that they are going to be reliable people to place into your rental properties.
Here’s a downloadable calculator that we use to screen our applicants’ finances and make sure that we are comfortable with them affording rents. ‘Save As’ the calculator to be able to use it for yourself.
You might ask, “Why are we so invasive into someone’s income?” We know that most people are going to pay their phone bill, car payment, food, and entertainment before they pay their housing expenses if they get into a crunch. I don’t get why, but that’s the mentality that we have encountered while owning rental properties.
Within the spreadsheet, you’ll notice that there’s sections for anything from Gas & Groceries to Car Payments & Student Debts. You can add to it or take away as you wish.
How to Use the Calculator:
When you do a Credit Check on a tenant, you’ll get a rundown of their credit report. This credit report has all of their public financial information. You’ll be able to calculate how much all of their revolving debts are each month. Plug these numbers into the calculator. If there’s items within the credit report that we don’t have in the calculator, just add those into it (Make sure that the formula is calculating that cell that you added).
You’ll also have to use your best judgement of how much general life expenses are like Entertainment, Gas, Food, Clothes, etc. This varies per person and per area. There’s no way of knowing what someone might spend, which is why we use our best guess.
First off, if their income is NOT three times the rent, the calculator will automatically tell you by turning red. If it turns blue, then you’re good on the income being three times greater than the rental amount.
We have added a percentage at the bottom of the calculator showing how much of their remaining income is compared to their income at the end of each month.
Why does this matter? Because life sucks and we all have emergencies. If someone does not have extra money at the end of each month then they won’t be able to afford these emergencies and they aren’t going to pay you when their car breaks down.
Use your best judgement here. We like for the remaining income to be about 25% of their income after all main expenses. We have had great success with this formula, but realize that it’s not going to be easy to find tenants meeting this criteria. The time spent finding them upfront is well worth the easy of management throughout the year.
What If They Don’t Have Good Finances?
So what happens if you have a set of tenants that want to move in and they are the best qualified based on referrals, credit, and background checks, but their finances are questionable on whether they can comfortably afford your rental properties?
We have these people get co signers. Co signers MUST go through a credit check and income verification as well. We generally turn down co signers that don’t have above a 700 credit score. The reason we are more strict on them is because if things go south, these people have to cover their own financial responsibilities plus the tenant’s in our property.
Another reason this comes in helpful is if you take into account the fact that tenants tend to wear down rental properties (yes, more than the security deposit covers). We try to bill them immediately for things going wrong. If they don’t have extra monies, then you won’t get that money to fix your rental properties.
The ability to afford rates on rental properties, along with the rest of life’s expenses, is very important for us to verify for our prospective tenants. It can be a make or break for how well our rental properties perform. Take the time upfront to make sure everything is ‘up to snuff’ and you’ll have a much easier time managing rental properties in your real estate investing career.
Ahhhh…. The life of an Expert Tenant Screener..