Leverage (debt) allows both individuals and businesses to grow exponentially. When dealing with leverage, it is important to understand the concepts of free cash flow, debt service coverage, and liens. As long as your net annual income covers your interest and amortization payment by a factor of 1.20 or higher, it will most likely be approved by the bank.
This factor (or debt service coverage ratio) is calculated as:
Gross rent - all operating expenses (property taxes, insurance, property mgmt cost, maintenance) = net monthly income
Divide Net Annual Income by Total Debt Cost = Debt Service Coverage ratio
Gross Rent = $800/month x 12 = $9,600/year
Property Taxes = $1,000/year
Insurance = $500/year
Property Management Cost = $960/year
Maintenance = $400/year
Net Annual Income = $6,740 = ($9,600 - $1,000 - $500 - $960 - $400)
Assumed Debt = $48,000
Interest = 6%
Amortization = 30 years
Annual Interest = $3,456 = ($48,000 * 6% + 30 year amortization)
Debt Service Coverage Ratio: 1.95 = ($6,740/$3,456)
PASSES DEBT SERVICE RATIO REQUIREMENT OF 1.20!