A housing expense ratio is one of the most important computations used by mortgage lenders to calculate what proportion of a borrower’s income is required to meet housing expenses. The mortgage payment (principal and interest), property taxes, insurance, and other home-related fees such as maintenance or homeowner’s association dues are all part of the housing expenses.
Learn more about borrowers’ housing expense ratio needs, as well as how to calculate and increase your own.
What is the Housing Ratio?
The housing expense ratio, commonly known as the front-end ratio, is calculated by dividing the borrower’s housing expenses by their pre-tax income. At its most basic, it’s a simple statistic that shows how much of your income is spent on housing. It takes into account your mortgage payment, insurance, taxes, and other expenses. This ratio is used by mortgage lenders to determine if a home buyer qualifies for a mortgage loan.
Lenders commonly combine the housing expense ratio with the debt-to-income ratio (DTI). DTI allows lenders to assess how much money you spend on monthly obligations vs how much money comes into your home.
Both of these models provide lenders with a more complete picture of your financial status without requiring them to examine your credit score or debt payment history.
What Is the Housing Expense Ratio?
The housing expense ratio is a useful indicator for lenders to consider when deciding whether to underwrite a loan for a prospective borrower. It simply assesses a potential borrower’s ability to repay mortgage debt on a home they wish to acquire.
However, housing expense ratio computations are frequently employed in conjunction with debt-to-income ratios. This provides a more thorough view of the creditworthiness of a prospective borrower.
However, homebuyers can utilize the housing expense ratio to determine how much home they can afford safely based on their present income level.
What Does Borrowers’ Housing Expense Ratio Mean?
You should know your approximate housing expense ratio before beginning the home-buying process. As a result, if yours is 28 percent or less, you can be reasonably certain that you will meet at least that portion of the lender’s criteria.
Keep in mind that lenders consider your entire DTI ratio as well as your credit history. So, if your credit score is good, a little higher housing expense ratio may not preclude you from getting authorized in some circumstances and for certain loan programs.
If your ratio is high, you may be able to reduce it in the months before applying for a mortgage. First, make a higher down payment, which will reduce your monthly mortgage payment. If you can afford it, put down 20% or more to avoid having to pay private mortgage insurance (PMI). This is another strategy to reduce your monthly housing costs.
It’s also a good idea to look around for the best interest rate, which will reduce your monthly mortgage payment. Improving your credit score in the months leading up to your property hunt could help you qualify for even better rates.
How to Calculate Out Your Housing Expense Ratio
To calculate your housing expense ratio, you don’t need any complicated formulas or digital calculators. You can figure out this ratio by using a few standard metrics. You should already know about your income and the price of a house you wish to buy.
Let’s go over how to calculate the housing expense ratio step by step.
- Add up all of your housing costs.
- Calculate your total gross salary.
- Subtract your pre-tax income from the total.
- Analyze the outcomes
#1. Add up all of your housing expenses.
To begin, total all of the housing costs you may incur when purchasing a new home. Mortgage underwriters will follow suit.
Assume you had a $250,000 loan with a 30-year term and a 3.2 percent interest rate. You should also keep the following fees in mind:
- Mortgage insurance of $208
- Housing association costs of $250
- Property taxes of $250
- Homeowners insurance costs $136.
- Your initial principle and interest mortgage payment will be $1080.
When you sum up all of the extra costs, you get $1924. Remember that these housing costs do not cover the complete cost of the home, as you will not pay $250,000 upfront.
#2. Calculate Your Total Gross Salary
You must now calculate the total gross salary you might expect each month. For the sake of this example, assume you earn $7150 every month. Remember to include any income from your work, bonuses, child support or alimony payments, or other pretax income when calculating this statistic.
#3. Subtract your pre-tax income from your total.
To calculate your housing expense ratio, divide your expected housing expenses by your monthly income. The formula is as follows:
$1924 / $7150 = 0.269, or roughly 27%
According to the housing expense ratio formula, you’ll spend around 27 percent of your pretax income on typical housing expenses.
#4. Analyze the Results
You should now assess the results of your housing expense ratio. Remember that underwriters typically do not approve loans unless the housing expense ratio is at or below 28 percent.
Because the ratio is 27 percent in our hypothetical case above, the prospective borrower is likely to be authorized for a loan (assuming the underwriter analyzes only the housing expense ratio). If your housing expense ratio exceeds 28 percent, you may find yourself financially stressed.
However, if your housing expense ratio is greater than 28 percent, you may still be eligible to obtain a mortgage loan (though your loan options will necessarily be limited). Some lenders, for example, will approve you if you submit a larger down payment or if you have collateral.
In general, it’s a good idea to enhance your housing expense ratio over the next several months or years if necessary. You can do this by looking for a more cheap home, finding a house with lower taxes or no extra fees, raising your income by transferring careers, and so on.
How Should the Housing Expense Ratio Be Interpreted?
Lenders often set a threshold of 28 percent for the housing expense ratio when approving mortgage loans. A lender may accept a ratio of more than 28 percent provided the loan-to-value ratio (LTV) is low and/or the borrower has a good credit history.
Keeping monthly housing expenses to 28 percent of the borrower’s gross income aids in determining how much the debtor can afford to pay on a mortgage each month.
The debt-to-income ratio is the same. If the overall DTI is less than 36 percent, which is a good sign, the borrower will most likely be able to get all types of credit at an appealing interest rate, particularly for mortgages.
Debt to Income Ratio vs. Housing Expense Ratio
The housing expense ratio is a valuable indicator since it compares your pretax income to what you would most likely pay each month after acquiring a home.
However, the debt-to-income ratio is equally significant. It calculates your debt in relation to your income. In general, lenders will only approve loans for borrowers who have a debt-to-income ratio of 36% or less, which means that their debts do not exceed 36% of their overall income.
Both tools are useful, and most underwriters will consider both ratios when deciding whether to approve a loan. You cannot neglect DTI in favour of the housing expense ratio or vice versa if you want to be accepted.
What is the 28/36 Rule and how does it impact your loan?
The 28/36 guideline reminds you that your housing expense ratio should not exceed “28 percent,” and your DTI should not exceed “36 percent.” The housing expense ratio is typically referred to as the front-end ratio by underwriters, whereas the DTI ratio is referred to as the back-end ratio.
If you ever want to know your chances of getting a loan, look at these two numbers and see if your finances suit the norm. Otherwise, you may need to make a higher down payment or pay off your debt before qualifying for a mortgage loan.
What factors influence ‘how much house can I afford?’
The following elements are important in determining affordability: 1) your monthly income; 2) cash reserves to fund your down payment and closing costs; 3) your monthly spending, and 4) your credit profile.
- Income — Money that you receive on a regular basis, such as a wage or investment income. Your income establishes a benchmark for how much you can afford to pay each month.
- Cash reserves – This is the amount of money set aside for a down payment and closing charges. You can borrow money from your savings, investments, or other sources.
- Debt and costs — Monthly responsibilities such as credit cards, auto payments, student loans, groceries, utilities, insurance, and so on.
- Credit profile – A lender’s perception of you as a borrower is influenced by your credit score and the amount of debt you owe. These criteria will influence how much money you can borrow and the mortgage interest rate you will receive.
Your mortgage rate is the first step in determining your home’s affordability.
Any home affordability calculator will most likely include an estimate of the mortgage interest rate you will be paid. Lenders will decide your loan eligibility based on four primary factors:
- As previously discussed, your debt-to-income ratio.
- Your track record of paying bills on time.
- Evidence of a consistent income
- The amount of money you’ve saved for a down payment, as well as a financial cushion for closing costs and other expenses you’ll incur when moving into a new home.
Lenders will price your loan if they believe you are mortgage-worthy. This entails calculating the interest rate you will be charged. The mortgage rate you’ll get is heavily influenced by your credit score.
The lower the interest rate, of course, the cheaper your monthly payment.
Summary
Finally, the housing expense ratio is merely another approach to assess your chances of getting a loan authorized, and it’s a wonderful way to determine whether a given house is reasonable by delving deep into its expenditures. Furthermore, it’s a great method to prevent having your credit score harmed by applying for several loans when you may not have a good chance of getting approved in the first place.
You can make more informed house-hunting decisions if you use the information supplied by your housing expense ratio.
Housing Ratio FAQs
What is the 36% rule?
The 28/36 guideline is one method for determining how much of your income should go toward your mortgage. This rule states that your mortgage payment should not exceed 28 percent of your monthly pre-tax income and 36 percent of your total debt. The debt-to-income (DTI) ratio is another term for this.
What's the 50 30 20 budget rule?
Senator Elizabeth Warren popularized the so-called “50/20/30 budget rule” (also known as “50-30-20”) in her book, All Your Worth: The Ultimate Lifetime Money Plan. The basic idea is to divide after-tax income into 50 percent needs, 30 percent wants, and 20 percent savings.
What is the maximum housing ratio for FHA?
The highest permissible FHA DTI Ratio with compensating factors is 56.9 percent, which participating FHA lenders may allow based on specific compensating factors that serve to lessen the lender’s risk.
