A housing expense ratio is the percentage of your pre-tax income that goes toward your housing expenses. Lenders often use the housing expense ratio, also known as the front-end ratio, when they decide whether to approve you for a mortgage. You arrive at this number by dividing your housing expenses by your income and multiplying by 100.
Learn how to calculate your housing expense ratio, what expenses to include, and how mortgage lenders use this factor in the approval process.
Key Takeaways
- The housing expense ratio represents the percentage of your gross income that goes toward housing expenses.
- Housing expenses can include the mortgage payment, insurance, property taxes, and other costs.
- Lenders use the housing expense ratio to evaluate your creditworthiness for a mortgage loan.
- Generally, lenders prefer the housing expense ratio to be below 28%.
A Deep Dive into the Housing Expense Ratio
The housing expense ratio is a crucial metric that mortgage lenders use to evaluate whether you can manage a mortgage. This ratio is calculated by dividing the monetary amount you’re paying toward monthly housing expenses by your gross monthly income and multiplying by 100.
Housing expenses may incorporate your mortgage payment, as well as costs of mortgage insurance and property taxes.
This ratio, along with other metrics like your debt-to-income ratio, helps a lender determine the size of a loan for which you qualify. Income ratios are vital components of the underwriting process and can prevent you from receiving credit approval—even with a good credit score. If you’re considering a mortgage or any other loan, understanding your housing expense ratio is critical to knowing how much you can afford to borrow.
Housing Expense Ratio vs. Debt-to-Income Ratio
The housing expense ratio, often termed the front-end ratio, is a primary component of your total debt-to-income ratio. It is usually assessed first in the underwriting process for a mortgage loan.
Both housing expense ratio and debt-to-income ratio require you to disclose your pre-tax or gross income. When calculating the housing expense ratio, lenders will total all housing expense obligations, including potential mortgage principal and interest payments, property taxes, hazard insurance, mortgage insurance, and association fees.
The sum of these housing expenses is then divided by your pre-tax income to arrive at the housing expense ratio, which can be calculated using either monthly or annual payments.
Note
The housing expense ratio threshold for mortgage loan approvals is generally 28%, though it can vary by lender.
Importance of the Debt-to-Income Ratio
Debt-to-income is another crucial component for loan approval. Mortgage lenders will check the average amount of money you pay to creditors monthly through your credit report.
The total monthly debt payments are divided by your monthly income to determine your debt-to-income ratio. Usually, a ratio of 36% or less is preferred, though it can rise to 45% if you have excellent credit.
Underwriters consider potential strains that mortgage payments could add to your financial burden and overall debt. When determining maximum mortgage credit, an underwriting analysis involves hypothetical scenarios affecting both the housing expense ratio and debt-to-income ratio.
Lending Standards
A housing expense ratio higher than the standard 28% might be acceptable if other financial factors are favorable, such as a low loan-to-value ratio or excellent credit. If you apply jointly with a co-borrower, you can reduce the housing expense ratio.
Note
A variable-rate loan with an initially lower monthly payment may help you qualify by reducing your initial housing expense ratio.
Borrowers considering a home loan may want to plan their monthly budgets using the 28% and 36% levels. Keeping housing expenses below 28% of your income can help you gauge how much you can afford to pay monthly on a mortgage. Additionally, maintaining a total debt-to-income ratio below 36% can simplify securing other forms of credit or loans, including a mortgage.
What Is the 28/36 Rule?
The 28/36 rule advises spending no more than 28% of your gross monthly income on housing payments (rent or mortgage) and no more than 36% on total debt payments, which include credit card and personal loan payments.
Understanding Household Expense Ratio
A household expenses ratio, used predominantly for budgeting, differs from a housing expense ratio. The latter focuses on housing costs compared to your income and is used by lenders, while the former includes daily living costs such as groceries, utilities, and other necessary expenses. Ideally, the household expense ratio should be under 50%.
Maximum Housing Ratio Acceptability
Lender requirements for the maximum housing expense ratio usually target values around 28% or 25%. Even if a lender approves you for a specific amount, carefully consider whether you can afford it in practice. Take into account how a mortgage payment fits into your budget.
Final Thoughts
The housing expense ratio is a foundational metric to comprehend for your finances, especially when applying for a mortgage. Lenders depend on this ratio to predict your likelihood to meet financial obligations. A lower housing expense ratio signifies reduced risk for lenders, increasing your chances for mortgage approval.
Related Terms: Debt-to-Income Ratio, Front-End Ratio, Loan Underwriting.
References
- Michigan Department of Financial Services. “Qualifying for a Mortgage”.
- Consumer Financial Protection Bureau. “What Is a Debt-to-Income Ratio?”
- Federal Deposit Insurance Corp. “Loans and Mortgages”.
- Sallie Mae. “B3-6-02, Debt-to-Income Ratios (02/05/2020)”.
- Consumer Financial Protection Bureau (CFPB). “Debt-to-Income Calculator”.
