A housing ratio is a term that is both important to the lender and the borrower. It determines your eligibility for a loan by checking your creditworthiness. This article is a guide to everything you need to know about your housing estate ratio, including how to calculate it from your income.
What Is a Housing Expense Ratio?
A housing expense ratio is a ratio that compares housing costs to income before taxes. It is frequently used by lenders to approve borrowers for loans. A front-end ratio is another name for a housing expense ratio.
In most mortgage loans, the housing expense ratio is employed. Lenders examine a borrower’s credit profile in depth to ensure that they will be able to repay the mortgage obligation.
The ratio is frequently used in conjunction with the debt-to-income ratio (DTI) to establish the borrower’s maximum credit limit.
How Does The Housing Expense Ratio Work?
When examining a borrower’s credit profile for a loan, one indicator utilized is the housing expense ratio. It’s most commonly used in mortgage loans to assess a potential borrower’s ability to repay a home’s mortgage debt.
When establishing the maximum credit amount to extend to a borrower, this ratio is usually utilized in conjunction with debt-to-income. Even with a decent credit score, income ratios are an important part of the screening process and can prevent a borrower from gaining credit approval.
If you’re thinking about getting a mortgage or another type of loan, calculating your housing expense ratio will help you figure out how much money you can borrow.
How Do You Calculate Your Housing Ratio?
Take your pre-tax monthly income and calculate it by your housing expenses to get your housing expense ratio. This formula is used by mortgage lenders to estimate the risk of a loan, and it is carried out by an underwriter.
Let’s have a look at the calculation step by step. We’ll go over it with an example so you can understand how everything works together.
#1. Add up all of your housing costs.
A mortgage underwriter adds up all of your housing-related charges to determine your housing expense ratio. We’ll utilize a $250,000 loan for 30 years at a 3.2 percent interest rate for the first step of our example. National averages were used to calculate taxes, HOA fees, homeowners insurance, and private mortgage insurance.
- Property taxes are estimated to be $250.
- Mortgage payment: $1,081.17 (principal and interest).
- Homeowners’ insurance costs $136 per year.
- $208.33 in mortgage insurance
- Fees for the housing association: $250
When all of these costs are added together, the total monthly housing expense is $1,925.50.
#2. Subtract your pre-tax income from your total income.
The next step is to compare your pre-tax income against your costs. We’ll take $86,011 as the median family gross income (year pre-tax earnings) in this example. This works out to $7,167.58 each month.
We’ll divide our expense ($1,925.50) by our income ($7,167.58) to arrive at our housing expense ratio. Our result is 0.27, or 27 percent, when rounded up. This means that housing costs account for 27% of our pre-tax income.
#3. Examine the outcomes
An underwriter understands at this point that our hypothetical gross monthly income will qualify for a loan. The rule of thumb for qualifying for a mortgage with a housing expense ratio of less than 28 percent is that anything less than that is good. If your debt-to-income ratio is greater than 28 percent, you may be stretched too thin and find it difficult to meet your monthly mortgage payment or other commitments.
This criterion is used to make final loan approval decisions. It’s a crucial statistic in determining whether or not you can purchase a property. Mortgage lenders want to make sure you have cheap housing, so you won’t be authorized if your income isn’t sufficient to cover the loan installments.
While certain lending programs allow for larger housing expense ratios, anything beyond 28 percent would limit your alternatives. If you find yourself in this scenario, think about how you might cut your expense ratio or hunt for a housing with cheaper monthly payments. To put it another way, you can put down a larger deposit, find a more affordable home, or look for a home in an area with no HOA fees or reduced real estate taxes.
In summary, the housing ratio formula is as follows:
Importantly, both monthly and annual payments can be used to calculate the housing expense ratio.
How to Interpret the Housing Expense Ratio Calculation
Lenders often set a 28 percent housing expense ratio as a minimum requirement for mortgage loan approval. If the loan-to-value ratio (LTV) is modest and/or the borrower has a good credit history, a lender may accept a ratio higher than 28 percent.
Maintaining a monthly housing expense of 28 percent of a borrower’s gross income aids in determining how much a debtor can afford to pay on a mortgage each month.
The debt-to-income ratio is the same way. If a borrower’s overall DTI is less than 36 percent, which is a favorable sign, he or she will be able to obtain all sorts of credit at a reasonable interest rate, including mortgages.
Borrowers considering a house purchase may choose to arrange their monthly budgets around the 28 percent and 36 percent levels. Maintaining a monthly housing expense of 28 percent of a borrower’s income can assist in determining how much a borrower can afford to pay on a mortgage on a monthly basis. When qualifying for a mortgage loan, maintaining a total debt-to-income below 36 percent can make it easier for a borrower to get all sorts of credit, particularly mortgage credit. Selecting specific mortgage products with modest beginning payments, as well as applying jointly with a co-borrower, might minimize a housing expense ratio.
Other lending ratios include the debt-to-income ratio and the loan-to-value ratio, in addition to the housing expense ratio.
What is the Debt-to-Income Ratio?
The debt-to-income (DTI) ratio is one of the lending ratios that depicts the monthly link between a person’s debt repayments and gross income. Before paying off the costs, gross income is merely a monthly payout (e.g., salary) (taxes, interest expense, etc.).
To put it another way, the debt-to-income ratio is a percentage of gross income that is utilized to pay down debt.
The following is the DTI formula:
Mortgage lenders use the ratio a lot when determining whether or not a borrower will be able to repay the loan.
Anyone who takes out a loan must reveal his or her pretax income. This is a key factor in calculating the housing expense ratio and the debt-to-income ratio.
Debt-to-Income Ratio vs. Housing Expense Ratio
The housing expense ratio is also known as the front-end ratio. This is because it is a partial component of a borrower’s overall debt-to-income and may be examined first in the underwriting process for a mortgage loan. The housing expense ratio requires a borrower to disclose their pre-tax income, which is an important aspect in both the housing expense ratio and the debt-to-income ratio.
An underwriter will add all of a borrower’s housing expense responsibilities, including possible mortgage principal and interest payments, property taxes, hazard insurance, mortgage insurance, and association fees when computing the housing expense ratio.
The housing expense ratio is calculated by dividing the total housing expenses by the borrower’s pre-tax income. Monthly or annual payments can be used to calculate the housing expense ratio. The housing expense ratio (HER) is commonly set at 28 percent for mortgage loan approval.
Another important factor in loan acceptance is the debt-to-income ratio. When you apply for a mortgage loan, the creditor will collect the average amount of money you pay to creditors each month. The debt-to-income ratio is calculated by dividing the sum by the borrower’s monthly income. For loan acceptance, borrowers must have a debt-to-income ratio of 36 percent or less.
Mortgage underwriters will take into account how much stress a mortgage payment will put on a borrower’s credit history. An underwriting study comprises hypothetical scenarios of monthly mortgage payments and the potential implications on both the housing expense ratio and the debt-to-income ratio levels for establishing the maximum amount of mortgage credit accessible to a borrower.
Loan to Value Ratio
When purchasing a home, there is one more ratio to be aware of. This one, on the other hand, affects whether or not you will be approved for a mortgage to purchase or refinance a home.
The loan-to-value ratio specifies the percentage of a home’s value that you are requesting to be financed. Most private mortgage lenders will need a down payment of at least 5% of the home’s worth when acquiring a home. As a result, you’ll have a loan-to-value ratio of 95%. This means you’re looking for a loan that will cover 95% of the cost of your housing.
You’ll need a loan-to-value ratio of at least 80% to avoid the private mortgage insurance requirement that comes with mortgages with down payments of less than 20%.
You’ll normally need a loan-to-value ratio of 80 percent or below to refinance your house loan. However, there are programs available, some of which are funded by the federal government, that allow homeowners with greater loan-to-value ratios to refinance.
Importance of The Loan-to-Value Ratio
A high LTV ratio, in general, suggests a high level of lending risk. The rationale for this is that the mortgage is secured by the purchased property (e.g., a house). As a result, the LTV ratio compares the loan size requested to the size of the pledged collateral.
The calculation of the LTV ratio is important in mortgage underwriting for the reasons stated above. If the LTV ratio is less than 80%, for example, conventional mortgage lenders will normally offer favorable loan terms.
If an applicant’s LTV ratio is greater than 80% but less than 100%, a loan can still be given if the applicant has a good credit history. The loan terms, on the other hand, are likely to involve higher interest rates and the purchase of private mortgage insurance (PMI). Loans with an LTV ratio of more than 100% are more likely to be turned down.
The Loan-to-Value Ratio Formula
The loan-to-value ratio is calculated using the following formula:
Loan-to-Value Ratio Example
John is attempting to obtain a mortgage from a bank in order to purchase a new home. He requires a loan of $500,000. The bank, on the other hand, wants to calculate the loan-to-value ratio to analyze the loan’s risks.
The current worth of the house John wishes to buy has been determined by an impartial appraiser to be $700,000. As a result, the mortgage’s loan-to-value ratio is:
A loan-to-value ratio of 71 percent is generally seen as posing a modest risk to the lender. As a result, John’s mortgage application is likely to be approved by the bank.
The housing expense ratio, often known as the house-to-income ratio, is a simple approach for you and your lender to figure out how much home you can afford. If you’re considering asking for a loan, you should first calculate your housing expense ratio.
Housing Ratio FAQs
How is the housing expense ratio calculated?
Simply calculate the total of all property expenses by a pretax income to get the housing expense ratio.
What is the 36% rule?
The 36% rule is a crucial number for homebuyers. It states that your mortgage payment should not exceed 28 percent of your monthly pre-tax income and 36 percent of your overall debt. The debt-to-income (DTI) ratio is another term for this.