When purchasing a house, mortgage lender underwriters look at many factors for approval, from your credit score rating to how much debt you might be carrying. One important factor that impacts how much of a loan you can qualify for is your housing expense ratio.
If you are looking to buy a home soon, understanding what your housing expense ratio is can help you plan for how much of a house you can afford and if you can qualify for a loan.
What is a Housing Expense Ratio?
A housing expense ratio, often referred to as the front-end ratio, is the percentage of a borrower’s income before taxes that can be used toward their monthly housing budget. In other words, how much of your income can and should go towards paying for the mortgage and other associated expenses?
Items that are included in housing expenses are:
- Mortgage payment
- Property taxes
- Homeowners insurance
- Mortgage insurance
- Any homeowner’s association costs or HOA fees.
Keep in mind these are just costs that are associated with a mortgage, and they do not include utilities or other bills that come with the cost of owning a home.
How to Calculate the Housing Expense Ratio
The housing expense ratio is determined by dividing your borrower’s housing expenses by your gross income to get a percentage. The formula for the housing expense ratio percentage is as follows:
Housing Expense Ratio = (Total Housing Expenses / Pre-tax Income) x 100
The mortgage lender then analyzes this percentage to decide how much of a loan you qualify for. To find your monthly housing expenses, you must add all the items from the above list, including the principal and interest on your mortgage payment.
Housing Expense Ratio Example
Find Your Monthly Housing Expenses Total
The average home price in Tennessee in 2022 was 303,453. If you were to get a conventional, 30-year mortgage for, say, $300,000 with a current rate of 6.5% and 20% down, your monthly payment would be $1,896.20 without any additional fees. However, to calculate your total housing expenses, you need to include the following:
- Principal and interest mortgage payment: $1,896.20
- Estimated property taxes:$275.00
- Homeowners insurance: $130.00
- Mortgage insurance: $208.33
- Housing association fees: $100
Adding those together brings your total monthly housing expense to $2,609.53.
Divide housing expense by gross income
Once you have your monthly housing expense total, you need to find your monthly pre-tax income. If you are making $100,000 a year, your monthly income would be $8,333 before taxes.
Using the monthly housing expense total, divide that by your monthly income and multiply it by 100 to find your housing expense ratio.
2,608.53 / 8,333 = 0.310 x 100 = 31.30 or 31%.
The 31% represents how much of your income will be going to housing costs. However, 31% is a bit high for many underwriters, and they may end up rejecting the application unless you have exceptional credit or a loan that allows a higher ratio.
What is the Ideal Percentage for a Housing Ratio?
When looking at housing expense ratios, underwriters aim for under 28% for qualification. The reasoning behind this is that anything above 28% is believed to stretch a person’s finances too much and, therefore, would be a risk to the loan.
While this may seem unfair, it’s to protect both you and the lender from a defaulted loan. The 28% is based on the framework of a conventional mortgage loan, however, and programs such as FHA loans allow for a higher expense ratio.
What to Do if Your Housing Ratio is High
If you find that your ratio is above the 28% threshold, there are steps you can take to reduce your housing expenses:
- Looking for a small loan with a smaller monthly payment
- Increasing your monthly income through a raise or other sources of income
- Save for a larger down payment, which will reduce your monthly payment amount
- Improve your credit score; if you have a high credit score, some lenders may accept a slightly higher housing ratio
- Pay down debts
- Remove mortgage insurance from your monthly payments – if you have a large enough down payment to do so
Debt-to-Income Ratio: How it Affects the Housing Expense Ratio
To see if you are qualified for a mortgage, an underwriter will look at your housing expense ratio and your debt-to-income ratio, or DTI. It can also be referred to as the back-end ratio.
Your debt-to-income ratio is calculated by adding up your monthly expenses, including your housing expenses, alimony or child support, other loan payments, credit card monthly payments, and other debts.
Once you have your monthly expenses, you divide that number by your gross monthly income, just as you do with the housing expense ratio. The final number will be your DTI, which will be a higher percentage than your housing expense ratio percentage. The formula for debt-to-income is the same as the housing expense ratio, except it includes any debts and extra fixed monthly payments.
Lenders look for lower numbers, as with your housing expense ratio. The maximum percentage for most mortgage lenders is 36%. You will often hear or see the term “28/36 rule” when it comes to general housing ratios, referring to the maximum amount of housing expense and DTI you should have when applying for a loan. If you exceed either of these numbers, it may limit your mortgage options.
Your debt-to-income can be adjusted more than your housing expense ratio, which tends to be a more fixed number once you have a house and location in mind. For example, if you have a high-interest credit card, your DTI will include that interest. By moving that debt to a lower interest rate credit card, though, your DTI ratio will be lowered. Your overall debt will remain the same amount.
It’s important to consider both your debt-to-income ratio and your housing expense ratio when applying for loans; if one is higher than the other, it will still impact your chances of approval.
Are there Exceptions to the Housing Expense Ratio?
Although reaching a housing expense ratio of 28% or lower is the best option, there are a few programs that will accept high ratios, such as:
FHA Loans – Although most lenders will require you to have a housing expense ratio of 28% or lower, the FHA will occasionally allow borrowers to use up to 31% of their income towards housing expenses. They are also flexible on the debt-to-income ratio, allowing up to 43% of the income to be used toward housing expenses and debt.
USDA Loans – The USDA loan program can be great for home buyers looking for a program that doesn’t require a large down payment and is slightly more flexible regarding their housing expense ratio. They will allow up to 32% of a borrower’s income to be used towards housing expenses and up to 41% for debt and housing expenses.
Consider a Cosigner – Lenders may be more likely to approve your loan with a high DTI or housing ratio if you have a cosigner who can help guarantee that the mortgage will be paid in full and on time. If you have a cosigner with an FHA loan, the cosigner is not required to live with you. However, choose who you want to be your cosigner carefully; they must have a good score and a steady income that meets the requirements.
Lenders may also be more flexible on your housing expense ratio if it’s borderline to the ideal percentage. For example, if you have a ratio of 30% for housing expenses but your credit is excellent, and you have a steady income, they may approve you just with a higher interest rate.
Ultimately, if your housing expense ratio or debt-to-income ratio is too high, it might be better to reconsider purchasing a house and focusing on lowering the numbers to reach your financial goal and not stretch yourself too thin.
The Importance of a Good Housing Expense Ratio
Having a housing expense ratio below 28% is ideal. Underwriters for your mortgage will be more likely to approve your loan application because you are less of a financial risk and can afford the loan without any trouble. They will also take a look at your debt-to-income ratio to ensure you don’t have too much debt that will overcome your mortgage payments.
While having the ideal “28/36” ratio for housing expenses is a large factor in determining if you are approved for a loan, lenders will often look at the entirety of your financial background and well-being. A high housing expense ratio doesn’t automatically mean you will be rejected from your dream home; your excellent credit score and maybe even a cosigner might help you be approved.
If you need help with how calculating your housing ratio or have questions about finding the right loan for your mortgage, feel free to contact one of our lenders, who can help walk you through the process.
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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.
