You will probably hear plenty of real estate and mortgage-related terms when considering a home purchase.
One of them is the housing ratio, also referred to as the house expense ratio. Your mortgage company will review your housing ratio to decide if you can qualify for a home loan.
Here, we will detail what this ratio is, how it is calculated, and why it’s vital to your future.
Housing Ratio Definition
So, what is the housing ratio? This number compares housing costs to pre-tax income. Many mortgage companies use this ratio to qualify you for a home loan. Some lenders also refer to this number as the front-end ratio.
The housing ratio is one-way lenders review your credit profile for a mortgage. This ratio is often considered when the lender needs to see if you have the income to pay for the loan.
This number is often used with your debt-to-income ratio to figure out the most home you can afford to buy. The ratio is an essential part of the mortgage underwriting process. If it’s too high, you may be rejected for the mortgage even with stellar credit.
How To Calculate Housing Expense Ratio
Wonder how to calculate the housing ratio? Just divide your possible monthly mortgage payment by your gross monthly income (this is how much you earn without taxes and deductions).
Say your total house payment is $2,000, and you make $8,000 per month in gross income. Divide $2,000 by $8,000. So, your housing expense ratio is 25%. That ratio would be viewed positively by most lenders.
When your housing ratio is below 28%, it suggests to the lender that you can afford the mortgage. It’s important that the home buyer can afford the loan, of course. But it’s also vital there is enough money left over to pay other debts and have money left over.
The lender will make its final loan approval decision with this figure. After all, it’s vital to understand if you can afford the home or not. Lenders want to verify that you can afford the house.
Debt-To-Income Ratio
The debt-to-income ratio is another vital part of mortgage approval. When the mortgage company considers you for a loan, they will check how much you make in monthly debt payments.
This sum is divided by your monthly income, the debt-to-income ratio. Most lenders want to see a 36% or less debt-to-income ratio for mortgage approval.
Mortgage companies will examine the possible financial stress the loan payment will add to your credit profile. So, when the lender determines how much mortgage you can afford, they will analyze possible monthly mortgage payment scenarios.
The lender will also look at the possible effects on your housing and debt-to-income ratios.
Remember, your debt-to-income ratio includes all of your debt expenses. These include:
- Car loans
- Student loans
- Personal loans
- Child support
- Alimony
- Credit cards
You may improve your debt-to-income ratio by getting a smaller mortgage or paying down debt.
Comparing House Expense And Debt-To-Income Ratio
This is also called the front-end ratio because it is part of your total debt-to-income. The housing expense ratio is frequently considered first when the loan officer underwrites your loan.
You need to disclose your pre-tax income so the lender can calculate the housing ratio.
When the lender calculates your housing to income ratio, the loan officer will add up all your housing costs. This number includes mortgage principal and interest, real estate taxes, homeowners insurance, HOV fees, and mortgage insurance.
The total of your monthly housing expenses is divided by your pre-tax income. This figure is your housing ratio. This number can be determined with annual or monthly payments.
Most lenders want to see a housing expense of 28%. If your gross monthly income isn’t high enough, the lender won’t approve you. Some mortgage lenders may approve you for higher than 28%. But there are not as many options.
What Does The Housing Ratio Mean For You?
We’ve covered what the housing ratio is. But what does it mean when applying for a loan?
You should start the homebuying process by knowing what your housing expense ratio is. If it’s 28% or less, you know you meet the lender’s standards in this area.
Please remember that the mortgage company will also check your overall debt-to-income ratio and credit profile. If your housing ratio is higher, you may still qualify for the loan with a good credit score.
Have a high ratio? You may be able to lower it before you apply for the home loan. One solution is to make a higher down payment. It used to be a requirement to put down at least 20% when buying a home.
This often isn’t necessary today. For example, you can be approved for an FHA loan with only 3.5% down. But putting down so little money means a higher mortgage payment. Putting down 20% on your home will reduce your payment and decrease your housing ratio.
Putting at least 20% down also will eliminate your mortgage insurance. When you have a lower down payment, most lenders require you to pay for monthly mortgage insurance. People who put less money down tend to default on their mortgages more often. Mortgage insurance reimburses the lender in case of mortgage default.
Also, you may think about ‘paying points’ on the mortgage. This means you pay the lender during the closing to lower the interest rate, which gives you a lower payment.
Each point you buy costs 1% of the loan amount. For instance, one point on a $200,000 mortgage would cost you $2,000. This amount can be paid in cash at closing. Or, you can wrap it into the loan amount and pay it over time.
Each point you pay usually lowers the rate by .25%. So, buying one point would lower a 3% mortgage rate to 2.75% But how much each point reduces the rate varies by lender.
And shop several lenders for the lowest interest rate, which can make a dramatic difference with your monthly payment.
Another option is to get a co-signer on the loan. Having a co-signer can raise your income and that will improve your housing ratio. Or, consider renegotiating the price with the seller. If the seller needs to sell quickly, they may agree to lower the price.
The 28/36 Rule
Lenders often follow this rule to decide if you can afford the mortgage. As noted above, 28% is the housing ratio. The 36% is your debt-to-income ratio.
Together, your housing ratio is called the front-end ratio. The DTi is called the back-end ratio.
Other Considerations
The lender usually wants to see a 28% housing expense ratio. But another factor is whether you should spend that much. Everyone’s financial picture is different.
On the one hand, if you don’t spend as much on entertainment and a car, you may be able to afford a higher mortgage at 28% or even 30%.
Also, if you live in New York City or San Francisco, keeping your housing ratio under 28% is probably a pipedream. Did you know most New York City residents pay almost ⅔ of their income for housing?
Some financial experts maintain that most people can afford to spend about 29% of their gross monthly income on housing costs. This may be as high as 41% if they have no other debts. But not every lender will allow you to have a housing expense ratio over 28%. So you will need to shop for several lenders.
On the other hand, if you want to retire soon, you may want to spend less than 28% on housing. Even if you can qualify for the loan, spending less on your mortgage means money left over for other things.
Say you make $8,000 per month in gross income. If the maximum housing expense ratio is 28%, you can qualify for a $2,200 per month payment. But if you can lower your monthly payment, you can invest that money instead.
Maybe you can get the seller to drop the price, or you can pay points to lower the interest rate.
Doing that can help you bank thousands of dollars in savings per year, which you can invest in your future.
Summary
The housing ratio is a fast way for you and your mortgage lender to figure out how much you can afford. If you are thinking about applying for a home loan, calculate your housing ratio with Mashvisor’s mortgage calculator. Having this information is so important.
It helps to know your housing ratio before you even apply for the loan. If it’s too high, you know to look for a less expensive home. You also have other options, such as paying points to the lender, making a higher downpayment, or paying down debt.
When you know what your housing ratio is, you can move forward with the knowledge that the home is within your means.
If you’re just getting started with your home search, you can always rely on Mashvisor. We can assist you with finding a property, researching the best housing markets, and much more.