Definition
The Housing Expense Ratio is a measure used by financial lenders to determine a borrower’s housing affordability. The ratio is calculated by dividing a borrower’s total monthly housing expenses, such as mortgage payments, property tax, homeowners insurance, and any homeowners association (HOA) fees, by their gross monthly income. Generally, lenders prefer this ratio to be no more than 28-30%, indicating that the borrower is not spending more than that percentage of their income on housing.
Phonetic
The phonetic pronunciation of “Housing Expense Ratio” is: “how-zing ex-pens ray-shee-oh”.
Key Takeaways
- Housing Expense Ratio is a fundamental parameter in mortgage lending: It is a ratio used by lenders to establish if a borrower can afford a mortgage payment. The higher the ratio, the riskier it is for the lender to issue the mortgage.
- Calculation of Housing Expense Ratio: The ratio is calculated by dividing a borrower’s estimated monthly housing expense (which includes mortgage payments, insurance, and property taxes) by his or her monthly gross income. It is expressed as a percentage.
- Importance in the home buying process: This ratio helps both the prospective buyer and the lender to understand the financial health and readiness of the buyer for taking on a home purchase. Lenders prefer a housing expense ratio of 28% or less. If the ratio is above 28%, it typically suggests potential difficulty in managing other expenses and debts.
Importance
The Housing Expense Ratio is a crucial tool in the finance industry, especially in the mortgage underwriting process. It is used to assess a potential borrower’s financial capability to cover their housing costs, which includes mortgage payments, property taxes, insurance, and potential homeowner-association dues. Lenders use this ratio to determine the percentage of a borrower’s gross monthly income that goes towards housing expenses. It essentially provides lenders with an understanding of a borrower’s reliability and risk factor, which play a central role in decisions surrounding loan approval and interest rates. Hence, maintaining a low and acceptable housing expense ratio is important for borrowers seeking favorable financing options.
Explanation
The Housing Expense Ratio is a critical tool utilized primarily by lenders in the mortgage industry. Its primary purpose is to assist the lender in determining a potential borrower’s ability to manage or handle mortgage payments based on their monthly income. When a borrower applies for a housing loan, lenders need to evaluate if the borrower can consistently meet the financial obligations involved, and the housing expense ratio plays an integral role in this assessment process.This ratio is calculated by dividing a borrower’s estimated future monthly housing expenses (which may include mortgage principal and interest, property taxes, home insurance, and possibly homeowners association fees) by their gross monthly income. The resulting ratio is typically expressed as a percentage. This is used as an indicator of the chunk of income that would be dedicated towards housing-related costs. A lower percentage is seen as favourable as it implies a lower risk for the lender, indicating that the borrower has a greater proportion of income left to cover other expenses or unexpected costs. A higher ratio, on the other hand, could suggest financial overextension and may cause the lender to think twice before approving a loan application.
Examples
The housing expense ratio is a term often utilized in the lending industry, and refers to the proportion of a borrower’s income which represents housing-related expenses. This includes mortgage payments, property taxes, and homeowner’s insurance. Here are three pertinent examples:1. Alex makes $5,000 per month before taxes. His monthly mortgage payment is $1,500. According to the housing expense ratio, he spends 30% ($1,500/$5,000) of his gross income on his housing costs. Since lenders typically prefer a ratio no higher than 28%, Alex might find difficulty being approved for additional loans.2. Sarah earns $250,000 every year before taxes which equals to about $20,833 per month. Her housing expenses, including her mortgage, property taxes, and homeowner’s insurance, total $5,000 per month. Therefore, her housing expense ratio is 24% ($5,000/$20,833), which is considered acceptable by most lenders.3. Steve makes $85,000 per year before taxes or approximately $7,083 per month. He spends $2,400 on his mortgage, insurance, and taxes. Therefore, his housing expense ratio is 34% ($2,400/$7,083). This high ratio may lead banks and financial institutions to consider him a risky borrower since he is investing a large portion of his income into housing costs.
Frequently Asked Questions(FAQ)
What is Housing Expense Ratio?
The Housing Expense Ratio is a personal finance measure that compares an individual’s or family’s housing expenses to their gross income.
How is the Housing Expense Ratio calculated?
The Housing Expense Ratio is calculated by dividing an individual’s or family’s monthly housing expenses by their gross monthly income. It’s then typically multiplied by 100 to get a percentage.
What do the percentages in Housing Expense Ratio mean?
The percentages in a Housing Expense Ratio refer to the portion of gross income that goes to housing expenses. For example, a Housing Expense Ratio of 30% means that 30% of someone’s gross income is used to cover their housing expenses.
Which expenses are included in the Housing Expense Ratio?
The Housing Expense Ratio typically includes mortgage payments (principal and interest), property taxes, home insurance, and homeowner association (HOA) fees.
What is a good Housing Expense Ratio?
Generally, a Housing Expense Ratio should not exceed 28-30% of your gross income. Lenders often use this benchmark to decide whether to approve or deny a mortgage.
What happens if my Housing Expense Ratio is high?
If your Housing Expense Ratio is high, it means a significant portion of your income is going toward housing expenses. This could indicate a risk for lenders and make it more difficult for you to secure a mortgage or other loans.
How can I improve my Housing Expense Ratio?
You can improve your Housing Expense Ratio by increasing your income, reducing your housing expenses, or both. This might involve finding a higher-paying job, paying off a chunk of your mortgage, refinancing to a lower rate, or seeking cheaper home insurance.
Can the Housing Expense Ratio be used by tenants too?
Yes, the Housing Expense Ratio can also be used by tenants. In this case, the monthly rent and utilities would take the place of mortgage payments and similar costs.
Related Finance Terms
- Debt-to-Income Ratio
- Mortgage Underwriting
- Gross Monthly Income
- Front-End Ratio
- Back-End Ratio
Sources for More Information
