When you purchase a home, mortgage lenders go through a number of variables including your credit score, your income, and your work history with a fine-toothed comb. Even if all these indicate you’re a good candidate for a mortgage, an “expense ratio” could still be a deal breaker.
What is an Expense Ratio?
Your expense ratio is the metric that helps lenders quantify how much a mortgage will stress your income. This number, also known as a front ratio, compares all of your housing expenses with your pretax household income.
The general rule of thumb is that you can purchase a home that costs two to three times your annual salary. However, this is only an estimate and does not account for your monthly bills, expenses, and debt.
How is an Expense Ratio Determined?
Lenders look at two percentages to come up with your expense ratio: your housing expense ratio and your debt-to-income ratio. Neither one needs to be perfect, but veering toward unacceptable might result in a denial.
Housing Expense Ratio
This ration analyzes only how your housing costs relate you your monthly income. To figure out this number, first determine all of the associated fees, costs, and responsibilities your potential new home will require.
- HOA Fees
- Homeowners Insurance
- Property Taxes
- Privat Mortgage Insurance, if you are putting less than 20% down
- Mortgage Principal
- Interest Payments
The greater disparity between your housing expenses and income, the lower and better your housing expense ratio is. The maximum ratio most lenders will permit is 28%. Anything below that is good.
Debt-to-Income Ratio
Most lenders require a debt-to-income ratio no higher than 36%, although people should try to get it to 28% or lower.
For example, a couple makes $5,000 a month. Their new housing costs will be $1,200 a month. Add in their two car loans of $500 total, and some student debt of $300 a month, for a total of $2000 a month. Dividing their total monthly debt by their income and multiplying that by 100 create a debt-to-income ratio of 40%, which is a risky bet. However, if their debt dropped by $600 a month, their ratio would be 28% and for most lenders, that is a good ratio.
