Housing expense ratio

What Is Housing Expense Ratio?

The housing expense ratio is a key metric in personal finance and mortgage lending that represents the percentage of a borrower's gross monthly income dedicated to housing-related costs. This ratio provides lenders with an initial assessment of an applicant's ability to comfortably afford a home loan. A lower housing expense ratio generally indicates greater financial stability and a reduced risk of default for the borrower. It is also referred to as the "front-end" ratio.

History and Origin

Prior to the 1930s, the American mortgage system was characterized by short-term loans, often with large balloon payments and high down payment requirements, making homeownership inaccessible for many. Mortgage underwriting was often informal and inconsistent. The Great Depression led to a surge in foreclosures and a dramatic decline in property values, prompting significant government intervention.¹⁸

A pivotal moment came with the creation of the Federal Housing Administration (FHA) in 1934, as part of the National Housing Act. The FHA introduced federally insured mortgages, which significantly reduced risk for lenders and encouraged them to offer loans with lower down payments and longer repayment terms, including the concept of a fully amortized loan.¹⁶, ¹⁷ These reforms aimed to stabilize the housing market and broaden access to homeownership. Along with these new lending practices, standardized qualifying ratios, including the housing expense ratio, emerged as essential tools for evaluating loan affordability and borrower creditworthiness.

Key Takeaways

• The housing expense ratio measures the percentage of gross monthly income allocated to primary housing costs.
• It includes principal, interest, property taxes, homeowners insurance, and any applicable private mortgage insurance (PMI) or Homeowners Association (HOA) fees.
• Lenders primarily use this ratio to determine a borrower's capacity to manage monthly mortgage payments.
• A commonly cited guideline for this ratio is 28%, although specific limits can vary by lender and loan type.
• Understanding your housing expense ratio is crucial for effective budgeting and financial planning before purchasing a home.

Formula and Calculation

The housing expense ratio is calculated by dividing your total monthly housing expenses by your gross monthly income and multiplying the result by 100 to express it as a percentage.

The formula is:

Where:

• Total Monthly Housing Expenses typically include:
  • Principal and Interest (P&I) on the mortgage
  • Monthly property taxes
  • Monthly homeowners insurance premiums
  • Monthly private mortgage insurance (PMI), if applicable
  • Monthly Homeowners Association (HOA) fees, if applicable
• Gross Monthly Income is your total income before taxes and other deductions.

Interpreting the Housing Expense Ratio

The interpretation of the housing expense ratio is central to mortgage qualification. Generally, most lenders prefer this ratio to be at or below 28% for a conventional loan.¹⁴, ¹⁵ This 28% guideline suggests that a borrower's core housing costs should not consume more than 28 cents of every dollar earned before taxes each month. Meeting this benchmark indicates that the borrower likely has sufficient income remaining to cover other living expenses and debts, contributing to overall financial health.

For FHA loans, the benchmark for the housing expense ratio is typically around 31%.¹², ¹³ While these are common guidelines, a higher housing expense ratio might be acceptable to lenders if a borrower presents strong compensating factors, such as a large down payment, substantial cash reserves, an excellent credit history, or other positive financial attributes.¹⁰, ¹¹ Conversely, a ratio significantly below 28% might suggest ample disposable income, potentially leading to more favorable loan terms or providing greater flexibility in personal finances.

Hypothetical Example

Consider Sarah, who is looking to purchase her first home. Her gross monthly income is $6,000. She has found a house where the estimated monthly housing expenses are as follows:

• Principal & Interest (P&I): $1,200
• Property Taxes: $250
• Homeowners Insurance: $100
• Private Mortgage Insurance (PMI): $75
• Homeowners Association (HOA) Fees: $50

To calculate her housing expense ratio:

1. Sum Total Monthly Housing Expenses: $$\$1,200 + \$250 + \$100 + \$75 + \$50 = \$1,675$$
2. Apply the Formula: $$\text{Housing Expense Ratio} = \frac{\$1,675}{\$6,000} \times 100 = 27.92\%$$

Sarah's housing expense ratio is approximately 27.92%. This ratio falls within the widely accepted 28% guideline for many conventional mortgage lenders, indicating that her housing costs are likely considered affordable relative to her income.

Practical Applications

The housing expense ratio has several practical applications across personal finance and real estate:

• Mortgage Qualification: This is its primary use. Lenders use the housing expense ratio as a quick screening tool during the initial stages of a mortgage application to assess a borrower's repayment capacity. It helps them determine the maximum loan amount an individual might qualify for.⁹
• Personal Budgeting and Financial Planning: Even without applying for a loan, individuals can calculate their own housing expense ratio to understand how much of their income is consumed by housing costs. This insight is invaluable for budgeting, helping to ensure that housing expenses leave enough room for other necessities, savings, and discretionary spending.
• Housing Affordability Assessments: Broader economic indicators, such as the Housing Affordability Index (HAI) published by organizations like the National Association of Realtors (NAR) and the St. Louis Federal Reserve, utilize similar principles to gauge whether a typical family can afford a median-priced home in a given area. An index value of 100 suggests that a family with median income has just enough to qualify for a mortgage on a median-priced home.⁸ Monitoring these indices can provide insights into the overall accessibility of housing in different markets.

Limitations and Criticisms

While a useful benchmark, the housing expense ratio has limitations. It provides a snapshot of housing affordability but doesn't offer a complete picture of a borrower's financial capacity.

• Incomplete Financial Picture: The housing expense ratio focuses solely on housing costs relative to gross monthly income. It does not account for other significant financial obligations such as credit card debt, student loans, car payments, or childcare costs. This narrow focus means that a borrower with a low housing expense ratio could still be financially stretched thin if they carry substantial other debts.
• Rigidity of Guidelines: The common 28% guideline, while widely used, may not fit every individual's financial situation. Some borrowers might comfortably manage a higher ratio due to low or no other debts, significant savings, or a stable career path with high earning potential. Conversely, a borrower below the 28% threshold might still struggle if they have high non-housing expenses.⁷
• Gross vs. Net Income: The ratio is calculated using gross income, which is income before taxes and deductions. This means it doesn't reflect actual take-home pay, which is what people use to pay their bills. A high tax burden or significant payroll deductions (e.g., for health insurance or retirement contributions) can make a seemingly affordable housing expense ratio less manageable in reality.
• Market Fluctuations: The stability of the housing expense ratio can be impacted by market dynamics, such as fluctuating property taxes or homeowners insurance premiums, which are often beyond a homeowner's direct control.

Housing Expense Ratio vs. Debt-to-Income Ratio

The housing expense ratio and the debt-to-income ratio (DTI) are both critical measures used by lenders to assess a borrower's ability to afford a mortgage, but they differ in scope. The housing expense ratio, also known as the "front-end ratio," specifically calculates the percentage of your gross monthly income that goes towards principal, interest, taxes, and insurance (PITI), along with any applicable Private Mortgage Insurance (PMI) and Homeowners Association (HOA) Fees. It provides a focused view on housing-related affordability.

In contrast, the debt-to-income ratio (DTI), often called the "back-end ratio," is more comprehensive. It includes all monthly housing expenses plus all other recurring monthly debts, such as car payments, student loan payments, and minimum credit card payments. This broader ratio typically has a higher acceptable limit, commonly 36% for conventional loans and up to 43% or even 50% with compensating factors for FHA loans.⁵, ⁶ While the housing expense ratio indicates if you can afford the house payment itself, the DTI ratio assesses your overall debt burden relative to your income, providing a more holistic measure of your capacity to manage all your monthly financial obligations.

FAQs

Q1: What is considered a good housing expense ratio?

A housing expense ratio of 28% or lower is generally considered good by most lenders for a conventional loan. For FHA loans, a ratio of up to 31% is often acceptable.³, ⁴

Q2: What costs are included in the housing expense ratio calculation?

The housing expense ratio includes the principal and interest payment on your mortgage, estimated monthly property taxes, homeowners insurance premiums, and any applicable private mortgage insurance (PMI) or Homeowners Association (HOA) fees.

Q3: Can I still get a mortgage if my housing expense ratio is higher than the guideline?

Possibly. While guidelines exist, lenders may approve loans with a higher housing expense ratio if you have strong "compensating factors." These can include a large down payment, significant cash reserves, an excellent credit score, or a very stable job history.¹, ²

Q4: Does the housing expense ratio use gross or net income?

The housing expense ratio is calculated using your gross monthly income, which is your income before any taxes or deductions are withheld.

Q5: How can I improve my housing expense ratio?

To improve your housing expense ratio, you can either increase your gross monthly income, reduce your total monthly housing expenses (e.g., by making a larger down payment to lower the loan amount, or choosing a less expensive home), or work to lower or eliminate any private mortgage insurance (PMI) if applicable. Improving this ratio can also be part of broader financial health budgeting.