What Is the Housing Ratio and How Is It Calculated?
Discover the essential financial metric that measures housing affordability and guides lending decisions for homeowners.
The housing ratio is a financial metric that offers insights into housing affordability. It serves as an indicator for individuals assessing their personal budget and plays a central role for financial institutions evaluating loan applications. Understanding this ratio helps in navigating homeownership and maintaining sound personal finances. It shows how much of one’s income is dedicated to housing costs.
Defining the Housing Ratio
The housing ratio represents the percentage of an individual’s gross monthly income allocated to housing-related expenses. Lenders commonly refer to this metric as the “front-end debt-to-income ratio.”
Housing expenses include the principal and interest (P&I) payments on a mortgage loan, property taxes (T), homeowner’s insurance (I), and, if applicable, mortgage insurance (MI) and homeowners association (HOA) fees. These combined costs form the numerator in the housing ratio calculation. Gross monthly income, the denominator, refers to an individual’s total income before any taxes, deductions, or other expenses are withheld.
Calculating Your Housing Ratio
Calculating your housing ratio involves a straightforward process. This assessment helps determine if your housing expenses align with your income. The calculation begins by determining your total gross monthly income.
To identify your gross monthly income, sum all income sources received before any deductions for taxes, insurance, or retirement contributions. This includes your regular salary or wages, commissions, bonuses, and any self-employment earnings. For instance, if you earn an annual salary of $72,000, your gross monthly income would be $6,000 ($72,000 / 12). Other sources like rental income or spousal support are also included.
Next, identify your total monthly housing expenses. This includes your anticipated monthly principal and interest payments on a mortgage, estimated monthly property taxes, which can vary by location and property value, and homeowner’s insurance premiums. If your down payment is less than a certain threshold, you might also include private mortgage insurance (PMI) or FHA mortgage insurance premiums (MIP). Homeowners association (HOA) fees must also be added to this total.
Once you have these two figures, perform the calculation using the formula: (Total Monthly Housing Expenses / Gross Monthly Income) x 100. For example, if your total estimated monthly housing expenses are $1,680 and your gross monthly income is $6,000, your housing ratio would be ($1,680 / $6,000) x 100 = 28%.
How Lenders Use Housing Ratios
Lenders use the housing ratio as a key component in their mortgage approval decisions. This ratio indicates a borrower’s capacity to manage monthly mortgage payments without undue financial strain. It helps lenders assess the risk associated with extending a home loan.
In evaluating a borrower’s financial health, lenders consider two primary debt-to-income ratios: the “front-end” ratio and the “back-end” ratio, also known as the total debt-to-income (DTI) ratio. While the front-end ratio focuses solely on housing costs, the back-end DTI includes all other recurring monthly debt payments. These additional debts can include credit card minimum payments, car loans, student loans, and other personal loan obligations.
Lenders set thresholds for these ratios to determine loan eligibility. A common guideline for the front-end ratio is 28%, meaning housing expenses should not exceed 28% of the borrower’s gross monthly income. For the back-end DTI, a threshold is 36%, though some loan programs or compensating factors like an excellent credit score or substantial down payment may allow for higher ratios, sometimes up to 43% or 50%. Lenders also consider other factors such as the borrower’s credit score, the amount of the down payment, and financial reserves.