Housing Expense Ratio

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What is the Housing Expense Ratio?

A housing expense ratio is a lending ratio used by creditors to determine if individuals qualify to borrow money or receive a loan. It is often used when lending mortgage loans.

This ratio is also a front-end ratio because it is usually considered first in the debt process and used in the borrower’s debt-to-income.

The housing expense ratio compares housing expenses with individuals earning before tax (EBT) or pre-tax income. Total housing expenses consist of mortgage expenses (the principal and interest) and operating expenses (e.g., property tax, insurance, utility bills, etc.).

The ratio considers various housing expenses submitted to creditors during the debt process. These expenses strongly influence the value and subsequent debt decision.

It is used during a credit analysis, which is a financial analysis conducted by lenders to gauge borrowers' ability to meet their debt obligations. It can also help borrowers determine the likelihood of getting approved for a loan and make financial decisions.

This ratio is often used, along with other lending ratios like debt-to-income (DTI) and loan-to-value (LTV), to dictate how much credit is available to individuals.

These ratios are vital to getting approved for loans. However, individuals with good credit scores can still be disapproved of mortgages if these lending ratios indicate otherwise.

A cosigner or co-borrower, for instance, your spouse, can help decrease the housing expense ratio and increase your chances of qualifying.

Key Takeaways

The Housing Expense Ratio (HER) is a financial metric used by lenders to assess a borrower's ability to manage monthly housing payments. It compares the borrower's gross monthly income to their monthly housing expenses.
Housing expenses typically include mortgage principal and interest, property taxes, homeowners insurance, and sometimes homeowners association (HOA) fees.
The HER helps lenders evaluate the risk associated with lending to a borrower. A lower HER indicates that the borrower has more income available to cover other expenses and potential financial emergencies.
A lower HER also suggests that the borrower can comfortably afford their housing payments without being overly burdened.

Housing Expense Ratio vs. Debt-to-income Ratio

Creditors use the housing expense and debt-to-income ratio to determine if individuals can meet their debt obligations and approve loans. Both are used to gauge the likelihood of individuals repaying their mortgages or the risk of them defaulting.

The debt-to-income ratio looks at an individual's monthly debt repayments and gross income every month. Gross income is an individual's salary before paying any expenses (e.g., taxes, interest, etc.).

While the housing expense ratio looks specifically at the percentage of pretax income it would take to pay housing expenses, DTI is broader. It looks at the % of gross income needed to pay off all debts that month.

The debt-to-income ratio has a simple calculation using monthly debt payments and gross income, where:

This ratio, alongside the housing expense ratio, will help determine how risky it would be to grant the individual a loan and if they should be approved for one.

Housing Expense Ratio vs. Loan-to-Value (LTV) Ratio

The loan-to-value ratio is another lending ratio creditors use to determine if individuals qualify for a mortgage. A loan-to-value ratio compares the loan amount to the value of the asset purchased. In this case, it would be the mortgage and the property value.

A high loan-to-value ratio raises some red flags as this indicates to creditors that an individual is more likely to default on the mortgage. Thus, individuals with higher LTV ratios are considered to be high-risk loans. This can result in a higher interest rate.

The LTV ratio differs from the housing expense and debt-to-income ratio as it does not look directly at an individual's income but focuses on the amount of money an individual wants to borrow.

The loan-to-value ratio has a simple calculation using monthly debt payments and gross income, where:

All three ratios work together to determine if someone will be approved for a mortgage and at what rate.

Calculating Housing Expense Ratio

It is a simple calculation involving two variables:

Total housing expenses
Pretax income or earnings before tax (EBT)

This ratio can be calculated on an annual or monthly basis. It is up to the lender to decide their preferred method.

Since this calculation is a ratio, the value will be between 0 and 1 or 0 and 100%.

It indicates what percentage of your pretax income will go towards housing expenses. A lower number demonstrates that housing expenses take up less or only a tiny portion of your income.

Most creditors and lenders have the house expenses ratio threshold. This threshold indicates the maximum value the ratio can be for a lender to consider approving a loan and providing money.

Regarding a mortgage loan, the threshold for the ratio is 28%. A ratio higher than 28% would indicate the borrower may be unable to fulfill their debt obligation. Thus, the lower the percentage is, the better.

However, there are some exceptions. An individual higher than 28% can still be approved for a mortgage if the loan-to-value ratio (LTV) is low and the borrower has a good credit history.

Furthermore, another ratio the bank or creditors consider is the debt-to-income ratio. The threshold for the debt-to-income ratio is 36%. Individuals with a ratio of less than 36% are more likely to get approved for a mortgage at an attractive interest rate.

Having a spouse or another individual who can cosign on the mortgage is also helpful as it would reduce your housing expenses ratio.

Example Of Housing Expense Ratio

Here is a comprehensive example that will calculate the housing expense ratio and how it can be interpreted.

Imagine two individuals, individual A and individual B, who go to XYZ Bank for a mortgage. Individual A’s total housing expenses are $3,456, and their monthly pretax income is $10,324.

On the other hand, individual B is using yearly estimates. Their total annual housing expenses are $32,690, and their pretax income for the year is $125,324.

Individual A surpasses the threshold of 28% set by banks for most mortgage payments. Thus, it will be harder for them to get approved for a mortgage. Banks will also look at their LTV ratio and their DTI ratio.

Thus, if these are low, Individual A may be able to qualify.

However, individual A will most likely have a higher interest rate.

On the other hand, individual B is shy of that 28% threshold. Thus, they are more likely to get approved for a mortgage, especially if their credit history, LTV ratio, and DTI ratio are good.