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What Is a Good Expense Ratio for Home Buyers?

what is a good expense ratio for home buyers?

Terminator3D/iStock; realtor.com

When you purchase a home, mortgage lenders go through a number of anxiety-inducing variables—including your credit score, your income, and your work history—with a fine-toothed comb. But even if all these indicate you’re a good candidate for a mortgage, something called an “expense ratio” could still be a deal breaker.

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—but this is only an estimate, and does not account for your monthly bills, expenses, and debt,” says financial expert Harrine Freeman.

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 ratio analyzes only how your housing costs relate to your monthly income. To figure out this number, first determine all of the associated fees, costs, and responsibilities your potential new home will require. Consider the following:

  • HOA fees
  • Homeowners insurance premiums
  • Property taxes
  • Private mortgage insurance, if you’re 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.

For example, say a couple’s possible monthly mortgage is $975—but homeowners insurance will cost $75 a month, taxes tack on $50 a month, and the neighborhood HOA fees are $25 a month. Since they’re not putting 20% down, the lender requires a $75 PMI payment, bringing their total housing costs to $1,200.

Divided by their cumulative monthly salary (before taxes) of $5,000, Harry and Sally’s housing expense-to-income ratio is 28%—the absolute maximum most lenders will permit.

Debt-to-income ratio

Most lenders require a debt-to-income ratio no higher than 36%, although Freeman says people should try to get it to 28% or lower.

Here’s an example: Our friends Harry and Sally make $5,000 per month. Their new housing costs will be $1,200 per month. Add in their two car loans—$500 total—and the wife’s student debt—an additional $300 per month—to come up with a total cost of $2,000 per month.

Dividing their total monthly debt by their income and multiplying that by 100 create a debt-to-income ratio of 40%—a risky bet. But if their debt dropped by $600 a month, their ratio would be 28%. For most lenders, that ratio is acceptable.

The post What Is a Good Expense Ratio for Home Buyers? appeared first on Real Estate News & Insights | realtor.com®.