Understanding the Intricacies of Housing Expense Ratio
For the majority of individuals, acquiring a mortgage loan is a necessary step in purchasing a home. However, the process involved in qualifying for a mortgage loan involves a rigorous evaluation of the borrower's financial standing, with key metrics such as the housing expense ratio (HER) playing a crucial role. This article delves into the concept of the housing expense ratio, its importance in the loan approval process, and strategies that may potentially lower a borrower's housing expense ratio.
Conceptualizing the Housing Expense Ratio
At its core, the housing expense ratio, also known as the front-end ratio, is a comparison between an individual's housing expenses and their pre-tax income. Essentially, this ratio helps lenders to assess a borrower's ability to repay a mortgage loan, thus forming a significant part of the borrower's credit profile for a mortgage. It's the annual cost of mortgage payments - encompassing all insurances and expenses related to property ownership - divided by the individual's gross income.
The use of gross income in this calculation is strategic, as it accounts for the tax deductions often associated with mortgage payments. The ultimate goal of this ratio is to determine the feasibility of a borrower's potential home expenses against their income. In essence, it provides an insightful perspective on the scale of expenses associated with home ownership, which can help prevent individuals from overstretching their financial capacities.
Housing Expense Ratio: An Essential Tool in Lending
Lenders, especially banks, utilize the housing expense ratio to make informed decisions on whether or not to issue a mortgage loan. If an applicant's housing expense ratio exceeds 28%, their chances of obtaining approval for the mortgage loan diminish significantly. This is because a high ratio indicates that the applicant may struggle to manage their home expenses and income effectively, posing a potential default risk to the lender.
The housing expense ratio is more than a mere evaluative tool for borrowers. It also serves to protect lending institutions from the inherent risk of default associated with loans. By employing this ratio, lending institutions can perform due diligence, allowing them to underwrite loans with a clear understanding of the accompanying risk.
Institutions like Fannie Mae and Freddie Mac further alleviate the associated risk by exchanging the borrower's future cash payments for a lump sum given to the bank, which can then be utilized to fund other loans. However, this process still necessitates a proper qualification of the borrower through the housing expense ratio and other criteria.
Co-borrowing: A Strategy to Lower Housing Expense Ratio
Having a co-borrower, such as a spouse, can significantly lower a housing expense ratio. By adding another income stream, the ratio of housing expenses to pre-tax income decreases, making loan approval more likely. This is particularly beneficial for borrowers with excellent credit who might otherwise struggle with high-income ratios, thus increasing their chances of receiving approval for a mortgage.
The housing expense ratio serves as a critical metric in the mortgage loan approval process. It offers a comprehensive view of a borrowers' ability to manage their potential housing expenses against their income, thereby assisting lenders in making informed decisions and mitigating potential risks. By understanding this ratio and employing strategies like co-borrowing, prospective homeowners can improve their chances of securing a mortgage loan and making their dream of owning a home a reality.
Summary:
When deciding whether to issue a mortgage loan to a customer, a bank or lender will look at the housing expense ratio, which is the annual cost of the mortgage payments, including all insurance and expenses related to owning the property, divided by the gross income of the individual.
Gross income is used because tax deductions can be taken for mortgage payments. If a proposed mortgage leaves the borrower with a housing expense ratio (HER) over 28%, they will usually not be approved for this mortgage loan. The HER is found by dividing all annual costs associated with the new home with the gross annual income of the (proposed) borrower.
The purpose of the calculation is to put the size of the expenses of buying a home into perspective. Obviously having a place to live will always be a significant expense, but it is also a significant need. Where people run into trouble is when they attempt to live beyond their means, and take on debt obligations that they cannot handle.
Banks and lending institutions have certain insurances that will protect them from some of the default risk on a loan, but the bank’s employees must perform due diligence so that the bank can underwrite the loan knowing how much risk they are taking on.
Fannie Mae and Freddie Mac transfer much of that risk away by immediately exchanging the cash payments that will be received from the borrower for a lump sum to the bank, which the bank will use to make other loans.
The bank must still show that the housing expense ratio and other criteria have qualified the borrower for the loan.