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.
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