The ratio between housing expenses and earnings before tax that is often used in credit analysis
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The housing expense ratio is a ratio that compares housing expenses to earnings before tax (EBT) or pretax income. The ratio is often utilized in credit analysis initiated by lenders during the lending process. In other words, lenders, such as banks, use the ratio during due diligence while qualifying a borrower for a loan.
The housing expense ratio is mainly used in mortgage loans. Lenders perform a comprehensive assessment of a borrower’s credit profile, making sure it would be able to repay the mortgage debt.
The ratio is commonly used in conjunction with the debt-to-income ratio (DTI) to determine the maximum amount of credit being available to the borrower.
Housing expense ratio is a ratio that compares housing expenses to earnings before tax (EBT) or pretax income.
The total house expense consists of all possible expenses associated with servicing a house (utilities, property taxes, and insurance, etc).
To calculate the housing expense ratio, simply take the sum of all property expenses and divide it by a pretax income.
What is the Total Housing Expense?
Total housing expense is an expense that comprises a homeowner’s monthly mortgage expense (principal and interest), operating expenses, such as property taxes and insurance, utility bills, and property management fees, etc. In fact, housing expenses embrace a large range of costs and are required to be submitted in the debt application process by lenders.
The total housing expense is a key component in calculating a borrower’s housing expense ratio.
How to Calculate the Housing Expense Ratio?
To calculate the housing expense ratio, lenders sum up all the housing expense obligations of a borrower, such as operating expenses like future mortgage principal and interest expenses, monthly utilities, property insurance, and property taxes, etc. The sum is then divided by the borrower’s pretax income to arrive at the housing expense ratio.
Importantly, the housing expense ratio can be calculated using both monthly and annual payments.
How to Interpret the Housing Expense Ratio?
The threshold for the housing expense ratio set by lenders for mortgage loan approvals is typically equal to 28%. A ratio higher than 28% can be accepted by a lender if the loan-to-value ratio (LTV) is low and/or the borrower demonstrates an excellent credit history.
Keeping monthly housing expenses to 28% of the borrower’s gross income assists in estimating how much the debtor can afford to pay monthly on a mortgage.
The same applies to the debt-to-income ratio. If the total DTI is far below 36%, which is a good sign, a borrower will be most likely able to secure all types of credit at an attractive interest rate, specifically, for mortgages.
In addition to the housing expense ratio, other lending ratios also include loan-to-value ratio and debt-to-income ratio.
What is the Debt-To-Income Ratio?
The debt-to-income (DTI) ratio is one of the lending ratios that represent the relationship between an individual’s debt repayments and his/her gross income on a monthly basis. Gross income is simply a monthly paycheck (e.g., salary) before one pays off the costs (taxes, interest expense, etc.).
To put it another way, the debt-to-income ratio is a percent of gross income used to settle debt obligations.
The DTI formula is as follows:
The ratio is extensively utilized by mortgage lenders while evaluating the likelihood of a borrower to repay the mortgage.
Whoever is borrowing money will need to disclose his/her pretax income, which is an essential factor in the calculation of both the housing expense ratio and the debt-to-income ratio.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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