First-time homebuyers are drowning in mortgage payments. According to a recent report from the National Association of Realtors (NAR), first-time homebuyers are spending 37.8% of their income on their mortgage payments(i.e. principal and interest). The NAR asserts that such payments should not be more than 25% and housing costs in total (e.g. principal, interest, taxes, insurance, maintenance, etc.) should not be more than 30%. In light of those guidelines, first-time homebuyers are seemingly spreading themselves way too thin. If you're buying a home, you need to know about this general ratio and how lenders evaluate it.
What do lenders care about?
However, lenders - the institutions that issue your mortgage - look at a different calculation, called the Front-End Ratio.
The Front-End Ratio is calculated by dividing your mortgage payment (principal, interest, taxes, insurance, and sometimes HOA) by your gross income.
Lenders want to see your Front-End Ratio lower than or equal to 28% for most loans, and 31% for FHA loans, which are similar guidelines to those communicated by the NAR.
Why the Front-End Ratio calculation is flawed
When was the last time that you received a paycheck that wasn't taxed? My guess is never.
So why would lenders use a ratio that compares your mortgage payment to your gross income (i.e. your paycheck before taxes)? Are they lowering the hurdle to make it easier for them to issue a loan? Maybe.
If you're going to be conservative and rigorous about your financial position before making the biggest purchase of your life, I suggest using your after-tax income when calculating your Front-End Ratio.
Sure, the 28-31% guideline will be a bit harder to clear, but you need to make sure that you have enough slack to absorb any money mishaps. Bonus tip: If you want to be even more strict on yourself, calculate the ratio using your income after taxes and after retirement contributions.
How Moneyskope evaluates the Front-End Ratio
The Front-End Ratio is one of the many factors used to calculate your Wealth Score. To calculate the metric, we use after-tax monthly income instead of gross income, since it's more conservative. Not to mentioned that everyone has to pay taxes on income. Different from others in the industry, our guideline for the ratio is on a sliding scale to adjust for stage of life. At younger ages, our guideline starts at 28% and then decreases with age. The guideline goes down with age because as you get older, you'll most likely be making more money. Moreover, people don't generally move around that much so monthly mortgage payments should stay relatively consistent.1
The meteoric rise of home prices and interest rates are putting all homebuyers in a tough situation. As recent reports have shown, first-time homebuyers are finding themselves getting squeezed, and by getting squeezed by mortgage payments alone, there is less flexibility for all the other expenses life brings. If you're in the market for a house, use the Front-End ratio as a marker for home affordability, and consider using your after-tax income for a more conservative estimate.