Whether you’ve got a mortgage or a rent payment, housing is most people’s largest monthly expense. Many people pay thousands of dollars just to keep a roof over their heads, and that doesn’t include the cost of other essentials, like utilities.
Spending too much on housing can make it difficult to save for other long-term goals. It could also make it tough to get approved for a home loan if you want one.
Here’s a closer look at how much of your income conventional wisdom says you should spend on housing and how that stacks up to reality.
One-fifth of the typical homeowner’s income goes toward housing
The average American homeowner has a front-end debt-to-income (DTI) ratio of 20%, according to the Federal Reserve Bank of St. Louis. A front-end DTI looks at what percentage of your gross monthly income goes toward paying housing expenses. For example, if you earn $5,000 per month before taxes and your housing costs are $1,000, you’d have a front-end DTI of 20%.
That’s actually not too bad. Mortgage lenders like to see a DTI under 28%, though there may be a few banks willing to work with those with slightly higher ratios. The idea is that if you’re spending more than 28% of your monthly income on housing, you might have difficulty keeping up with your mortgage payments.
Even though mortgages are secured loans and your bank can repossess your home and sell it if need be, it would rather not do that. It would prefer that you stay on top of your payments so the bank receives cash instead. If there’s doubt of this happening, most institutions will take the safer bet and not lend to you.
The housing expenses of the front-end DTI ratio measure include more than just your mortgage. It also includes property taxes, homeowners insurance, and mortgage insurance, if applicable. So don’t forget to figure those costs in as well when calculating yours.
The value in knowing your front-end DTI ratio
Understanding your front-end DTI ratio can help you in several ways. First, if you’re shopping for a new home, it can give you a rough idea of how much house you can afford. You can use a mortgage calculator and online insurance quotes to estimate how much your monthly housing expenses will be. Check to see if the total is more than 28% of your gross monthly income. If it is, you may need to set your sights a little lower.
It can also be an overall measure of financial health. If you’re struggling with a ratio that’s too high, that could be a sign that you need to move somewhere more affordable or consider a side hustle to boost your monthly income.
You could also decide to refinance when mortgage rates are more affordable. This could help you score a lower monthly payment, which would reduce your front-end DTI ratio. But keep in mind, this could extend your loan term, and you’ll likely have to pay closing costs again.
It doesn’t hurt to keep track of your ratio over time. Ideally, it decreases as your income rises. This can be a great way to track your financial health as you work toward your other long-term financial goals.
