Understanding Lender Ratios and Credit Score Before Buying a Home

Written by: Niamh Douglas

I’ve been working with the 3rd Decade program* as a volunteer mentor for over a year now. As I progress on my mentor journey, I continue to see a common goal among my mentees: home ownership. I have found that many young professionals are unaware of the common lender ratios and what affects their credit scores.

I personally can relate, as I purchased a home towards the end of 2023. I know what a huge life decision it is and all the sometimes stressful situations that come with it. Hopefully, today’s article will provide some additional insight into what to expect before making the big decision.

What You Need to Know About Lender Ratios

First, let’s review the ratios that lenders commonly use to calculate the amount of debt that a consumer can take on. In the world of finance, we’d refer to these as the housing cost ratio (front-end), the consumer debt ratio, and the total debt (back-end) ratio.

Housing cost ratio (front-end ratio) = monthly mortgage payment (principal and interest + property tax + homeowners insurance + HOA fees) / gross (before tax) monthly income

This ratio should not exceed 28%.

Consumer debt ratio = monthly consumer debt payments / net (after-tax) monthly income

Consumer debt payments consist of payments outside of mortgage payments, like credit card and auto loan payments. This ratio should not exceed 20%.

Total debt ratio (back-end ratio) = monthly housing costs + consumer debt payments / gross (before tax) monthly income

For the total debt ratio, an important reminder is to use the minimum required payment amounts for the monthly housing costs and consumer debt payments. If your housing payment is currently $1500 and you’re paying $1700 to cut down interest, you’d use $1500 for the ratio. You want to use only the amounts that you are required to pay. This ratio should not exceed 36%.

The total debt and mortgage ratios use GROSS monthly income whereas the consumer debt ratio uses your NET monthly income. Why the difference?

The total debt and mortgage ratios both include monthly mortgage payments, which have tax-favored status. When filing your taxes, if your itemized deductions exceed the standard deduction, you can itemize the mortgage interest payments on your tax return. The consumer debt ratio does not include any payments that have this tax-favored status (credit cards, auto loans, etc.)

2024 standard deductions:

  • Single and Married Filing Separately – $14,600
  • Married Filing Jointly – $29,200
  • Head of Household – $21,900

What You Need to Know About Credit Scores

Lenders are also going to review your credit score. If you have a credit card, I’m sure you’ve been provided with alerts letting you know that there’s been a change to your score. Your credit score will fluctuate due to 5 categories that are each weighted differently:

  1. Payment history: Your payment history contributes to 35% of your total credit score. Have you been making your payments on time? Missed payments negatively affect this aspect of your score.
  2. Total debt: Your total debt contributes to 30% of your total credit score. Review how much you owe compared to the amount of available credit you have. It’s ok to owe a balance, but a higher percentage being used may be a red flag to lenders.
  3. Length of credit history: Your length of credit history contributes 15% of your total credit score. The longer lenders can see that you’ve had accounts open, the more positive the effect on your credit score.
  4. New credit history: Your new credit history contributes to 10% of your total credit score. Have you opened a few new credit cards this year? Each new inquiry will ding your credit score and remain on your credit report for two years. Be aware that opening several accounts within a short period can negatively affect your score.
  5. Types of credit used: Your types of credit used contribute to 10% of your total credit score. Lenders want to see your ability to manage different mixes of credit. These can be credit cards, student loans, mortgages, etc. This doesn’t mean that you should go out of your way to open new accounts just for the sake of adding to your credit mix. Refer to the items above to see how that could negatively affect your score (inquiries, length of credit history, total debt, and new credit history)

Key takeaways

Buying a home is a massive life decision and goal for a large percentage of individuals. It comes with a new responsibility and for most, a new liability – your mortgage! Of course, fluctuating mortgage rates and your down payment amount will also affect the home-buying process. It’s also a good idea to factor in expenses for annual home maintenance to manage the upkeep of your home.

Related: What You Need To Know About the Updated FAFSA