Know Your Expense to Income Ratio Before Applying For a Loan
Cost-to-Income for Home Loans and Business Loans
The expense-to-income ratio is a financial statistic that compares the cost of living expenses to your monthly income. It’s a valuable metric for determining your capability to maintain mortgage payments.
A company’s current financial health can be calculated using several methods and procedures. One way is the cost-to-income ratio, which compares operating expenses to revenue. If you’re in charge of your company’s finances, knowing this estimation method might assist you assess its current state. This article explains the cost-to-income ratio and how to calculate it in five steps.
Can You Afford a Good Home?
Are you searching for your dream home? One of the most important numbers to keep in mind won’t appear on a real estate listing or your paycheck. It’s your expense to income ratio, and it could make or break your ability to get a mortgage loan.
What is The Expense-to-Income Ratio?
The expense to income ratio is the monthly mortgage, tax, and insurance payments divided by your monthly pre-tax income. Mortgage lenders frequently use this ratio to assess a potential buyer’s creditworthiness or financial risk.
Mortgage lenders are looking for an expense to income ratio that is 28 percent or less. This is considered “safe” by the Federal Reserve. To calculate yours, add up the prospective mortgage payment, insurance payment and property tax bill for each month. Make sure to include interest, and divide that total by your monthly pre-tax income.
The 28%/36% rule – What it is and Why it Matters
To figure out ‘how much house can I afford,’ use the 28 percent / 36 percent rule, which states that you shouldn’t spend more than 28 percent of your gross monthly income on housing costs and 36 percent on total debts, which includes your mortgage, credit cards, and other loans such as auto and student loans.
For example, if you earn $5,500 per month and have $500 in previous debt obligations, your monthly mortgage payment should not be more than $1,480.
Although the 28/36 guideline is a widely regarded starting point for calculating home affordability, you should evaluate your whole financial condition when determining how much house you can buy.
How to Calculate Cost-to-Income Ratio for Business
To calculate the cost-to-income ratio, follow these five steps:
1. Identify and total your operating expenses
To calculate your ratio, you must first determine all of your company’s operational costs. Many costs must be considered, including administrative fees, wages, maintenance, repairs, travel, taxes, and the marketing budget. Gather all of these costs and double-check that your figures are correct to prevent making erroneous estimates. After you’ve figured out the costs for each expense, add them up to determine your overall operating costs.
2. Identify and total your finance expenses
Any payments associated to a property are referred to as finance expenses. These are essentially your loan payments, such as a mortgage or a lease for office space or a building. You normally pay your investors on a monthly or quarterly basis for these types of expenses over a specified period of time. Calculate the total spending after verifying the data for each financing expense.
3. Identify and total your financial income
The following step is to calculate your total financial or gross revenue. The gross income of a firm is the amount of money earned before deductions, costs, and taxes. If you have various sources of income and cash flow, be sure that all of your income streams are numerically accurate. Then sum together all of your earnings to get your overall financial income.
4. Calculate your operating income
Calculate the difference between the two estimates after you’ve gathered your entire financial income and total financial spending. This is your operational income, or the amount of money you made after deducting your financial expenses but before accounting for your running costs. Your operating income is $80,000 if your financial income is $100,000 and your financial expenses are $20,000.
5. Use the cost-to-income ratio formula
Divide your operating costs by your operating income and multiply the total by 100 to get your cost-to-income ratio. For instance, if a company’s running costs are $25,000 and its operating income is $80,000, the equation is (25,000 ÷ 80,000) x 100. This company’s entire cost-to-income ratio would be 31.25 percent. This is a good number since it shows the company is making more money than it is spending and has a healthy profit margin.
Why is the cost-to-income ratio important?
This ratio is crucial for businesses for a variety of reasons, including:
The cost-to-income ratio is a relatively simple statistic to calculate, therefore it may be used by anyone for their own business needs. You can use the formula regularly to obtain crucial information about your firm because it is simple to grasp and compute.
It enables you to examine your company’s present financial condition. You can also use it to generate an educated guess about your financial state in the future, assuming all other variables remain constant.
You can make better educated decisions when you understand your company’s financial status. This increases your chances of determining the best ways to increase your company’s profitability and striking the ideal balance between operational expenses and revenue.
You may find that the results of your ratio calculation are not profitable for your firm. With this information, you can pinpoint the source of the issues and devise strategies to boost your company’s profitability by reducing specific operational costs.
Universal for all:
The income ratio has a wide range of applications, therefore it may be used by both large and small organizations. The ratio can also be used by a freelancer to see if their profits are worth their time and effort.
Understanding your company’s financial situation can help you set relevant and achievable financial growth and profitability goals. When you set a cost-to-income ratio goal, you can pick between lowering operating expenses in certain areas or increasing revenue.
Development of policies:
Estimating your company’s financial situation and future will assist you in developing effective policies. You can put policies in place to help you enhance your operational processes, or you can undertake structural changes that will lead to positive financial growth.
You can establish your feasibility metrics after determining your company’s current ratio. This statistic assesses the viability of your business idea and whether or not it is profitable to pursue.
Ratios used in spreadsheet applications track the success of your business. This software employs an algorithm to update your ratio automatically, allowing for quick analyses for business operations decisions.
Expense-to-Income Ratio Example
If the lender determines your monthly mortgage payment will be about $1,200, plus $125 in property taxes and $60 in insurance, your total monthly housing costs are $1,385. If your monthly pre-tax income is $5,500, your ratio is about 25 percent – in the safe zone.
How Much House Can You Afford based on this Ratio?
Might you be able to afford spending a higher percentage of your income on housing costs? Sure. No one understands your financial picture better than you do. However, lenders have to be concerned about their own bottom line, and most won’t consider financing buyers who are planning to exceed that 28th percentile.
Understanding your ratio will help you restrict your property alternatives and boost your mortgage application.
Image via Flickr/burimevgeniya