The Front-End Ratio

With deference to the fallout from the sub-prime/credit crisis, remember that lenders are competing for your business, so they are trying to maximize your revenue stream to them for a given level of risk. In modern banking, originating lenders barely wait for your revenue stream of payments. Mortgages are packaged up into pools, thereby spreading the risk/return over hundreds of mortgages, which can then be cut into slices (or tranches), and sold to investors as bonds or investments. The originating lenders get a "cut" on this sale; investors assume an insured risk of poorly performing loans, and use the revenue stream as income and compensation for holding the risk. Everyone makes money, and you are the source of this revenue stream. The higher the interest rate for a given level of risk, the higher the value your mortgage contributes to the pool, and the higher the price the lender can sell investments in the pool in secondary markets. (In practice, its not so "perfect," but these are the basic dynamics). Lenders (and investors) seek to maximize revenue while minimizing risk.

Traditionally, there are two simple ratios lenders look at when deciding how much risk they are willing to take for the anticipated revenue stream of your payments. We will look at those numbers from the perspective of both the lender and the borrower.

The first is called your debt ratio, or more technically your front-end ratio. It is easy. Your front end ratio is the proportion of your gross income that you spend on your core housing expenses:

Front-End Ratio = PITI Expenses / Gross Income

"PITI Expenses" are core expenses relevant to the loan and collateral itself: Principal + Interest + Taxes + Insurance. Just take your mortgage payment (principal + interest), add to that property taxes and monthly insurance (both mortgage insurance [PMI], if required, and home owner insurance) and divide it by your gross monthly income. Your gross income is your income before taxes. Most companies take out tax payments from your pay check before you even get the check, so your gross income is the answer to the question "How much do I make?"; it is not the amount you actually take home each month (your "net").

Many times home insurance premiums and property taxes are added as part of your monthly payment to the mortgage servicer. The servicer accrues the insurance and tax payments in an escrow account and pays them for you when they are due. So often your front-end ratio is simply the mortgage bill you will see each month divided by your monthly gross income (annual income divided by 12).

Lenders differ on what is an acceptable ratio, but usually it is between 0.25 and 0.38. Bottom line: lenders will limit your core housing cost (Principal + Interest + Taxes + Insurance or PITI) to approximately 1/4 to 1/3 of your gross (before tax) income. Lenders differ on exactly what limits they use—those willing to lend you more and accept the risk of your increased indebtedness in return for greater interest payments will use a higher ratio, while those more conservative will use a lower ratio.

If your qualifying income is $60,000 annually, then your monthly gross income is $60,000 / 12 = $5,000 month. Thus a front-end ratio sets a monthly limit at somewhere between $1,250 (for a 0.25 front-end ratio) to $1,900 (for a 0.38 front-end ratio) per month:

Low Front-End Ratio = $1,250 / $5,000 = 0.25

High Front-End Ratio = $1,900 / $5,000 = 0.38

Insurance and taxes are not trivial. Home owners' insurance can run $500 - $1,500/yr, or about $100/month. If you finance more than 80% of the home's value (i.e., put less than 20% down), you will be required to pay mortgage insurance (so-called PMI). This can cost approximately 1/2 point (1/2 of 1%), or $50 - $150/month. Property taxes vary greatly; a rule of thumb is to budget 2% of the house's value per year. A $200,000 home would be $4,000 per year or $333 added to each month's payment. Just these basic expenses could easily add $500/month to the basic principal + interest payments.

The Back-End Ratio

The second ratio lenders often look at is called your household ratio or back-end ratio. This is also easy. Your back-end ratio is just like the front-end, except now we include your other monthly debt. This ratio should not exceed 0.36 to 0.40:

Back-End Ratio = (PITI Expenses + debt) / Gross Income

Lenders will look at both ratios and limit you by the lesser of the two.

Notice that the maximum front-end and back-end ratios are similar—about 0.4 or 40%. So if you carry credit card debt, auto debt, school loans or other debt, your back-end ratio may really limit you, even if you earn more than someone who is debt-free. For example, compare someone who makes $60,000/yr and is debt free with someone who makes $72,000/yr but owes $1,000/month in other debt. Both people gross $60,000 after debt payments. The back-end ratio for the first person sets a ceiling of $2,000 a month for housing:

Back-End Ratio = ($2,000 + $0 debt) / ($60,000/12) = 0.4

where 0.4 is the highest back-end ratio the lender will allow. The person who makes $72,000—and grosses the same $60,000 after paying $1,000/month in other debt—has a lower ceiling of $1,400:

Back-End Ratio = ($1,400 + $1,000 debt) / ($72,000/12) = 0.4.

So even though the second person earns 20% more, and even though both people have the same $60,000/yr after subtracting for servicing their debt, the second person is limited to much smaller monthly payments.

Carrying debt hurts you.

The difference between $2,000/mth and $1,400/mth is substantial in terms of the house you can buy, so carrying credit card or auto or other debt hurts your eligibility for a mortgage, even if you make more and have the equivalent income after serving the debt.

Is this fair? Lenders realize that if your total indebtedness exceeds 40% of your gross income, things start getting tight. The risk of default increases. So it does not matter if you are in debt because of a big house, or a relatively low income, or credit cards: they will not lend you money for a mortgage (or alternatively will charge you higher interest to cover their higher risk) if your total indebtedness exceeds 40%.

If lenders get nervous at front and back-end ratios approaching 0.4, that's a hint that ratios that high are truly associated with increased risk. And they are. Similarly, if ratios approaching 0.25 are at the low end—meaning virtually no lender would not consider lending if your ratio was below that, then this too is a simple signal that core housing expenses of approximately 1/4 of your gross income are considered reasonable for a broad swath of the population. And, indeed, they are. So how much house can one afford (as opposed to how much will they lend me)? Ideally, target your 15-year PITI at about 1/4 of your gross. If that is too tight, then target your 30-year PITI at the 1/4 lower bound and work an upper-limit budget on your 15-year PITI. Remember, houses are like little black holes for maintenance costs, repairs, utilities, cable, phone, internet, improvements, what-nots and forget-me-nots—none of them included in the above ratios—so being conservative on the core expense ratios is wise.


Adjustable Rate Mortgages (ARMs) adjust (change) the interest rate over time. In the U.S. common products are 3/1, 5/1, and 7/1 ARMs, which means that there is one rate for the first 3, 5, or 7 years respectively of the loan, which may then "adjust" each year for the remainder of the term. There are numerous variants, and in many countries consumers can get nothing but ARMs.

Fixed rate mortgages guarantee you the interest rate for the life of the loan. It can never rise; and only you can lower it, if you choose and circumstances allow, by refinancing into a new mortgage at a lower rate. Adjustable rate mortgages (ARMs) allow the lender (or "the market," for index-pegged ARMs) to reset the rate. There are usually restrictions on when, how often, and by how much the rate can change.

In the U.S. with ready access to fixed rate mortgages of 15 and 30 years, adjustable rate mortgages should be used only when you have a plan on how to handle the rate changes. Hoping for the best is not a plan. And as we now know, hoping that housing values will continue to appreciate so that appreciation alone will pay the down-payment on a refinance into a lower rate is also not a plan: it is a hope.

This does not say that fixed rate mortgages guarantee you the lowest total cost. There are many situations where a declining rate immediately benefits you as a borrower. And situations where increasing rates can be very pressing. The average of the two is never a simple average. So a dissuasion from ARMs is based on Tip Number One and the current low rate environment.

When interest rates are low, adjustable rate mortgages offer you compromised absolute value—compromised because rates are already low so what is the absolute amount you are actually gaining? If the lower initial rate with an ARM makes a big difference, then that should be a red flag that you may be in too deep. If rates are low, a fixed rate mortgage let's you lock the rate for 15 or 30 years. That's a huge advantage, since after you factor in inflation, the net rate is only a few percentage points; a good deal guaranteed for a long time. Affordable, fixed-rate mortgages are one of the good things in life; use them.

If rates are moderately high such that the initial ARM interest rate is attractively low, can you afford the risk with an ARM that they may go even higher, even if your initial rate is locked for 3, or 5, or 7 years? If rates are high and the ARM rate is "pegged" to an index, then if rates do lower, your adjustable rate mortgage will lower with it automatically without refinancing. But strong cases for this scenario have not been seen since the 1980s. If you bought an ARM in 1979 at a painful 12% on the anticipation that "lower rates must be coming," you had an even more painful experience as they rose to 18% over the next few years. The expectation today is that either interest rates will rise as the Federal Reserve pulls back and eventually ends Quantitative Easing, or they will remain mired at a low-water mark as the economy fails to break into sustainable growth and an expansionary trajectory. But honestly, nobody knows. If we do get to high mortgage rates, they are likely to be matched with high overall rates, including high saving account rates. So one may simply be better not entering the housing market at that time and saving for another day. High rates are bad for borrowers and rate trajectories cannot be predicted. Bottom line: ARMs shift lender rate risk from them to you; if the lender thinks it is in its best interest to shift the risk to you, are you willing to bet your home on that?

Are there ever times when an adjustable rate mortgage makes sense? Yes. In some countries you have no choice. In others, in special cases where you know you will sell the property within the window of a low adjustable rate, and where you already have sufficient equity such that you can absorb unanticipated fluctuations in the market price, and where you have sufficient wiggle room or funds to service the possibility of a higher interest rate, then an ARM can save you money. If you are eight years into a 15 year plan and sell and move, a 7/1 ARM with a large down payment (small principal) on your next mortgage may make sense (keeping you inside your 15 year "chunk.") And as noted above, if we ever get back to a high rate environment like the 1980s, ARMs may have a place. But only get an ARM after you've passed tips One, Two, and Three. Let them help you test if an ARM is right.

Today, if and as possible, adjustable rate mortgages (ARMs) are best left for real estate investment purposes, not for home ownership.


A second mortgage allows you to borrow against the equity of your house even if you already have a mortgage that is not fully paid. In the U.S. these are often fixed-rate mortgages for 15 or more years. Like a first mortgage, a second mortgage gives you access to a lump sum of cash now in return for regular payments. You use part of your house as collateral, which you re-acquire as you pay back the second mortgage. Thus also like a first mortgage, if you fail to pay back the loan as agreed, you can lose your home. Note that you can lose your entire home if you fail to pay back a second mortgage, even if it was collateralized on only part of your home (rights of the so-called second lien holder). If you paid interest to get the equity in the first place, selling it back to the bank just to buy it back again can be shockingly expensive when we look at the total amount of interest you are going to pay to own your home.

Second mortgages should be taken only in emergencies or special situations.

A home equity loan is similar, but not identical to a second mortgage. A home equity loan is a two-step process. You first apply for and then receive a line of credit. This is called a HELOC (Home Equity Line of Credit). Again, you put up the equity in your house as collateral. And again, you can lose your home if you fail to pay back the loan as agreed. But unlike a second mortgage where you borrow money in one large sum, with a home equity loan you can borrow a little now and a little later and a little more later, and so on (during the so-called "draw" period)—as much as you want up to your credit limit. Unlike many second mortgages, home equity loans usually have variable interest rates. After the draw period, the debt is repaid like a mortgage over, for example, 15 years, with regular payments subject to interest rate adjustments and no further ability to borrow against the collateral.

Selling your equity while living in your home pushes on Tip Number One: do not gamble your primary residence. And doing so at a variable rate (see ARMs: Adjustable Rate Mortgages) just ups the ante. So it is not a good idea to get a second mortgage or home equity loan for a boat, car, vacation, living room furniture, or most other things. You are buying these items on credit and risking your home in the process. If the items you buy depreciate—as most items do—then you are cashing in Good Debt for Bad Debt and not helping yourself in the long run.

Is there any time that a second mortgage or home equity loan is a good idea? Yes; there are three cases.

First, if you are cashing in equity to increase a home's value, then you may be increasing your Good Debt, and this can be OK sometimes. For example, taking a $50,000 home equity loan to add an extra bedroom and bathroom—two high value additions—could be worthwhile if your budget can handle the extra payments and the neighborhood and market can handle the larger house. It may be worthwhile because when you sell the house you may recoup some of your expenses—in other words, your investment. With actual appreciation, it is the basis of Good Debt. Yet in a fluctuating or down market, this "investment" can easily become a loss. Adding $50,000 in additions to a house that is losing 15% on the market is simply locking in a $50,000 x 0.15 = $7,500 loss. And considering that even with high-value additions like a bedroom or bathroom, you may recoup only 50% - 80% of the actual construction expense, and you are paying interest on that expense, the actual realized cost can be considerably more. The Good Debt quickly becomes Neutral Debt or worse once we lose the investment component.

What about other uses for a home equity loan? Are these Good Debt? Upgrading a kitchen and buying appliances: questionable on the former; No on the latter. Adding a deck: probably not. Furnishing the den with new recliners and a flat screen TV: No (are you kidding me?). As a general rule, use equity for equity. Use other financial vehicles, such as a savings account, for satisfying wants.

Second, if you have excessively high, so-called non-secured debt, such as high-interest rate credit card debt, that is jeopardizing your ability to keep your home, you can consider using home equity in the form of a second mortgage (fixed interest rate) to consolidate debt and stabilize your situation. But this should only be done in consultation with a financial planner, bankruptcy lawyer, or other professional who can assess the situation and guide you. Using home equity for debt consolidation is a last resort, because you are simply amortizing Bad Debt. But if your Bad Debt is so great that it is jeopardizing your entire financial foundation, then your home may be in jeopardy anyway. The actual risk to your home varies with local laws. In some cases you may want to maximize and preserve home equity, which is protected by law, and explicitly not roll-in credit card debt when facing bankruptcy (the opposite of trading equity for debt consolidation), so professional legal and tax advice should be sought.

Third, while home ownership is a goal, it does not trump everything in life. We protect what is dear to us. So in some cases we may use the equity as an asset, and cash it in to pay for something even more dear, such as medical expenses for a life-threatening condition for us or a loved one. A hard choice—or for a loved one perhaps a clear choice but no-doubt still hard to do—but something we do with a clear head.

The above three cases really cover only two conditions: use home equity strategically for home equity, or use it only in dire situations. Absent from above is using home equity for education, self-improvement, starting a business, or many other activities. It is not that these uses are not worthy activities, and they are certainly not cheap. But should one really risk one's home to pay for them? We seek a portfolio of financial vehicles and plans to achieve our many goals. Think of your secure home as a keystone, not a bank, to those goals.


We mentioned inflation in relation to ARMs, but what about for the other scenarios? Certainly, even given today's low inflationary environment, there will be inflation over the next 30 years. High inflation can help debtors, but it needs to be dangerously high for it to offset the benefits of simply paying off your debt early.

What about appreciation? If housing prices rise above inflation, for example the 15% year-over-year change as seen October 2004, then the more expensive houses reap the bigger gain. Jack and Jill's and Dick and Jane's $400,000 house would each see a 0.15 x $400,000 = $60,000 increase in value to $460,000. Miles and Holiday's 15% increase would be only half as much: $30,000. With the market appreciating rapidly, it is possible to gain more in appreciation than is spent in interest; in other words, buying the bigger, richer house is the better play. But the point is moot unless you are able to realize that appreciation in a transaction at that time (e.g., sell when high). And even so, appreciation has to be unusually high for any marked difference. By unusual, we mean an historical anomaly. Below is a graph of housing prices and inflation over the last half century.

Customize | FRED Economic Data from the St. Louis Fed

We see that only in a few periods have houses significantly and differentially appreciated (or depreciated) relative to the cost of living. Indeed, we expect on theoretical grounds, and—last few years not withstanding—confirmed on empirical grounds, that houses appreciate approximately with inflation. Nevertheless, some markets are truly "hot:" demand is systemically greater than supply, and these areas will experience localized true appreciation in excess of inflation. But this is unstable, and eventually prices must and will level or even fall as population trends equilibrate. And the bigger they are, the bigger they fall.

With a subsequent fall in prices, Jack and Jill and Dick and Jane stand the more to lose, while Miles and Holiday absorb a smaller absolute shock on a home with greater equity. Because of the loans, it takes Jack and Jill and Dick and Jane 113 months—9 years and 4 months—before they will have $60,000 in equity. So a 15% drop in home prices at any time over almost the first decade will put them "upside down" or "under water" (owing more than the house is worth), depending on how much they put down as a down payment. Meanwhile, Miles and Holiday will be clear after 40 months, a full 73 months before the others.

This is one of the dangers of long term loans. The less you pay against the principal, the more likely a downward adjustment in housing prices can cause you to owe more than your house is worth.

Tip Number One says do not gamble with your primary residence. Buying a house hoping that rising asset values will justify the finance details is gambling with your home.


When you shop for lenders and compare interest rates you will be given the choice to "buy down" the interest rate. Based on your credit score and risk-worthiness, you should qualify for what is called a "par" rate. This is basically the going rate for the loan.

The bank will then offer you a deal. You can have an even lower interest rate if you pay them some money up front. This is called "buying down the rate." You are basically paying interest up front. So if you pay something extra now, you can pay a little less each month for the life of the loan. You can also do the opposite: agree to a higher rate in exchange for some cash now—for example, to help cover some of the closing costs. Amortizing your closing costs over the life of the loan is something to avoid, because closing costs do not add to the equity of the home. (Closing costs are not Good Debt, they are costs). If you have anything less than a 7-10 year horizon on a given mortgage, points are often bad deals for you.

Buying down the rate will cost approximately 1% of the loan for each 0.25% (one quarter of 1%) reduction in the interest rate. The actual amounts will vary, but this is a good guide. One percent of the loan is called a point. When the point is used to buy down the rate, it is called a discount point. So, for example, a half percent reduction in the interest rate will cost you two points.

For Miles and Holiday, a 0.25% reduction in their rate from 6% to 5.75% will cost them 1% of $200,000 or $2,000 due at closing. At this new interest rate they just bought, their monthly payment drops by $27 month. This will usually work out to be a better deal than applying the money up front against the principal (for example, $198,000 over 15 years at 6%). But what about just keeping the money and using it for something else, such as paying closing costs in cash?

Paying $2,000 now for the privilege of paying a little less each month takes $2,000 / $27 = 74 months or six years and two months to break even. Just around the time that the average person moves and pays off the loan, yielding no advantage. But the situation is really a little worse. There will have been inflation over those six years, so the $2,000 paid up front is really worth more to you now than 74 installments of $27. If conservatively inflation is mild at 3% per year, it takes about 8 years to break even. And then there is the missed tax advantage. Interest on your primary residence is tax deductible; so are some types of points. In general, discount points on a primary residence are deductible in full for the year they were paid. In our example, a $2,000 deduction this year has to be offset by 15 years of slightly larger deductions due to the higher interest rate of 6% vs. 5.75% (about $4,840 over the life of the loan). Depending on Miles and Holiday's income and tax situation and how their tax bracket and deductions change over the years, it could take them closer to 10 years or more before they recouped, if ever, the original $2,000 they paid to the bank up front. Generously, over the life of the 15 year loan, buying down the rate could possibly save Miles and Holiday about $1,000 inflation-adjusted on the total $303K they will eventually pay, or 0.33%. That is not a lot of savings for the risk of a good chance that actually saving nothing—or worse. Bottom line: unless you have a solid, well-informed plan to justify rates, just shop for a good rate at "par," keep your cash at closing, and don't buy down the rate.

One last "point:" there is another type of point called an origination point, or origination fee. This too is a percentage of the loan. The cynic will say that origination points are a fee the lender puts on you for the "privilege" of lending you money. The apologists will say they legitimately cover costs incurred by the lender related to the loan origination process, as separate and distinct from the loan itself as a financial product, and thus disclosing them is not only the honest and right thing to do, it is the lawful and legally required thing to do. Laws are changing, and it may well be that origination points are increasingly becoming more the latter than the former. Still, they are cost to you for doing business with that particular lender independent of the loan terms themselves, and you may find better deals for the same loan elsewhere. In general, origination points are not tax deductible. If you have good credit you may be able to get a loan "at par" with zero origination points. After all, many lenders will be making their main profit by selling your loan on the secondary market, so there are plenty of places to make money. And if you have excellent credit, then your credit-worthiness is an asset in your favor, making bundling a loan underwritten to you a more valuable product. It is not unusual when negotiating for a mortgage to ask the lender to waive the origination points. Even show them competing lender GFEs (Good Faith Estimates). Some lenders will refuse on policy, some will refuse on circumstance, and some will indeed waive. And of course regardless, be sure to review the entire Good Faith Estimate for other costs so that Peter is not taking to pay Paul.

Next: Fifteen