Final answer:
Lenders use financial ratios to determine loan applicants' borrowing capacity. The key ratio is the income ratio, which is the monthly gross income divided by monthly housing expenses. This is known as the front-end ratio or housing-expense-to-income ratio and is crucial for loan approval. Option A is the correct answer.
Step-by-step explanation:
When lenders assess a loan applicant’s borrowing capacity, they look at a variety of financial ratios to determine the applicant’s ability to repay the loan. One of the key ratios used is the income ratio, particularly in relation to housing expenses.
The income ratio commonly used by lenders is the monthly gross income divided by monthly housing expenses. This ratio is known as the front-end ratio or housing-expense-to-income ratio, which provides lenders with a quick snapshot of an individual’s financial commitment to housing costs in relation to their overall income.
To calculate this ratio, you would take a look at the potential borrower's monthly income before any deductions. For instance, if they have an annual gross income of $60,000, their monthly gross income would be $5,000 (divided by 12 months).
If their estimated monthly housing expense, including mortgage, property taxes, and homeowners insurance, is $1,500, the ratio would be calculated as $5,000 (monthly gross income) divided by $1,500 (monthly housing expenses), which equals to a ratio of approximately 3.33. This suggests for every dollar of income, the borrower is committing roughly one-third of it to housing-related expenses.
It is important for the borrower to maintain a ratio that is acceptable to lenders to ensure they are not deemed as overextending themselves and thus, resulting in a decreased likelihood of loan approval.
In conclusion, the correct option that best expresses the income ratio used by lenders to assess a loan applicant’s borrowing capacity is Option a: Monthly gross income divided by monthly housing expenses.