A question many “for sale by owner” sellers ask is “how do I determine if a potential buyer can afford to buy my home?” In the real estate industry, this is known as “pre-qualifying” a buyer. You may think this is a complex process, but it’s actually quite simple and just involves a bit of math. Before we get to the math, there are a few terms you need to understand. The first is PITI, which is nothing more than an abbreviation for “principal, interest, taxes, and insurance.” This figure represents the MONTHLY cost of the mortgage principal and interest payment plus the monthly cost of property taxes and property insurance. The second term is “PROPORTION”. The ratio is a number most banks use as an indicator of how much of a buyer’s GROSS monthly income they could afford to spend on PITI. Are you still with me? Most banks use a 28% ratio without considering any other debt (credit cards, car payments, etc.). This ratio is sometimes called the “initial rate.” When other monthly debts are taken into account, a ratio of 36-40% is considered acceptable. This is known as the background ratio.
Now the formulas:
The initial ratio is calculated by simply dividing PITI by the monthly gross income. The back-end ratio is calculated by dividing PITI+DEBT by monthly gross income.
Let’s see the formula in action:
Fred wants to buy your house. Fred earns $50,000.00 per year. We need to know Fred’s MONTHLY gross income, so we divide $50,000.00 by 12 to get $4,166.66. If we know that Fred can safely pay 28% of this figure, we multiply $4166.66 X 0.28 to get $1166.66. That is all! Now we know how much Fred can pay per month for PITI.
At this point we have half the information we need to determine whether or not Fred can buy our house. Next, we need to know how much the PITI payment will be for our house.
We need four pieces of information to determine PITI:
1) Sale Price (Our example is 100,000.00)
From the sale price we subtract the down payment to determine how much Fred needs to borrow. This result leads us to another term you might run into. Loan-to-value ratio or LTV. Ex: Sale price $100,000 and initial payment of 5% = LTV Ration of 95%. In other words, the loan is 95% of the value of the property.
2) Mortgage amount (principal + interest).
The amount of the mortgage is generally the sale price minus the down payment. There are three factors in determining how much the PI&Interest portion of the payment will be. You need to know 1) loan amount; 2) interest rate; 3) Term of the loan in years. With these three figures, you can find a mortgage payment calculator almost anywhere on the Internet to calculate your mortgage payment, but remember that you still need to add the monthly portion of annual property taxes and the monthly portion of home insurance. risks (property insurance). For our example, with a 5% down payment, Fred would need to borrow $95,000.00. We will use an interest rate of 6% and a term of 30 years.
3) Annual taxes (Our example is $2,400.00)/12=$200.00 per month
Divide the annual taxes by 12 to get the monthly portion of property taxes.
4) Annual risk insurance (Our example is $600.00)/12=$50.00 per month
Divide the annual hazard insurance by 12 to get the monthly portion of the property insurance.
Now, let’s put it all together. A $95,000 mortgage at 6% for 30 years would produce a monthly PI
putting it all together
From our calculations above, we know that our buyer, Fred, can afford PITI of up to $1,166.66 per month. We know that the PITI needed to buy our house is $819.57. With this information we now know that Fred DOES qualify to purchase our home!
Of course, there are other requirements to qualify for a loan including a good credit rating and a job with at least two years of consecutive employment. More on that is our next issue.
