One questions many "for sale by
owner" sellers ask is "how can I determine if a potential
buyer can afford to buy my house?" In the real estate industry
this is referred to as "prequalifying" a buyer. You
might think this is a complex process but in reality it is actually
quite simple and only involves a little math.
Before we get to the math there are a few terms
you should 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 payment of principal and interest plus
the monthly cost of property taxes and homeowners insurance.
The second term is "RATIO". The ratio is a number
that most banks use as an indicator of how much of a buyers monthly
GROSS income they could afford to spend on PITI. Still with
me? Most banks use a ratio of 28% without considering
any other debts (credit cards, car payments etc.). This ratio
is sometimes referred to as the "front
end ratio". When you take into consideration
other monthly debt, a ratio of 3640% is considered acceptable. This
is referred to as the "back
end ratio".
Now for the formulas:
The frontend ratio is calculated simply by
dividing PITI by the gross monthly income. Back end ratio is
calculated by dividing PITI+DEBT by the gross monthly income.
Let see the formula in action:
Fred wants to buy your house. Fred earns
$50,000.00 per year. We need to know Fred's gross MONTHLY
income so we divide $50,000.00 by 12 and we get $4,166.66. If
we know that Fred can safely afford 28% of this figure we multiply
$4,166.66 X .28 to get $1,166.66. That's it! Now we
know how much Fred can afford to pay per month for PITI.
At this point we have half of the information we
need to determine whether or not Fred can buy our house. Next
we need to know just how much the PITI
payment is going to be for our house.
We need four pieces of information to determine
PITI:
1)
Sales Price (Our example is 100,000.00)
From the
sales price we subtract the down payment to determine how much Fred
needs to borrow. This result brings us to another term you
might run across. Loan
to Value ratio or LTV. Eg: Sale price
$100,000 and down payment of 5% = LTV ration of 95%. Said
another way, the loan is 95% of the value of the
property.
2)
Mortgage amount (principal + interest).
The
mortgage amount is generally the sales price less the down
payment. There are three factors in determining how much the
P&I (principal & 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 just about anywhere on the internet to
calculate the mortgage payment, but remember you still need to add
in the monthly portion of annual property taxes and the monthly
portion of hazard insurance (property insurance). For our
example, with 5% down 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 come up with the monthly portion of the
property taxes.
4)
Annual hazard insurance (Our example is $600.00)/12=$50.00 per month
Divide the
annual hazard insurance by 12 to come up with the monthly portion of
the property insurance.
Now, let's
put it all together. A mortgage of $95,000 at 6% for 30 years
would produce a monthly P&I payment of $569.57 per month.
This figure was produced by our payment
calculator. Add in taxes of $200.00 per month and add
in insurance of $50.00 per month and the PITI necessary to purchase
our house equals $819.57.
Putting
it all together
From our
calculations above we know that our buyer Fred can afford PITI up to
$1,166.66 per month. We know that the PITI needed to purchase
our house is $819.57. With this information we now know that
Fred DOES qualify to purchase our house!
Of course,
there are other requirements to qualify for a loan including a good
credit rating and a job with at least two years consecutive
employment. More about that is our next issue.
