A question many “for sale by owner” sellers ask is “how can I determine if a potential buyer can afford to buy my home?” In the real estate industry, this is known as “prequalification” of a buyer. You may think that this is a complex process, but it is actually quite simple and only involves a bit of math. Before getting started with the math, there are a few terms you need to understand. The first is PITI, which is just 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 insurance. The second term is “RATIO.” The ratio is a number that most banks use as an indicator of how much buyers’ monthly GROSS income they could spend on PITI. Still with me? banks use a 28% ratio without taking into account any other debt. (credit cards, car payments, etc.). This ratio is sometimes called an “initial ratio.” When other monthly debts are taken into account, it is considered An acceptable ratio of 36-40% This is known as the “back-end ratio”.
Now for the formulas:
The front-end index is calculated simply by dividing PITI by monthly gross income. The backend index is calculated by dividing PITI + DEBT by the 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 gross MONTHLY income, so we divide $ 50,000.00 by 12 and we get $ 4,166.66. If we know that Fred can safely pay 28% of this figure, we multiply $ 4,166.66 X .28 to get $ 1,166.66. 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 Fred can buy our house or not. Next, we need to know how much PITI’s payment will be for our house.
We need four pieces of information to determine PITI:
1) Sales price (our example is 100,000.00)
We subtract the down payment from the sale price to determine how much Fred needs to borrow. This result brings us to another term that you might come across. Loan-to-value or LTV ratio. For example: $ 100,000 sale price and 5% down payment = 95% LTV ration. In other words, the loan is 95% of the property’s value.
2) Amount of the mortgage (principal + interest).
The mortgage amount is generally the sale price minus the down payment. There are three factors to determine how much the payment portion will be (PI and interest). 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 have to add the monthly part of the annual property taxes and the monthly part of the insurance against 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 the 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 homeowners insurance.
Now, let’s put it all together. A $ 95,000 6% mortgage for 30 years would produce a monthly PI
Putting it all together
From our previous calculations we know that our buyer Fred can pay PITI 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 buy 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 consecutive years of employment. More on that is our next issue.