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How to Prequalify a Buyer When You Sell Your Home "By Owner"

A question that many “for sale by owner” sellers ask is “How do I determine if a potential buyer can afford my home?” In the real estate industry this is referred to as “pre-qualifying” a buyer. You might think that this is a complicated process but in fact it is actually very simple and only takes 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 acronym for “principal, interest, taxes and insurance”. This number represents the MONTHLY cost of the mortgage payment in principal and interest plus the monthly cost of property taxes and homeowner’s insurance. This is the second time. “RATIO”. The rate is a number that most banks use as an indication of how much of a customer’s monthly GROSS income they can afford to spend on PITI. Still with me? Most banks use a rate of 28% regardless of other loans. (credit cards, car payments etc.) Sometimes this rate is referred to as the “front end rate”. 36-40% is acceptable when you consider other monthly payments. “rear end ratio”.

Now for the formula:

The front-end ratio is calculated simply by dividing the PITI by the gross monthly income. The latter amount is calculated by dividing PITI + DEBT by gross monthly income.

Let’s see the formula in action:

Fred wants to buy your house. Fred earns $50,000.00 a year. We need to know Fred’s MONTHLY gross 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 amount we add $4,166.66 X .28 to get $1,166.66. That’s it! Now we know how much Fred can pay for PITI per month.

At this point we have about half of the information we need to determine whether or not Fred can buy our house. Next we need to know how much the PITI amount will be for our house.

To determine PITI we need four pieces of information:

1) Selling 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 brings us to another term that you can pass on. Loan to Value Ratio or LTV. Example: $100,000 sales price and 5% down payment = 95% LTV ratio. In other words, the loan is 95% of the property value.

2) Mortgage amount (principal + interest).

The mortgage amount is usually the sales price less the down payment. There are three factors that determine how much the PI & interest portion will be. You need to know 1) the loan amount; 2) interest rate; 3) Loan period in years. With these three numbers you can find a mortgage payment calculator almost anywhere on the internet to calculate your mortgage payment, but remember that you still need to calculate the monthly portion of the annual property taxes and the monthly portion of the add hazard insurance (property insurance). In our example, with 5% down Fred needs 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 risk insurance by 12 to get the monthly home insurance premium.

Now, let’s all agree. A $95,000 mortgage at 6% for 30 years will produce a monthly PI.

All together

From our calculations above we know that our buyer Fred can pay as little as $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 is qualified to buy our house!

Of course, there are other requirements to qualify for a loan, including a good credit score and a job with at least two years of continuous work. More about that is our next topic.

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