What is Pre-Qualification?
One questions many buyers ask is "how much can I afford"?
In the real estate industry this is referred to as "pre-qualifying"
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 36-40% is considered acceptable. This is referred
to as the "back end ratio".
Now for the formulas:
The front-end 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
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
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. If you would like to get pre-approved
now there is no charge and no committment.