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

One question many For Sale by Owner sellers ask is “how do I determine if a potential buyer can afford to buy my house?” In the real estate industry, this is called “pre-qualifying” a buyer. You might think this is a complicated process, but it’s actually quite simple and only involves a little math. Before we get to the math, you need to understand a few terms. The first is PITI, which is nothing more than an acronym for “Principal, Interest, Taxes and Insurance.” This figure represents the MONTHLY cost of the mortgage payment in principal and interest plus the monthly cost of property taxes and homeowners insurance. The second term is “RATIO”. The ratio is a number most banks use as an indicator of how much of a buyers monthly GROSS income they could afford to spend on PITI. are you still with me Most banks use a ratio of 28% without taking into account other debts (credit cards, car payments, etc.). This ratio is sometimes called the “front-end ratio.” When you consider other monthly debt, a ratio of 36-40% is considered acceptable. This is called the “back end ratio”.

Now for the formulas:

The front end ratio is calculated simply by dividing the PITI by the gross monthly income. The final ratio 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 per year. We need to know Fred’s MONTHLY gross income so we divide $50,000.00 by 12 and get $4,166.66. If we know that Fred can safely afford 28% of that figure, we multiply $4166.66 X 0.28 to get $1166.66. It is! Now we know how much Fred can afford to 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 exactly how much the PITI payment will be for our house.

We need four pieces of information to determine PITI:

1) Selling 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 you may encounter. Loan-to-value ratio, or LTV. For example: Sales price $100,000 and a down payment of 5% = LTV ration of 95%. In other words, the loan is 95% of the value of the property.

2) Amount of the mortgage (principal + interest).

The mortgage amount is usually the sales price minus the down payment. There are three factors in determining how much the PI and interest portion of the payment will be. You need to know 1) the amount of the loan; 2) interest rate; 3) Term of the loan 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 add the monthly portion of annual property taxes and the monthly portion of hazard insurance (insurance of property). 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 get 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 get the monthly property insurance portion.

Now, let’s put it all together. A $95,000 mortgage at 6% for 30 years would result in 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 required PITI 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 score and a job with at least two years of continuous employment. More on that in our next issue.

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