One of the questions that “for sale by owner” sellers ask is “How do I determine if a potential buyer can buy my home?” This is referred to in the real estate industry as a “pre-qualified” buyer. You might think this is a complicated process but it is actually quite simple and involves very little math. Before we get to the math, there are some terms you should understand. The first is PITI which is nothing more than an acronym for Equity, Interest, Taxes, and Insurance. This number represents the monthly cost of a principal and interest mortgage payment plus the monthly cost of property taxes and homeowners insurance. The second term is “ratio.” The ratio is a number Most banks use it as an indicator of how much buyers’ gross monthly income they can afford to spend on PITI.Still with me?Most banks use 28% without thinking about any other debt (credit cards, car payments etc.) This ratio is sometimes referred to as “Front end ratio.” When you consider other monthly debts, 36-40% is considered acceptable. This is referred to as “back end ratio.”

Now for the formulas:

The front end ratio is calculated simply by dividing PITI by your total monthly income. The back end ratio is calculated by dividing PITI + DEBT by the total monthly income.

Let’s see the formula in action:

Fred wants to buy your home. Fred earns $50,000.00 a year. We need to know Fred’s total monthly income, so we divide $50000.00 by 12 and get $4166.66. If we know that Fred can safely withstand 28% of that number, we multiply $4,166.66 by .28 to get $1,166.66. This is! We now know how much Fred can pay per month for PITI.

At this point, we have half of the information we need to determine if Fred can buy our house or not. Next, we need to know how much the PITI payment for our house is.

We need four pieces of information to identify a PITI:

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 leads us to another term you may encounter. The insurance-to-value ratio or LTV. For example: $100,000 selling price and 5% down payment = 95% LTV stake. It is said in another way, the insurance is 95% of the value of the property.

2) The amount of the mortgage (capital + interest).

Typically, the mortgage amount is the sale price minus the down payment. There are three factors in determining the amount of the PI (and interest) portion of a payment. You need to know 1) the amount of the insurance; 2) the interest rate; 3) The term of the insurance is in years. With these three numbers, you can find a mortgage payments calculator almost anywhere on the Internet to calculate mortgage payments, but remember that you still need to add up the monthly portion of annual property taxes and the monthly portion of risk insurance (property insurance). For example, with a 5% drop, Fred would need to borrow $95,000.00. We will use an interest rate of 6% for a period 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 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 portion of the property insurance.

Now, let’s put it together. A mortgage of $95,000 at 6% for 30 years would yield PI per month

put everything together

From our calculations above, we know that a unique buyer can charge up to $1,166.66 per month. We know that the PITI needed to purchase our home is $819.57. With this information, we now know that Fred is eligible to buy our home!

Of course, there are other requirements to qualify for a insurance including a good credit rating and a job of at least two years of consecutive work. More on this is our next issue.