Prequalifying buyers is an important step for both the buyer and you. You get an idea of how to handle the buyer and the buyer gets an introduction to reality - how much, give or take a small margin of error, he or she can really spend on a home. Calculating loan ratios for the buyer requires first calculating the monthly housing costs, which are commonly known as PITI (principal, interest, taxes, and insurance).

The Ratios

At the initial interview, the buyer has already told you the loan balance or principal amount of the loan when you asked how much he or she intends to use as a down payment. Often they are interested in using a thirty-year, fixed-rate loan, which gives you the term of the loan. You know the interest rate from the lender’s rate sheet and the future value is zero. The calculator will then calculate the monthly principal and interest payment.

You now have the first two numbers for your PITI figure, principal and interest. You also have the last two numbers, because you collected ahead of time the likely tax and insurance amounts for the price range and neighborhoods of interest to your buyer.

Please note that PITI can also include other costs besides principal, interest, taxes, and insurance. Demographic changes in most markets mean that much of our population is growing older. Even those who are not older are often in families where both spouses work. As a result, more homes are purchased that are part of condominium or homeowners’ associations. People these days are less eager and have less time than in the past to cut the lawn or shovel the snow.

But you and I both know that those monthly association fees are not optional. Moreover, the lenders and underwriters know it, too. Therefore, PITI has now become PITIAF (association fee)!

To calculate the ratios with the correct PITI number, you need to add the average monthly association fee for the price range and neighborhood of most interest to your buyers. I urge you to be fiscally conservative with your advice. Do not qualify them for a home without including the likely cost of the monthly association fee. The house they called you about may not be part of an association, but what if the house they purchase is? Including the potential association fee is not difficult, because the information is easily available from the MLS. And again, they will be pleased they decided to work with you if there are no surprises in the transaction.

Moreover, this can be another way to demonstrate that you are different and better than the other agents who have shown them homes. Even on the off-chance that the other agents can pre-qualify the buyer, most likely the agent is from the old school and is using PITI rather than the more accurate indication of a buyer’s financial potential: PITIAF!

Front-end Ratio.

Most of the hard work is done. The front-end ratio is calculated simply by dividing PITI by their gross monthly income.

The questions asked at this point revolve around which earnings they can use for their gross monthly income. Without delving into the complexities that they can discuss with a loan officer, the basic rule is that if they have earned the income for at least two years, they can count it. Often people are moving due to a new job and/or jobs for themselves and their spouse. In general, as long as the new job is similar to their previous job, they can use that income.

Part-time income can be included if the part-time job has been part of their lives for at least two years. End-of-the-year or performance bonuses can be included if either they have earned these bonuses for the last two years or if their employer will indicate in writing that they are likely to earn the bonus this year.

Should they not meet the secondary mortgage market criteria for using all their income (i.e., the two-year requirement) at a minimum, a lender will likely consider the extra potential income a compensating factor which will improve the likelihood that their loan will be approved.

Another question that comes up is whether we are interested in their take-home pay or their gross monthly income. It is the gross monthly income amount before taxes and before any other amounts are deducted that is the number we need.

You have heard the phrase garbage in, garbage out. It applies to our calculations. When I have veteran agents in my classes who have been qualifying buyers for years, we will run a quick exercise to ensure they know how to qualify buyers. Many calculate the right answer, but those who miss it make the same mistake I do: all the numbers used when calculating PITI and the ratios must be monthly figures.

The most frequent culprits are the PMI and association fee amounts. Be sure to divide any and all annual figures by twelve to ensure your advice is not garbage!

Back-end Ratio

The back-end ratio is similar to the front-end ratio except that the buyer’s monthly long-term debt is included in the numerator, which is the top number in the equation.

I learned once that when working with first-time buyers, their financial challenge is not coming up with enough cash for the down payment and closing costs, but their monthly debt payments. Gifts from family members is part of the reason having enough money on hand is often less of a problem than their debt burden.

A recent study shows that the back-end debt for young, first-time buyers may become even more of a problem. Average credit card debt has increased $1,000 for undergraduate students to almost $2,800 in the last two years. Since 1998, students with credit cards increased from 67% to 78%. Even more important is their conclusion that people under thirty-five years old are the people least likely to pay off their credit card bill each month.

The front-end ratio is: PITI divided by Gross Monthly Income.

The back-end ratio is: PITI + Debt divided by Gross Monthly Income.

These debts are usually monthly payments for student loans, child support, alimony, or car payments. Credit card debt is included when there is a recurring minimum payment each month due to the fact that the buyer does not pay off his or her loan balance when his or her statement arrives.

The key to finding out which numbers to use when discussing the back-end ratio is to ask about any debts that would not be paid off in the next six months. They may have a credit card balance of $300, but if they pay their entire credit card bill each month, that amount is not included. If they have a $6,000 auto loan, use the monthly payment, not the $6,000 figure.

Some lenders will only include debts still due after ten months. I recommend you take a more conservative approach and use a six-month timetable.

In effect, you are asking them how much they wish to spend each month on PITI. Then ask them how much they wish to use for a down payment (their “loan-to-value ratio”). Then divide by 28% their PITI figure to calculate a monthly figure. Multiply that by twelve months for their most comfortable price range.

You have demonstrated your expertise and counseled your buyers effectively without making them uncomfortable about sharing their finances with you.

Published: March 26, 2002

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Mike Merin, CRB, CRS, ITI is the author of ATTACK THE MARKET! Specialize in Negotiating, Finance, Pricing or Technology which details how an agent can guarantee his or her success by learning and marketing skills that consumers value today. With graduate degrees from Columbia University, Mike was a negotiator for the U.S. Government in Washington, Moscow, and the capitals of our most significant trading partners. Beginning in 1985, he purchased with partners his first of several investment properties. He left the international arena to support his wife’s career and joined Prudential Fox & Roach REALTORS® as a successful agent in the Philadelphia area. An award-winning author, you can read or purchase Mike’s publications at www.mikemerin.com.