Pre-qualifying for a Mortgage – What is it?
First off, let’s cover the difference between pre-qualification and pre-approval. Many people
think these things are the same, but they’re not. Pre-qualification is based on a quick review of
your finances and credit. Pre-approval looks at everything regarding your finances, debt and
credit. Think of pre-qualification as a “quick review” from the lender and pre-approval as a
longer, more detailed review. Here’s a more formal definition of pre-approval, pre-approval: The process of applying for a loan and obtaining approval for a maximum loan amount before having a purchase agreement. When you get pre-approved for a home loan, the lender will look at your income, debt and credit, among other things. This review will give you a good idea how much of a mortgage you can afford. Being pre-approved also shows sellers you’re serious about (and capable of) buying their house. This can be a factor in hot markets where the sellers receive multiple offers. For example, if you bid on a home along with three other prospective buyers, but you’re the only one who has been pre-approved by a lender, then you stand the greatest chance of having your offer accepted. It has also become standard practice to have a pre-qualification letter in hand when you present an offer to purchase a home. The sellers will be more comfortable with you since a lender has said, in essence, “Yes, this person is worthy of a home loan.” The buyers without pre-approval, on the other hand, would be “unknown quantities” to the seller. Pre-approval also helps identify credit problems early on. If you missed something when reviewing your credit during the self-assessment phase (Part 1 of this guide), the pre-approval process will bring it to light.
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 per month
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 $819.57.
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. Call us to set up an appointment at 716-754-2550 or submit the form below.