Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson we will look at some of the financial ratios used to determine how much of a monthly mortgage payment a buyer can qualify for, without wasting time on unaffordable properties.

Bob is a real estate agent whose client, Tom, makes \$60,000 a year. It wouldn't make sense for Bob to show Tom homes that are impossible or highly difficult for Tom to afford. There is a guideline available for agents to use to estimate how large of a mortgage the client can obtain. Let's take a look at how Bob can calculate Tom's financial ratios to figure out what's affordable in his situation.

## Income and Expense Ratios

A common rule of thumb is for a homeowner's total house payment which includes principal, interest, taxes, and insurance, to not exceed 28% of his income. The income and expense ratio compares a buyer's income with the percentage of that income that goes toward home expenses. The formula multiples the maximum percentage of home expenses by the buyer's income. Since Tom makes \$60,000 a year, 28% of his income is \$16,800 a year, or \$1,400 a month.

That \$1,400 a month figure gives Bob a good idea of what Tom can afford. If Tom wants to get a typical 30-year mortgage, he will be able to afford a larger purchase price compared to a 15-year mortgage. In addition to the length of the loan term, the exact amount of the home purchase price will depend on interest rates, property taxes, and insurance costs. Adjustable rate mortgages may allow Tom to buy a more expensive house now, but it is significant risk because he will not be able to afford the home when the interest rates rise.

Why is this ratio so important? Firstly, banks will not approve a loan for a buyer who is likely to default on that loan. Secondly, even if a buyer can technically afford the home, it is possible to borrow so much that the buyer becomes house poor. In this case, the buyer has so much income going towards simply paying the mortgage that it becomes impossible to take care of other financial responsibilities and goals such as retirement savings, kid's college tuition, vacations, etc.

## Debt-to-Income Ratio

Many homeowners still have debts such as student loans, cars notes, and personal credit cards. These monthly costs eat into the amount of money that can be spent on a home without becoming house poor. Different lenders will allow only a certain portion of Tom's income to go towards all debt payments including the house. The debt-to-income ratio is a ratio of the sum of Tom's monthly debt payments retracted from his monthly income. A typical rule of thumb for lenders is to not exceed a 36% debt-to-income ratio. Meanwhile, government guaranteed programs such as Fannie Mae allow up to 45% in cases where the buyer has an exceptional credit history.

Using the Fannie Mae loan rate of 45%, Bob sees that Tom's total monthly debt payments- including the house- cannot exceed \$2,250. The formula looks like this:

\$60,000 X 0.45 = \$27,000; \$27,000 / 12 = \$2,250

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