Home Buyer Qualification Calculations

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, 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.

Buyer Qualification

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

To unlock this lesson you must be a Study.com Member.
Create your account

Register to view this lesson

Are you a student or a teacher?

Unlock Your Education

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back
What teachers are saying about Study.com
Try it now

Earning College Credit

Did you know… We have over 220 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Used by over 30 million students worldwide
Create an account