It is common for sellers to agree to owner finance without thoroughly considering the buyer’s financial capacity. Consequently, the buyer may end up being unable to meet the payment obligations. As a seller, it is imperative to conduct a thorough assessment of the buyer’s financial capabilities to ensure that the payment arrangement is feasible and viable for both parties involved. This is one of the first steps in setting the ground for an owner finance deal
For a seller, the prospect of frequent monthly payments or even the threat of foreclosure can be an unwelcome source of anxiety and distress.
There are 3 ways to calculate how much your buyer can pay.
Way #1 – By the buyer’s income
When inquiring about a buyer’s ability to afford a home, real estate agents and lenders commonly utilize the Income Rule. This rule specifies that the sum of the monthly mortgage payment, property taxes, and homeowner insurance and the total cannot surpass a set percentage of the buyer’s income. Clarifying this crucial financial guideline can aid in making informed decisions and achieving successful homeownership.
The front-end ratio, commonly known as the housing expense ratio, typically falls within the range of 25 percent to 30 percent for the majority of lenders.
To determine the amount of monthly housing expense allowed for a maximum percentage of 30 percent, use this formula: multiply the monthly income of $5,000 by .30 to get $1,5000. For a home with taxes and insurance of $250 per month, the maximum monthly mortgage payment is $1250. At a 8 percent interest rate for a 30-year loan, this payment will support a loan of $170,490. Assuming a 10 percent down payment, the maximum price of the home this buyer can afford will be $189,433. Stick to these guidelines when considering a mortgage and avoid exceeding maximum amounts.
Way #2 – Total debt
According to the Debt Rule, an individual’s total debt expense should not exceed a certain percentage of their income. This total debt expense includes the sum of the mortgage payment and monthly payments towards pre-existing debts such as credit cards and car loans.
The ratio will be 36 to 45 percent.
To determine the maximum monthly mortgage payment that a buyer can afford, a specific percentage of their monthly income must be taken into account. For example, if this maximum is set at 36 percent and the buyer’s monthly income is $4,000, their monthly payment cannot exceed $1,440, which is calculated by multiplying their income by the percentage limit. However, other expenses such as taxes and insurance, as well as existing debt service, must also be factored in. Assuming monthly expenses of $200 for taxes and insurance and $240 for existing debt service, the maximum mortgage payment the buyer can afford is $1,000. Based on a 7 percent interest rate and a 30-year loan term, this payment can support a loan of $150,308. Taking into account a 5 percent down payment, the maximum price of the home the buyer can afford would be $158,218, which is significantly higher than what the Income rule calculated. Therefore, by calculating the maximum mortgage payment a buyer can afford, they can determine the highest price range of homes they can consider purchasing.
Way #3 – Sufficient cash
According to the Cash Rule, the buyer is required to possess adequate funds in order to fulfill the down payment obligation and also cover additional expenses associated with the settlement process.
Assuming herewith that the buyer possesses an amount of $12,000 and taking into account that the aggregate of the down payment and other associated settlement expenses comprises precisely ten percent of the net purchase price, it follows that the said cash limit shall cap at $120,000 (figured thusly: $12,000 ÷ .10 = $120,000).
Out of the three maximums in question, the one that boasts the lowest value would be the most prudent affordability estimate to utilize in the present scenario.
So let’s put everything together for owner finance deal.
It can be all too easy to overestimate the extent to which a potential home buyer can afford a house, particularly if one disregards the three essential rules governing this process. Mortgage lenders in the past have fallen victim to this same mistake, paying the price for neglecting these standards. To avoid such mishaps, be sure to adhere strictly to these guidelines.
The prevalent issue of subprime toxic mortgages can be attributed to the provision of loans to buyers incapable of affording the payments. However, it is important to note that there is no federal bailout program for sellers who choose to accept owner financing. This has significant implications on the current headline-grabbing situation.
Exercise caution and confirm the financial solvency of the prospective buyer prior to agreeing to any installments concerning the home loan especially in cases where you as the seller plan to use owner finance as a lending tool.
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