There is a quick formula used by the home lending industry to size up an affordable monthly payment to match the buyer's budget. This formula creates what is known as a Debt-to-Income ratio. Also called a DTI, this figure illustrates a reasonable amount of debt that can be serviced over time based on the buyer's income. This figure is important to keep in mind while evaluating rent to own homes.
The DTI is based on two important affordability ratios, called the Front Ratio and Back Ratio.
The Front and Back Ratios are used by mortgage lenders to determine the maximum loan amount the buyer may qualify for. The loan amount is based on a calculated monthly dollar amount, based on the buyer's income. This amount is a guideline to use while considering which rent to own homes to target for purchase.
The final loan amount may vary and depending on the buyer's credit history, lifestyle choices and overall financial priorities. The maximum loan amount allowed may or may not be the ultimate target because each buyer's financial situation is different. However, having a maximum monthly payment amount in mind gives both the buyer and seller a reasonable figure to use when considering if a home is a good financial candidate for the rent to own home arrangement, or lease option home purchase.
The Front Ratio is the percent of income that lenders use to determine a reasonable monthly amount the buyer can afford to pay for housing costs. Housing costs include the principle and interest on the home loan, plus taxes and insurance. These four financial elements, also known as PITI, are the basic obligations a buyer must meet for the rent to own home purchase.
In general, for the Front Ratio mortgage lenders allow 28% of a buyer's gross income (the income earned before income taxes are deducted) to cover PITI. Loans issued under the FHA(the U.S. Federal Housing Authority) a slightly higher higher amount: 31%.
The Back Ratio includes the obligations calculated in the Front Ratio, plus adds other types of ongoing debt the buyer may need to budget for, including things like credit card payments, car loans, student loan payments, alimony, child support or miscellaneous judgments. This ratio is 36% for regular lenders or 43% for FHA lenders. So this means, lenders will like to see buyers paying no more than between 36% and 43% of their gross income toward ongoing debt or longer term financial obligations. These figures do not include daily expenses like groceries, utility bills or other sundry living expenses.
To see the monthly DTI figure that lenders will use to evaluate a home buyer, first figure out the gross monthly income for the buyer. For example, consider a buyer (and the buyer could be a single person or a couple) has a gross annual income of single or joint income of $66,000 per year. Dividing the annual amount by 12 months equals $5,500 per month (gross earnings, prior to taxes). Use this number to calculate both a Front Ratio and Back Ratio monthly payment maximum by multiplying.
Standard Lender: ($5,500 gross monthly income) * (.28) = $1,540
FHA Lender: ($5,500 gross monthly income) * (.31) = $1,705
Standard Lender: ($5,500 gross monthly income) * (.36) = $1,980
FHA Lender: ($5,500 gross monthly income) * (.43) = $2,365
To review the way to calculate the DTI monthly maximum, a buyer needs to take their annual gross earnings amount (before taxes and deductions), divide by 12 (to calculate monthly gross income), then multiply the gross monthly income by .28 for a standard Front Ratio DTI, and .36 for a standard Back Ratio DTI figure. Do the same multiplied by .36 and .43 for FHA Front and Back Ratios.
Translating Monthly Payments into Purchase Price
Translating monthly payments into a home purchase price is fairly straightforward, however, there are many factors and variables that will determine how the purchase price breaks down into monthly payments. There is no one-size-fits-all calculation to turn a monthly figure into a purchase price, but it is easy to come up with some general assumptions to help buyers find a ballpark price. And, once the Front End and Back End DTI amounts are determined, a mortgage broker can help a buyer by reviewing the various mortgage options available on the market to support a target purchase price.
Assuming a buyer has a profile like the one calculated in the earlier example ($66,000 gross annual income), and falls in line with the DTI Back Ratio used by standard lenders, the buyer has a budget of $1,540 for a standard home loan (non-FHA). Consider these assumptions for an example:
- 30-year, fixed rate loan
- Loan interest rate = 6%
- Annual property taxes = $3,000 (1.5% of the purchase price)
- Buyer's down payment = $6,000
- Annual home insurance = $500
- Monthly PMI (mortgage insurance) = $80
Of course, if the rent to own home arrangement allows the buyer to use a portion of the monthly rent rate toward Option Credits, a much larger down payment can accumulate. This would translate into either a lower monthly mortgage payment if all other aspects of the above assumptions held. Or, the larger down payment could help the buyer purchase a higher priced home.
In any event, it is important for renter-buyers to research their local market for information on the local property tax rates and insurance costs. From there, basic mortgage calculators can be used to help buyers identify which purchase prices could fit their DTI budgets.