Many sellers accept owner financing without any idea of how much the buyer can actually afford to pay.The last thing a seller wants is to stress over receiving monthly payments or worse, getting the property back through foreclosure.
3 Ways to Calculate Payment Affordability Before Accepting Seller Financing
The amount a buyer can afford to spend on a house depends on their income, overall debt, cash they can put down, credit rating, and the mortgage terms.
There are three different calculations that are traditionally used by mortgage companies to determine how much house a buyer can afford. These are known as the Income Rule, the Debt Rule, and the Cash Rule. While owner financing does not require the strict use of these rules, it makes sense to utilize the standard as a guideline. (Better safe than really sorry, right?)
1. Income Rule
If you ask a real estate agent or lender for an estimate of how much house a buyer can afford, they’ll typically use a version of the Income rule. The Income Rule says that the monthly housing expense — which is the sum of the mortgage payment, property taxes, and homeowner insurance premium — cannot exceed a percentage of income.
This is often referred to as the front-end ratio and ranges from 27 percent to 30 percent for most lenders.
If the maximum percentage is 28 percent, for example, and the monthly income is $4,000, the monthly housing expense can’t exceed $1,120 (4,000 x .28 = 1,120). If taxes and insurance on the home are $200 per month, the maximum monthly mortgage payment is $920. At 7 percent interest for a 30-year loan, that payment will support a loan of $138,282. Assuming a 5 percent down payment, the maximum price of the home this buyer can afford would then be $145,561.
2. Debt Rule
The Debt Rule says that the total debt expense – which is the sum of the total mortgage payment plus monthly payments on existing debt like cars, credit cards, etc. – cannot exceed a percentage of income.
This is often referred to as the back-end ratio and ranges from 36 percent to 43 percent.
If this maximum is 36 percent, for example, and the monthly income is $4,000, the monthly payment can’t exceed $1,440 ($4,000 x .36 = 1,440). If taxes and insurance are $200 a month, and existing debt service is $240, the maximum mortgage payment the buyer can afford is $1,000. At 7 percent interest and a 30-year loan, this payment will support a loan of $150,308. Assuming a 5 percent down payment, the maximum price of the home would then be $158,218. (You’ll notice that’s significantly higher than what we calculated using the Income rule.)
3. Cash Rule
The Cash Rule says that the buyer must have cash sufficient to meet the down payment requirement plus other settlement costs.
If the buyer has $12,000 and the sum of the down payment requirement and other settlement costs are 10 percent of the sale price, then the maximum sale price using the cash rule is $120,000 (12,000 divided by .10 = 120,000).
Since this is the lowest of the three maximums in this example, it would be the affordability estimate that is safest to use for this scenario.
Putting It All Together for Seller Financing
How much house a buyer can afford is easy to overestimate if you ignore one of the three rules. Don’t make the same mistake as many of the mortgage lenders that ignored these standards in past years.
Granting loans to buyers that could not afford the payment played a large role in the current sub prime toxic mortgage mess that is currently in the headlines. There is no federal bailout program for sellers accepting owner financing.
Play it safe and be sure the buyer can afford the house payment before accepting payments over time.