LESSON 2: Find Out How Much Home You Can Afford

Before you even begin to think about what type of home you want or what neighborhood you would like to live in, you'll need to determine what you can afford. The answer will depend, partly, on the amount of cash you can bring to the purchase. But more importantly, consider how large a monthly payment you can afford based on your income and other debt obligations.

Lender Standards

Lenders use a set of ratios to determine the maximum loan payment they think borrowers can handle without getting financially overextended. Most (though not all) lenders use 28% and 36% limits.

The 28% limit is the maximum amount of your gross monthly income that can be used to pay principal, interest, taxes and insurance (PITI). For example, if you have gross earnings of $5,000 per month, the 28% standard would limit your PITI payment to no more than $1,400 per month. With a 7% interest rate on a 30-year mortgage, that $1,400 payment would qualify you to borrow about $208,000 (depending on the cost of insurance and taxes).

But wait! You still have a 36% limit to worry about. This second ratio holds your PITI payment plus all your other payments for long-term debt (e.g., credit cards, car loans, etc.) to no more than 36% of your gross monthly income. Say you earn $5,000 per month and have monthly installment payments totaling $600 per month. The 36% test would limit your PITI payment to just $1,200 (.36 x $5,000 = $1,800; $1,800 - $600 = $1,200). At that payment level, you could borrow about $180,000.
Add your down payment to the lower of the two amounts the ratios qualify you to borrow, and you'll know the top price you can pay for a home. (Of course, your actual numbers will vary from those above; give us a call to find out how much you could borrow based on your particular income/debt situation.)

Beyond Ratios

Bear in mind, just because a lender is willing to loan you a certain amount of money for a home purchase doesn't mean you should borrow that much. The ratios yield a maximum amount, which may be too much for some borrowers to handle realistically.

Say you live in an area with a high cost of living, or you have an expensive hobby, or there are additional debt obligations on the horizon -- college tuition, elder care, child care. The 64% of income you have left over (after 36% goes to your PITI and debt) may not be enough to cover all your other expenses comfortably. You could end up living 'house rich and cash poor,' perhaps even defaulting on your home loan.

On the other hand, borrowers who know their income will increase steadily in subsequent years, or who are close to retiring some long-term debt, may want to take the full amount offered by a lender. You may even want to increase the amount of money you qualify for by retiring some of your long-term debt before applying for a loan. Another way to maximize your loan amount is to shop for a lower interest rate -- the lower the interest rate, the more principal you can afford to borrow.

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