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How Much Can You Afford?

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The first step in finding a home is figuring out how much you can afford to spend. We'll look at six different factors to consider when making this decision, with three of them related to mortgages, and the other three focused on broader personal considerations, such as how long you plan to own the home.

The Mortgage

Taking out a mortgage is probably the biggest hassle facing prospective home owners. The bank will want to ask you all sorts of nosy questions about your income and savings (or lack thereof), and then might not even lend you as much as you need. The nerve!

Of course, there is a reason for this. Put yourself in the bank's shoes: If you were going to lend people money, what would you want to know about them? Basically, you'd like to know 1) if they make enough money to pay you back, 2) if they've been trustworthy in the past, and 3) if they have something of value should they be unable to pay you back.

Congratulations: In financial parlance, you've just been introduced to the concepts of income, credit worthiness, and collateral. Let's look at each one, and how they affect what you can afford.

Do you make enough to pay the lender back?

Your lender will want to know not only how much money you have, but how much you will likely make over the next 30 years. Also, what are your other debts? Do you owe money for college loans or credit card charges? Do you have any other assets? Things like stocks and mutual funds or personal property like a boat or a car are also considered in figuring out how much a bank will lend you.

Ideally, you will want to come up with at least 20% of the value of your new home as a down payment, to avoid things like mortgage insurance payments. But, you probably qualify for plenty of financing arrangements that will get you into a new home for as little as 3% of the asking price. We'll talk more about mortgages and those special programs later.

The lender will also plug your income numbers into a couple of formulas: the front-end ratio (having to do with your mortgage payments) and the back-end ratio (having to do with your debt).

Let's say your gross income is $4,000 a month, and you have $400 a month in debt payments. The rule of thumb is that they'll allow you to pay 29% of your gross income toward your mortgage payment every month. This is known as the front-end ratio. In this example, 29% of $4,000 is just under $1,200 a month -- so, they'll reason, you can put $1,200 toward your mortgage payment.

Your debt ratio, or back-end ratio, on the other hand, is $400/$4,000, or 10%. That's not bad. They don't want more than 41% of your gross income going to total debt -- mortgage, credit card interest, and other payments -- and in this case you're paying 39% towards that purpose. (These ratios can vary somewhat; the ones given here are just examples).

Have you been trustworthy in the past?

What is your credit rating? The three major credit reporting agencies are Experian, Equifax, and Trans Union. You can request credit reports individually from each agency -- or order from all three agencies in one easy step at TrueCredit.com. Before you order your report, we suggest you check out A Fool's Guide to Credit Scoring for an overview of the credit scoring process and tips on how to maximize your credit score.

Your credit report -- a nifty little compilation of your personal financial history -- will reveal whether you have a track record of paying your bills on time. If not, there are ways to clean up your credit that will make you more attractive to lenders. We walk you through the steps in the Settle Your Personal Finances section of our 13 Steps to Investing Foolishly.

Do you have any collateral?

The house you buy will generally be considered collateral for your mortgage. As a result, in case you can't repay the loan, the bank can decide to do something really nasty: foreclose on the mortgage and repossess the house. You will find yourself out on the street -- with your dog, your La-Z-Boy, your collection of unpublished poetry, a couple of suitcases, and your toiletries kit. Your house now belongs to the bank, and it is unlikely that anyone will ever loan you money again. Hot tip: Avoid this scenario at all costs.

Your Considerations

How much you make, your creditworthiness, and how much collateral you have are all questions from the bank's point of view, because how much house you can afford is largely a question of how big a loan you can afford. Now, let's look at a few things from your point of view.

Your Timeline

To determine whether you should buy a new home, think about how long you're planning to stay in it. It generally doesn't make economic sense to buy if you are only planning to stay there for a couple of years. Why? Because you're going to be paying fees to buy and then to sell your house. It would have to appreciate in value very quickly between the time you buy it and the time you sell it to make it financially worthwhile. In other words, you'd have to get lucky.

Your Comfort Zone

Before you borrow $90,000, $200,000, or whatever you need for your mortgage, figure out whether you can really afford it. Just because the bank will loan it to you, doesn't mean that you will live your life in such a way as to be able to pay it back. Are you planning to have a big family? Would you rather replace your Chevy Cavalier with a new Mercedes? Your house payment is just one piece of your financial puzzle. What might you need to give up to make that house a reality and are you really willing to do it?

As part of our collection of tools to help you in your home purchase, we've made a personal worksheet that you can use to get an accurate snapshot of your financial situation. This is for your own use; we've put together another one that will more closely mirror the information that a prospective lender will want.

Should You Rent Instead?

What if you're renting? Would you be better off in a home you own, from a month-to-month financial standpoint? As we'll see, there are tax advantages that make buying a home more affordable than you might imagine. Head on over to our Fool calculator to get an answer to the question, Am I better off renting? Then, if the answer to that question is "No," click on over to another handy, dandy Fool calculator to figure out just how much house you can afford.