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How Much Home Can You Afford?

Taking out a mortgage is probably the biggest hassle facing prospective homeowners. The bank asks you all sorts of nosy questions about your income and savings, and after you've poured your heart out and shared all your money secrets, they might not even lend you as much as you need. The nerve!

Of course, they do have a point. Put yourself in the bank's shoes: If you were going to lend people money, what would you want to know about them? Of course you'd want to know whether:

  1. They make enough money to pay you back.
  2. They've been trustworthy in the past.
  3. They have something of value to trade, 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 -- the three main factors that go into the lending decision. 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 also 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'll 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 (also called private mortgage insurance, or PMI). 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.

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).

For instance, let's say your gross income is $4,000 a month, and you have $400 a month in debt payments. A common rule of thumb is that they'll allow you to pay around 30% of your gross income toward your mortgage payment every month. This is known as the front-end ratio. In this example, 30% of $4,000 is $1,200 a month -- so, they'll reason, you can afford 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 around 40% of your gross income going to total debt -- mortgage, credit card interest, and other payments -- and in this case, your payments add up to 39%. (These ratios can vary somewhat; the ones given here are just examples).

Have you been trustworthy in the past?
Potential mates aren't the only ones curious about your past. Your lender wants to know your history, too, before deciding whether or not to commit. 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. Before you even start shopping around for a loan, pull your reports from the major credit reporting bureaus by going to the AnnualCreditReport.com website. If you see anything unsavory, clean it up to make yourself more attractive to lenders.

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.

Now, let's discuss your needs
How much you make, your creditworthiness, and how much collateral you have are all questions from the bank's point of view, because the amount of 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're only planning to stay there for a couple of years. Since you'll be paying fees to buy and then sell your house, it would have to appreciate in value very quickly while you're living there to make the entire deal financially worthwhile.

Your comfort zone
Before you borrow $100,000, $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'll be able to pay it back -- at least, not without cutting into other goals that may be a priority for you. Are you planning to have a big family? Would you rather spend money on travel or spoiling the grandkids?

Remember, your house payment is just one piece of your financial puzzle. Carefully consider what you might need to give up to make that house a reality, and ask yourself whether you're really willing to do it.

For more on buying and selling a home, read about:


Read/Post Comments (10) | Recommend This Article (51)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 02, 2009, at 5:35 PM, 4Wynds wrote:

    I think this article fails to do the uninformed reader justice in that many of these mortgage calculators for "how much home can I afford" calculate based upon gross income. This doesn't take into consideration you're (or should be) contributing a chunk each period to your retirement accounts, contributing a chunk to charity, and contributing an ever increasing chunk to health insurance. I realize that the "comfort zone" excerpt above may be used as a disclaimer but, many people (including banks) don't consider these other large line items/cash outflows in an individual's statement of cash flows.

  • Report this Comment On March 01, 2009, at 2:32 PM, Nordikelt wrote:

    Interesting and useful article, but I would also like some guidance regarding the choice between deciding to buy a finished house and buying a lot then hiring a general contractor to build.

    Is it generally less expensive to buy a finished house? What about new development vs established neighborhood? Are there any rules-of-thumb or is each town a whole new ballgame?

  • Report this Comment On July 06, 2009, at 2:11 PM, GramaCindy wrote:

    Is it foolish to try to buy a home when all you have is retirement income?

  • Report this Comment On August 19, 2009, at 8:07 AM, lemoneater wrote:

    I once read a booklet written in the 1940's that said a mortgage ideally should not be more than a quarter of your take home pay. That works for me!

    Another thing to consider is how much square footage do you really need? A hidden cost of homes is how much work it takes to keep it up--home repairs and cleaning. (Usually new construction should be less trouble than old construction, unless the old construction is of superior quality.) If your home is over a certain number of square feet chances are you will need help in cleaning it. Even if I could afford it I wouldn't want a home that would require the use of a GPS to locate rooms :)

  • Report this Comment On August 24, 2010, at 6:34 AM, BearishKW wrote:

    It is also important, when considering a market to buy in, to speculate on the near-term upside value of the place. If you make $40,000 to $50,000 per year, you can probably only afford a $1,000,0000 to $2,000,000 home. The reason you have to shoot so low on the purchase price? You do have to factor in food and a 50" plasma.

    Make sure the place has large entrance ways as well. When you ultimately fail at gaming the system, it will make moving out in the middle of the night easier. Be sure to pour at least one bag of cement down your toilets and leave the water running. If you can't afford the place after all, then nobody deserves to. Leave a couple days worth of food and water for the animals you leave behind, and some weed-killer for the next-door neighbors (who's home value you are also eroding) and you're well on your way to being a responsible home owner.

    Welcome to the club!

    ....I recently became a new, first-time home buyer. I had 20% towards the purchase price, over a year in reserve payments, and flawless credit...still had to fight tooth and nail to give my soul away to the lenders. When I finally did top that mountain, I soon realized it was the least of my worries. I must have looked at 50+ places, most of them beautiful homes that had been TRASHED by their prior owners who strategically defaulted. These are the same people that are screaming bloody murder over the banks screwing them, and demanding taxpayer-funded bailouts. Sad how accountability is a thing of the past.

    Follow the author's guidelines and build up your reserves. If you have even the slightest concern that you can't afford it, walk, and find something less expensive. Home ownership comes with plenty hidden costs. And you'll thank yourself for spending less later, when you pay it off ahead of time. That is what makes you rich.

  • Report this Comment On May 31, 2011, at 8:12 AM, unsavyinvestor wrote:

    I bought my first home when I was 20 following basic economics that was taught in High School.

    Never mortgage more than one years worth of income at 6.5% interest (conservative)

    Your mortgage payment or rent should never exceed more than one weeks take home paycheck.

    I purchased my second home at 33 following the same rules. I always had money left over for car payments, insurance, vacations, investments etc...

    I purchased my third home after making a small profit on the second and buying a home at the end of the declared recession. This time I have an interest rate of 3.75% and I mortgaged 30k more than my annual income but kept my payment at no more than a weeks take home paycheck. We live extremely comfortable in a desireable neighborhood with our heads high above water

  • Report this Comment On May 10, 2013, at 8:55 AM, IvanaMoscow wrote:

    been doing some research in Detroit lately and it seems tempting. Home prices in the city keep on rising and Dan Gilbert's downtown masterplan looks amazing. Thoughts on owning a property in Detroit?

  • Report this Comment On October 17, 2013, at 7:47 PM, Heidikitty wrote:

    How do you handle things when you would always like to go dutch treat rather than pay for someone else who insisted on paying for you last time? I like to do my own budget without seeming like a scrooge.

  • Report this Comment On December 12, 2013, at 4:48 AM, HarryKyin wrote:

    To afford a home we need to have a backup in type of property which can be mortgaged in lieu of loan from bank. That does not means if you have a costly property to mortgage you take the complete cost of the property as your loan. You must always keep in mind that the loan you have to repay. So with proper understanding of the repay amount every month or every quarter you have to select the new property with the value suitable to your pocket.

  • Report this Comment On July 14, 2014, at 3:52 PM, eugened314 wrote:

    I am looking to purchase a new home, and I found a lot of great information in this article. After reading your remarks about the "comfort zone", I have reduced the budget for my purchase. My credit is excellent, and the bank will approve me for a significant amount. However, you never know what could happen, and I don't want to find myself in a hole. Thank you for your help.

    Eugene Dean | http://www.realtyinalabama.com/

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