The answer is simple: How much of your monthly income can you put towards your mortgage
Mortgage lenders are chiefly concerned with your ability to repay the mortgage. To determine if you qualify for a loan, they will consider your credit history, your monthly gross income and how much cash you'll be able to accumulate for a down payment. So how much house can you afford? To know that, you need to understand a concept called "debt-to-income ratios."
Debt-to-income ratios
The standard debt-to-income ratios are:
The housing expense, or front-end ratio, shows how much of your gross (pretax) monthly income would go toward the mortgage payment. As a general guideline, your monthly mortgage payment, including principal, interest, real estate taxes and homeowners insurance, should not exceed 28 percent of your gross monthly income. To calculate your housing expense, multiply your annual salary by 0.28, then divide by 12 (months). The answer is your maximum housing expense.
The total debt-to-income, or back-end ratio, shows how much of your gross income would go toward all of your debt obligations, including mortgage, car loans, child support and alimony, credit card bills, student loans and condominium fees.
In general, your total monthly debt obligation should not exceed 36 percent of your gross income. To calculate your debt-to-income ratio, multiply your annual salary by 0.36, then divide by 12 (months). The answer is your maximum allowable debt-to-income ratio.
Example
Take a home buyer who makes $40,000 a year. The maximum amount for monthly mortgage-related payments at 28 percent of gross income would be $933. ($40,000 times 0.28 equals $11,200, and $11,200 divided by 12 months equals $933.33.)
Furthermore, the lender says the total debt payments each month should not exceed 36 percent, which comes to $1,200. ($40,000 times 0.36 equals $14,400, and $14,400 divided by 12 months equals $1,200.)
The following chart shows your maximum monthly payment and maximum allowable debt load based on your gross annual income (remember, gross income is pre-tax income):
Gross Income
28% of Monthly
36% of Monthly
$20,000
$467
$600
$30,000
$700
$900
$40,000
$933
$1,200
$50,000
$1,167
$1,500
$60,000
$1,400
$1,800
$80,000
$1,867
$2,400
$100,000
$2,333
$3,000
$150,000
$3,500
$4,500
Here's a look at typical debt ratio requirements by loan type:
Conventional loans:
Housing costs: 26 to 28 percent of monthly gross income.
Housing plus debt costs: 33-36 percent of monthly gross income.
FHA loans:
Housing costs: 29 percent of monthly gross income.
Housing plus debt costs: 41 percent of monthly gross income.
Taxes and Insurance
In addition, lenders include the cost of taxes and insurance when calculating how much house you can afford:
Real estate taxes:
Because property taxes are part of your monthly mortgage payment, it is important to get an estimate of what yours would be. Ask your real estate agent or tax office for the rates that apply in the area you want to buy.
Homeowners insurance:
You must insure your property to obtain a mortgage. You can get an estimate of insurance costs from an insurance agent or insurance company. Be sure to inquire about special requirements for hazard insurance, such as mandatory coverage for floods, earthquakes, or wind in coastal areas. If you put down less than 20 percent of your home's value, you also will have to obtain mortgage insurance or take out a second loan, called a piggyback loan, to bring the first mortgage down to 80 percent of the purchase price. Both alternatives will raise your monthly payment.
Mortgage Tip: Adjustable Mortgages – Is The Risk Worth it?
Why do people take out ARM loans anyway? An ARM is an Adjustable Rate Mortgage and these can suit many people perfectly. The idea is that you have a term where your interest rate is fixed. This term can be as short as one month and as high as ten years. ARM loans are ideal for starter homes or condos, where you plan only to stay for 3-10 years and then you plan to sell. They can also be great for getting into the home of your dreams with a slightly lower payment. The risk is that when you refinance your mortgage, the interest rates may be higher, so although you are getting a great deal in the short term, your long term interests are not as clear. If you are in the financial industry and you follow interest rates, an adjustable mortgage is probably a great plan. The key is knowing when to refinance into a fixed rate mortgage to protect your long term property interests.
Debt-to-income ratios