How Much Home Can You Afford?

It's a big decision but you have officially made it--you want to become a homeowner. However, you're not sure how much you should be comfortable with spending and/or borrowing. First of all, if you fit into the mold of the overwhelming majority of homeowners, the following equation will reflect your path to owning your own home: down payment + mortgage loan = buying home. Let's look at the common formula used by lenders to determine what you can afford and when it's appropriate to apply or disregard it for alternatives.

The ratio test. The vast majority of lenders use a 28/36-ratio test to figure out the mortgage you qualify for. What do these numbers represent? The sum of your monthly mortgage payment, homeowner's insurance and property taxes shouldn't be more than 28 percent of your monthly gross income. The second part of the ratio is that your monthly debts, including your mortgage payment, shouldn't be more than 36 percent of your monthly income.

Gross Monthly Income x 0.28 = Maximum Monthly Mortgage Payment

Gross Monthly Income x 0.36 = Maximum Total Monthly Debt

Example Jessica and Justin, a married couple, have a monthly gross income of $10,000. The monthly mortgage payment they would qualify for is $2,800 ($10,000 x .28 = $2,800). The total amount of Jessica and Justin's monthly debt, including their mortgage payment, shouldn't be more than $3,600 ($10,000 x .36 = $3,600).

We'd like to point out that while this ratio test is the most popular, it is by no means the only measure you should apply to calculate the amount of the mortgage you qualify for. While this test is the simplest method lenders use, it doesn't always accurately reflect the reality of your financial ability to make mortgage payments. For example, perhaps you know that in two months you will be getting a huge promotion and a raise to match. Or that your grandparents are going to start giving you, your husband, and your two children annual gifts of $14,000 each starting in 2014 as part of their estate planning. Therefore, the 28/36-ratio formula doesn't give lenders a realistic picture of what your financial ability is in regards to a monthly mortgage payment.

Warning On the other hand, we strongly caution you against taking on more than you can handle. Similar to what has happened in the credit card industry and despite (and somewhat due to) the recent real estate economic crisis, lenders eagerly pursue loan borrowers with good credit histories for loans that can go above the traditional formula. Be wary of lenders that try to convince you that you qualify for a loan that requires you to spend almost 50 percent of your monthly income on your mortgage payment. Be realistic about what you can afford. If you want to keep that good credit record, realize that there is often a vast difference in the amount of the mortgage you can get vs. the one you can handle. You will be the one with the monthly payment, so make sure you're comfortable with the amount you are taking on.

Mortgage payment worksheet. We would like to suggest that you use the following worksheet to get a detailed idea of what kind of home payment you can afford to make each month. This worksheet includes the total of your fixed income and expenses on a monthly basis, excluding your cost for rent or your present mortgage. The result is the amount you actually have left for a monthly mortgage payment.

Some of the figures will be more fixed than others, but do your best to use amounts that most closely represent your actual financial situation. For example, if you have been receiving alimony or maintenance payments for five years, but in six months you will no longer be receiving any, leave this amount out of the calculation of your total monthly income. Be sure not to include your monthly housing expenses, such as rent and utilities, when you calculate your monthly expenses.

When you are pre-approved for a mortgage, lenders may not take into account items such as nursery school costs, private school uniforms, annual vacation expenses, etc. Make sure you consider all expenses, so you have a true picture of the mortgage payment you can be comfortable with.

Once you go through this process you can arrive at a figure that's pretty accurate when it comes to what you can afford to spend as opposed to what you think you can spend.

Planning Tools How much can you really afford to spend monthly on a mortgage payment? This Calculating the Mortgage Payment You Can Afford Worksheet will help you organize your income and expenses, so you can determine how large of a payment will fit into your individual circumstances.

How much can you borrow? When you have determined what you can afford to spend on a monthly mortgage payment, the next step is to calculate how much you can afford to borrow to purchase your home.

Financial Calculators The first step in buying a house is determining your budget. Use this Mortgage Qualifier Calculator to help you find out how much you can borrow. Fill in the entry fields and click on the "View Report" button to see a complete amortization schedule of your mortgage payments.

Remember too, all the various costs associated with owning your own home. Whatever you estimate you will need for repairs, etc., you are sure to have underestimated the amount. A lot depends on the type of home you are buying as well. Is your home brand-new? Is the house you're buying less than 15 years old and in pretty good shape, but several things will need repair or replacing soon? Maybe you're buying an old farmhouse that has a lot of charm, but needs constant plumbing repairs. Will you take care of the grounds yourself or pay gardeners and lawn services to tend to that? Is your new home part of a community with a homeowner's association and a monthly fee for the maintenance of community property? As you can see, the mortgage payment itself is only the tip of the iceberg when it comes to home ownership! However, don't let that stop you from taking the home ownership plunge. Just be sure to leave yourself some breathing room when it comes to that monthly mortgage payment so you can sleep at night.