A major cause of the recent housing crisis is the number of homeowners who ended up purchasing property and saddled with loans that, it turned out, they couldn't really afford. To avoid that trap, some key questions in determining how much home you can afford are: How much can you pay monthly? What are the financial requirements for different loans? What tools can you use for your mortgage search?The rule of thumb when it comes to home affordability is that most potential homebuyers should be able to pay for a home that costs between 2 and 2½ times their gross annual household income. So if a prospective homeowner earns $50,000 a year, he or she can probably afford a home that costs between $100,000 and $125,000.For those who can afford a big down payment, and have little or no debt, buying a home up to four times their annual income may be feasible.
Mortgage Lenders' RulesBut the most realistic way to assess the range of homes that you can afford is to look at your finances from a lender's perspective.Mortgage lenders use two main calculations to decide what you can afford: the front-end ratio and the back-end ratio. (They're not nearly as complicated as they might sound.)
The front-end ratio, also known as the housing expense ratio, is simply the percentage of your gross (that is, pretax) monthly income that will go toward paying the mortgage. Conservative lenders generally want that to be less than 28 percent, but some accept 30 percent or higher. If you earn $5,000 per month, and the lender has a 28 percent threshold, the most it'd likely be comfortable with would be $1,400 ($5,000 x 0.28).
The back-end ratio, or the debt-to-income ratio, is the percentage of your gross monthly income that will goes toward paying all debt obligations -- not just mortgage payments but credit cards, child support, car and student loans, etc. Many lenders want the back-end ratio to be lower than 36 percent, but some allow 40 percent or more. If you earn $5,000 per month and your monthly debt obligations are $300, or 6 percent of your gross monthly income, your back-end ratio will be 34 percent ($1,400 + $300). Since that's below the threshold of $1,800, or 36 percent ($5,000 x 0.28), you could have a good shot at qualifying for a loan.
