Buying a Home: How Much Home Can You Afford?

First, you will have to come up with a down payment—the amount you must pay up front before a lender is willing to give you a mortgage to finance the rest of the cost of a home. Generally, lenders want to see a down payment of 5% to 20% of the purchase price. The higher your down payment, the lower your monthly mortgage payments and closing costs will be.

If you qualify as a veteran of the armed forces, you may be eligible for a Veterans Affairs loan, which has the lowest down payment requirements. Likewise, a first-time home buyer may qualify for special terms. Contact your local Housing and Urban Development (HUD) office, as well as local city, county and state housing bureaus, for information about first-time buyer programs in your area.

Sometimes a seller is willing to finance a mortgage with little or no down payment. But be aware of potential problems in seller-financed arrangements and have an attorney check over your written agreements.

Once you know how much of a down payment you can afford, you’ll need to calculate the monthly mortgage payment you can handle. Lenders generally want your monthly payments (which include principal plus interest, property taxes and home insurance premiums) to equal no more than 28% of your gross income. They also figure you can handle total debt (mortgage payments plus car payments, credit card payments, etc.) up to a maximum of 36% of your gross income.

Chart A, below, will help you determine the monthly mortgage payments, including insurance and property taxes, that you can afford. For example, if you have a $4,000 monthly gross income, you may be able to afford a $1,120 payment ($4,000 x .28). Lenders assume that 15% of the monthly amount you can afford will cover taxes and insurance.

Chart B, below, will help you determine what your total monthly debt can be, in addition to the mortgage, in order to be qualified by a lender. Lenders want to be sure you can meet all of your regular monthly debts, so they use a second criterion: the 36% formula. For example, if you have a $4,000 monthly gross income, your total regular monthly debt (including a mortgage payment) should not exceed $1,440 ($4,000 x .36). Note: If you have high outstanding debts, such as auto loans or credit card balances, it may be more difficult to qualify for a mortgage.

Another guideline says that at an interest rate of 10%, you can afford a home that costs between two and two and a half times your annual gross income. A household income of $50,000 means you can look at homes in the range of $100,000 to $125,000. However, this is a wide range, and you’ll want to find your comfort level within the range by getting a clearer understanding of your overall financial picture.

Now that you have an idea about what you can afford on a monthly basis, ask someone at a bank or mortgage company to show you a chart of current interest rates. Keep in mind that the length of the loan affects the monthly payment.

Generally, banks calculate monthly principal and interest payments per $1,000 borrowed. The chart below reflects current rates per $1,000.

Here's how the chart works. Let's say you purchase a $100,000 home. You have $10,000 for a down payment and seek a mortgage for the remaining $90,000.

The bank agrees to lend you the $90,000 over the course of 30 years at 8%. To calculate your monthly mortgage payments, multiply 90 (the number of thousands borrowed) by $7.34 (from the chart above). Your monthly mortgage payments would be $660. Note, however, that this does not include property taxes or homeowners insurance. The chart below provides a more complete picture of the costs of owning a home. (Remember, owning your own home also requires the cost of ongoing maintenance and repairs.)

Of course, a bank, mortgage lending institution or online broker can help you with these calculations, especially if you choose to prequalify for a loan. By prequalifying for a mortgage you can find out exactly how much you can afford (your shopping price range) and the type of mortgage that’s best for you. And, if you become preapproved, you may have increased buying power over other nonapproved shoppers, which can also save you time once you find your new home.