How Much You Can Afford

Before you apply for a mortgage, you should have a realistic idea of how much you can afford to pay. If you apply for a mortgage amount that fits within your budget, you’ll be more likely to have your mortgage application approved.

A rule of thumb is to buy a home that costs less than 2½ to 3 times your annual income. (If you have good credit and a steady income—and do not owe a lot of money on other debt—then you can probably afford to buy a home worth 2½ to 3 times your annual gross income.) 

In order to figure out how much you can afford, first take a look at the four components of a mortgage payment—principal, interest, taxes, insurance (often referred to as PITI). Then do a bit of math to find out.

• Principal – The amount of money borrowed or the amount of the loan that has not yet been repaid to the lender. This does not include the interest you will pay to borrow that money. The principal balance (sometimes called the outstanding or unpaid principal balance) is the amount owed on the loan minus the amount you’ve repaid.
   
• Interest – The cost you pay to borrow money. It is the payment you make to a lender for the money it has loaned to you. Interest is usually expressed as a percentage of the amount borrowed.
   
• Taxes and Insurance – Funds collected as part of the borrower’s monthly payment and held in escrow for the payment of the borrower’s, or funds paid by the borrower for, state and local property taxes and insurance premiums. Homeowner's insurance is always needed to protect your home against losses.
  
  You may also have, or be required to have, mortgage payment insurance. Mortgage payment insurance protects lenders against losses caused by a borrower’s default on a mortgage loan. Mortgage Insurance (MI) or Private Mortgage Insurance (PMI) is often required by lenders if the borrower’s down payment is less than 20 percent of the purchase price.

How Much Can You Afford? Use Ratios to Help You Find Out!

To figure out how much of a monthly house payment you can afford, calculate your debt-to-income ratio. This will let you see how much of your income goes to pay your mortgage and other debts. It is important to keep your ratio low and within the guidelines. The higher your ratio is, the harder it will be for you to fit in your mortgage payment with your other debts and your daily living expenses.

Lenders use two ratios to qualify you for a loan—the debt-to-income ratio or “back end” ratio and the housing ratio or "front end" ratio.

Debt-to-Income Ratio or “Back End” Ratio

What that means: Maximum percentage of a borrower’s gross monthly income that can be used for the mortgage payment and all other debts

What it Should Be: A maximum back end ratio of no more than 36 to 41% is what lenders want to see.

How to Calculate: Divide your total monthly debt obligations by your total monthly gross income.

Example:

If your total monthly debt is $1,380 and your total monthly gross income is $3,500, then...

$1,380 ÷ $ 3,500 = 39.4%

Your debt-to-income ratio is 39.4%.

Housing Ratio or "Front End" Ratio

What that means: Percentage of your monthly gross income that you spend on your total mortgage payment (PITI)

What it Should Be: A maximum front end ratio of no more than 25 to 33% is what lenders want to see.

How to Calculate: Divide your total monthly housing expenses (including taxes and insurance) by your monthly gross income.

Example:

If your total monthly housing expenses are $975 and your total monthly gross income is $3,500, then...

$975 ÷ $ 3,500 = 27.9%

Your housing ratio is 27.9%.