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' Rules
But 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.
Types of Loans
There are three main types of mortgage loans: conventional; FHA (Federal Housing Administration); and VA (U.S. Department of Veterans Affairs).
A conventional loan is the most common type of loan in the U.S. and typically requires a down payment of at least 10 percent, as well as a pretty solid credit score. These mortgages present lenders with fewer hurdles than the other two.
FHA loans are a bit more forgiving, in the sense that they require down payments as low as 3.5 percent and are usually a bit more flexible with credit scores. Their thresholds for front-and back-end ratios are different from conventional loans, though.
VA loans are only available to U.S. military veterans and service members. To acquire a VA loan, a borrower doesn't have to make a payment, and isn't required to pay private mortgage insurance.
That's a quick overview, but there's much more to know about each type of loan. Prospective borrowers should do exhaustive research in order to determine what type of loan is best for them.
Potential homeowners also need to calculate other costs associated with a mortgage, like property taxes, homeowners insurance and closing costs.
But the costs don't end there. Owning a home entails other costs, such as maintenance, utilities, furniture, and homeowner association assessments. Be sure that you understand all the peripheral costs that you're likely to incur once you purchase a home. You can read more about these home costs by reading our guide: "Home Costs: 4 Crucial Questions Reveal Hidden Expenses."
Use Your Weapons
There are tools to help you determine what mortgage price is right for you. and homeownership calculators are easily found online and can help you hone in on how much house you actually can afford.
And use common sense. It's easy to get swept up by the ocean of numbers that figure into a discussion of affordability, but don't forget the basics. How much are you comfortable paying toward your home each month? How long do you plan on staying in the home? What would be the consequences of not being able to make your mortgage payments?
Owning a home can be an enriching experience, but it's important to carefully consider how much you're willing to give up for homeownership. You might find that renting is your best option right now. Knowing what you want to spend might be worlds apart from knowing what you actually can spend, so use every resource available to help determine how much you can afford to spend on a new home.
Another essential guide for first-time buyers:
Homebuying: 5 Key Steps to Your 1st Real Estate Purchase
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