How Much Can You Afford?

When you are shopping for a home, it makes sense to know your price range. Often the first step a real estate agent will take is prequalify you for a loan. This might be a ballpark figure or estimate based on typical loan setups, or you may formally apply for a loan and become preapproved. When you are preapproved, you need to submit various documents that specify your income and expenses. The lender then gives you a letter specifying the loan amount you qualify for based on your specific financial situation. Sellers prefer preapproved buyers because they know that the buyer will not have problems securing a loan for the home.

Want to know how much you can afford? To start, you need to total all of your income. Next, separately total all of your debt obligations: car payment, credit card balance, and so on. You can then use this information to get a rough estimate or a formal preapproval.

Getting a Ballpark Figure
Roughly, you can afford two to two-and-a-half times your gross income (your income before any debts or taxes have been deducted). So if you earn $70,000 a year, you can afford a house in the $140,000 to $175,000 for your home. But that doesn’t really paint an accurate picture. Consider someone who earns $70,000, has paid off her car, and doesn’t owe any balance on her credit cards to someone who makes the same amount, but has a car lease of $300 a month, a large credit card debt and a student loan to pay off. You can see that one person is a bigger credit risk than the other. That’s where your expenses come in.

Lenders like to look at the complete picture, and they use ratios of what you earn, what you can pay on a house, and what you owe. The most common debt to income ratios is 28/36. These ratios are based on monthly amounts. Like the ballpark estimate, you can figure your maximum monthly housing payment by totaling your monthly gross income and multiplying it by .28:

Gross monthly income X .28 (lender front-end ratio) = Maximum monthly house payment

The other figure in the debt to income ratio takes into account your expenses and is calculated like this:

Gross monthly income X .36 (overall debt or backend ratio) = Maximum monthly debt – Your current monthly debts = Amount left for monthly house payment

Getting Prequalified vs. Preapproved
You might go a step further to ensure you are looking at houses in a range you can afford. The simplest way to get an idea of your price range is to talk with a lender, provide them with income and debt information, and get an estimate of what you can afford. This is like the do-it-yourself method only you talk to a lender, and they may ask questions and require additional information. Getting prequalified doesn’t require a lot of time or money. That’s the advantage. The disadvantage is that you are not formally approved.

To get preapproved, you formally apply for a loan and provide documentation to the lender such as tax forms, monthly pay stubs, a credit check, and other certifiable information on your earnings and debt. The lender then provides you with a formal commitment for a specific date range (the next 60 days, for instance).

You’ll find pluses and minuses for both methods. You don’t need to spend a lot of time or money with prequalifying. On the downside, it’s not guaranteed that you can actually get the loan. For preapproval, you have to provide all the documentation and perhaps pay a loan application fee, but you don’t have to worry about getting approved for a loan. As mentioned, sellers like buyers that are preapproved because they know you can get financing for the home.

Checking Your Credit Score
As part of the loan process, you will need to get a credit check. This lists all the debt you owe as well as credit available to you. If you have always paid your bills on time, you shouldn’t have much to worry about. If you are routinely late or owe huge amounts on your credit cards, you may have a problem. It’s best to know beforehand what your credit check will reveal. You can then clean up any problems -- pay off credit debt or clear up any misunderstandings or mistakes on your report -- before the lender looks at the credit check.

You can get free credit checks from any of several credit check services such as Experian, TransUnion, or Equifax. You can also use these sites to get information about how your credit rating affects your available credit.