One of the first things that a prospective home buyer considers is how much house they can afford. To answer that question, there are four things that they will have to consider:
Conventional wisdom, and traditional underwriting practice says that a borrower can afford between 28% and 33% of their monthly salary toward their housing expenses. Housing expenses (sometimes referred to as PITI) include:
For example, if a borrower or borrowers make an annual salary of $60,000 per year, they would have a monthly income of $5,000. This would mean that their housing expense should be between $1,400 and $1,650 per month. The actual mortgage they could afford would be less than that since they would have to subtract out an estimate or the actual monthly property taxes, and an estimate or actual amount for the homeowner's insurance. To take this example to its logical conclusion, assume $2,400 per year (or $200 per month) for property taxes and $1,200 per year (or $100 per month) for insurance. This would leave them between $1,100 and $1,350 per month for their principal and interest mortgage payment. If you assume a 6% mortgage interest rate on a 30 year loan, they could afford a mortgage of $183,000 to $225,000.
Please note that the preceding example does not take into account other debt which may reduce the amount the borrower can afford. Also note that the housing expense ratio and the following total debt ratio are based on before tax monthly income.
Total Debt Expense
The similar rule of thumb for total debt expense is that no more than 36% to 38% of a borrower's monthly income should go to cover all monthly debt expense. As previously mentioned, total debt expense includes:
Using the same example as above, this would translate into $1,800 and $1,900 to cover all monthly debt expenses. That would be up to $400 per month over housing expense for other debt. It the borrowers have a significant amount of debt, then that would effectively reduce the amount of loan they can afford.
The ideal situation for a borrower is to be able to put down 20% or more as a down payment on the house they wish to purchase. While they can still probably get a loan if they put down less than 20% (dependent on the above housing and debt ratios, as well as their credit history and score), they will have to pay private mortgage insurance. Every dollar they pay in private mortgage insurance effectively decreases the amount available to pay the mortgage, reducing the the mortgage amount and the amount of home that they can afford.
The Borrower's "Comfort" Level
The last thing that a borrower should consider is less tangible. It is how comfortable they are with assuming a large amount of debt and the monthly payment obligations. A borrower should make some level of estimate of how much they spend on a monthly basis to maintain the life style that they wish to live. They should then evaluate this against the monthly housing and debt obligations as well as their after tax take home income. If there is not enough money to meet their debt obligations and still live the life style they want, then they may want to reconsider purchasing a home.
Home Affordability Calculator
For a simple and good home affordability calculator see Your Path to Home Ownership from Ginnie Mae.