Before you can start to dream about your new neighborhood and the freedom of waking up to your own space and dangling your own keys, you have to figure out how much house you can afford.
Some buyers start looking at home's they think should be in their price range, either because their friends recently bought in the area, or in a similar price bracket, or because they have pulled a figure from a hat. This kind of arbitrary approach is not doing your realtor any favors because it means he has no real idea of what kind of homes you qualify to buy and it is also an injustice to you because it can be really disappointing if the amount you can borrow is significantly less that you imagined.
So how then do you calculate how much home you can afford? The best way to figure this out is to get pre-approved for a loan. This means you will visit a mortgage broker, taking with you all the required documents and then get a letter from them stating how much they are willing to lend you. It is also possible to do a quick calculation on your own.
Look at Your Debt Situation from the Bank's Perspective
It helps if you assess your finances using the same terms as the lending institution. Lenders look at your debt to income ratio and use this as an indicator of how much credit they are willing to extend to you. Your debt to income ratio is simply your debt expressed as a percentage of your income. To calculate this figure simply add up all your debt obligations, which would include things like student loans, car loans, credit cards and any other loans and divide this figure by your total income.
Most lenders are willing to allow debt to income ratios to go up to 36%. A typical lender will prefer if your mortgage loan on its own accounts for only 28% of your income. This means that although your total debt, including the prospective mortgage can be allowed to use up 36% of your income, the mortgage on its own should exceed more than 25% of that amount. Therefore to calculate how much of a monthly mortgage payment you can handle you can simply find 28% of you gross salary.
Factor in Your Down Payment
100% financing is becoming a thing of the past. Most lenders now require a down payment of at least 20% of the purchase price of the property. This means you should have this amount in savings before seriously starting your house hunt.
Keep Some Money for Closing Costs, Property Taxes and Insurance
Forgetting to factor in closing costs, property taxes and home owner's insurance can make for a nasty surprise when you are knee-deep in the process. It is best to plan ahead and get an estimate of what these things might cost in your property bracket.
Figuring out how much house you can afford takes more than just saving aggressively for a little while and then making an intelligent guess. There are ways to get quite close to your estimate to minimize the stress of having to find money to cover things you forgot to include.