If you're searching, or have recently found that perfect piece of real estate, a new mortgage is probably on the horizon. No matter what price range you're looking at, it's likely that you're concerned about real estate prices and whether or not you really have the funds to comfortably purchase the property.

Exactly how much an individual can afford consists of two important elements: The amount you will be able to borrow from the bank along with the down payment you can provide. There are many other factors involved in the long-term ownership of a property such as taxes, upkeep, repairs, etc., but in this article we will concentrate on the initial purchase.

We will start by looking at the banks’ formula, which determines how much they will lend.  Judging by their latest exploits that may seem like a bad idea, but since the downfall of bad mortgages they are now much less likely to allow you to buy a house you can't afford. When deciding whether or not you qualify for a mortgage, the lender will look at your gross monthly income, your credit history, and your down payment.  The first thing you need to understand is your “debt-to-income ratios.”

Debt-to-income ratios consist of the “front-end ratio” which are the housing expenses and the “back-end ratio” which is the total debt-to-income.  Let’s take a closer look to explain the two.

Front-End Ratio:

The front-end ratio shows how much of your pretax income is available to go towards the mortgage.  Generally banks will give good rates if the monthly costs are around 28% of your income or less.  To put it more simply, if you take the mortgage payment (this includes the principal, interest on that principal, homeowners insurance, and real estate taxes), it shouldn’t exceed 28% of your monthly income.  Here is the formula:

Back-End Ratio:

The back-end ratio looks at how much of your income is tied up in paying your debt.  This can include any other mortgages, loans, credit card bills, child support, and the list goes on.  Banks generally like to see your total monthly debt payments to be equal to or less than 36 percent of your pretax income.  To give an example of the irresponsible lending practices during the housing bubble, that figure got as high as 49%.  Here is the formula:

Scenario:

Take a homebuyer who makes $55,000 a year. We would take $55,000 times 0.28 (28%), which equals $15,400.  Then we’d divide that by 12, which equals $1,283.00.  That number then becomes the maximum amount the bank would allow for the mortgage payment.  

The second thing you need to figure out is the maximum monthly debt you can carry. Since the bank says 36% is the limit, we would take $55,000 times 0.36 (36%), which equals $19,800.  Then divide that 12, which equals $1,650.  That number is the maximum amount of debt payments that you are required to pay monthly.

Chart:

Here is a chart that may make it easier for you to estimate your ratios without doing all of that math yourself.

Calculator:

Now that you understand how everything works, use the calculator to determine your exact figures.  Keep in mind, you will run across the term "PMI" which stands for "Private Mortgage Insurance".  Banks only require this if they are financing more than 80% of the purchase.