Before looking for the house of your dreams, you need to figure out how much you can actually afford. We will take you though the process from a lender’s perspective, as well as from your perspective.

The Bank

A recent Motley Fool article discusses three questions banks always want very specific answers to when you are trying to secure a loan: (1) Do you make enough money to pay them back, (2) How good have you been at paying your debts in the past, and (3) Do you have anything of value in case you cannot pay them back? Put another way, these questions get to the heart of the issues of income, credit worthiness and collateral. You will need to understand all of these concepts in order to succeed with the bank.

Income

Banks are very interested in how much you make now, and how much they expect you to make over the next 30 years. They are also interested in what other assets you may have, such as mutual funds. One of the first issues you will come across when trying to buy a house is whether you will be able to come up with 20% of your desired home’s value as a down payment. However, usually enough financial maneuvering can be done to bring that figure down to 5% or less.

Your income will also be used to calculate two formulae: the back-end ratio and the front-end ratio. The back-end ratio is simply monthly debt payments (including expected mortgage payments) divided by monthly income. Ideally, this figure should be less than 40%. The front-end ratio is simply a figure that is approximately 29% of your income; this figure is how much the bank will estimate you can put toward your mortgage payment.

Credit Worthiness

Your credit rating is what a bank will use to determine how trustworthy you are. You can request individual reports from the three major credit reporting agencies: Experian, Equifax and Trans Union. Alternatively, you can go to TrueCredit.com and get all three reports in one step, for a fee. This compilation of your personal financial history will give the bank a determination of whether you have a track record of paying your bills on time.

Collateral

What happens if you cannot come up with the mortgage payments? Usually the house you buy will be considered collateral for your mortgage. This, of course, means that there is a risk that if you cannot repay the loan, the bank can foreclose on the mortgage, and repossess your house. It is extremely important to avoid this eventuality. Besides leaving you homeless, it will also make it very unlikely that anyone will ever loan you money again.

You

Timeframe

Think about how long you will be staying in the home you purchase. Generally, it does not make economic sense to buy a new home if you are only planning to stay there a couple of years. This is because of the fees you have to pay when buying and selling your house. The only way it would make sense to buy a house you plan to sell within a few years is if you expect your house to appreciate significantly in value during that time.

Living Well

Simply because you can qualify for a loan of a certain size does not mean that you can comfortably live with such a loan. Analyze your life and what you will want over the next dozen years, such as new cars or fancy trips. Living with high mortgage payments will usually mean cutting back on some of life’s extravagancies.

By taking a step back and looking logically at what a lender would think of you and your situation, as well as at your own life and comfort level, you should be able to determine how much house you can reasonably afford.