In this economy, you should pay equal attention to another key factor: how much home you can afford.

Arguably one of the main causes behind the housing market collapse and the ensuing waves of millions of foreclosure properties is the fact that many homeowners got themselves in over their heads by buying too much home. That could easily be repeated again if homeowners do not learn the previous lessons of the foreclosure crisis.

So, how much home can you afford? How do you determine your budget? We’ll cover a few common ways to help you find the property that matches your budget and your dreams.

Does the Annual Salary Rule Still Apply?

One common rule of thumb is that you should buy a home that costs 2.5-3 times your annual salary. For example, if you and your spouse, together, are bringing home $80,000 a year, you should look for a home in the range of $200,000 to $240,000.

During the housing crisis, people were buying homes that they could not afford – sometimes to the tune of four, five, or six times (or more) their annual salaries. When they discovered that they could not make those massive payments, they lose their homes to the foreclosure process, along with millions of others.

Even people who relied on the salary estimate did poorly. Are there better ways to assess affordability?

Examining Income-to-Debt Ratios

One way to determine how much home you can afford is to look at the amount of debt you own versus your income.

Take your gross monthly income. Lenders examine affordability by comparing this amount with the amount you would need to pay monthly for a particular property, including principal, interest, taxes, and insurance (PITI). For lenders, affordability is 33% – meaning your PITI shouldn’t be more than a third of your gross monthly income.

A back-end ratio takes the front-end ratio (described above) and adds any other recurring debt that you pay monthly (such as credit cards or car payments). This percentage should be 45% or less for most lenders.

Determining Mortgage Payments

Another method is look at monthly payments. Let’s say 33% of your gross monthly income is $1,320. At a rate of, say, 4.5%, on a $150,000 loan and 1% property tax, you would pay approximately $950 a month in PITI. (This is assuming no other debt.) At $4,000, you would have a front-end ratio limit of $1,320, so you are well below that. Your back-end ratio limit would be $1,800. Therefore, $150,000 is roughly around the right price level for you.

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