How much of a loan can I afford?
Lenders evaluate a prospective borrower's ability to afford a loan based primarily upon two questions:
Up front costs
The most obvious of the up front costs that the borrower must cover is the down payment. While this has traditionally been an amount equal to at least 20% of the loan, in recent years, most lenders have relaxed this requirement such that 10%, 5% and even 0% down is not uncommon. Note that when making a down payment of less than 20%, the borrower is usually subject to PMI, an additional mandatory recurring cost.
When looking at whether the borrower can afford a mortgage's monthly payments, lenders look at a borrower's income relative to the projected housing cost. The traditional answer is that you should spend no more than roughly a third of your gross monthly income on your housing budget. Your housing budget includes not only the mortgage payment, but also homeowners insurance and taxes. Having other debt obligations, such as car payments or school loans, would decrease the size of a loan that you would be eligible for.
While one third of gross monthly income has served as the rule of thumb in the past, lenders these days can be much more generous in qualifying borrowers for larger loans. Just because a lender is willing to give you a certain size loan, however, does not mean that you can actually afford it. This is especially true of adjustable rate mortgages. It is important to consider not only whether you can afford the payments initially, but also whether you can afford the payments should interest rates rise.
If you are more fiscally conservative, you'll also want to include some additional margin of error to account for unexpected events, such as job loss or medical emergencies. For this reason, most financial planners recommend keeping at least six months worth of expenses in a liquid investment as an emergency fund. If a certain loan would require you to shortchange your emergency fund, you may want to consider borrowing a smaller amount.
Mortgage Application Process
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