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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

How Much Mortgage Can You Really Afford? These 2 Simple Formulas Will Tell You

Many people still consider home ownership to be "The American Dream." However, the dream can quickly become a nightmare if you are stuck with a mortgage you can’t afford.

It’s important to remember that your mortgage is a loan -- a big loan -- that you will need to pay back. Without proper planning and a little perspective, your mortgage can turn into a huge money pit.

You may want a mortgage so that you can buy a rental property, or you may want help with your primary residence. Either way, there is a solution to the dilemma of how much you can afford. But first, you need to ask yourself how much you will spend.

While your biggest monthly costs will be principal and interest, don’t forget to consider how much you might have to pay for mortgage insurance and property taxes. All of these items together are also referred to as PITI. (That's short for principle, interest, taxes and insurance.) 

But that isn't enough. You still need to figure out what you can afford, right?

Well, there are ways to find that out. They're each a bit different -- and are meant to be guidelines rather than hard-and-fast gospel rules -- but each can be useful, depending on what you're comfortable with.

Let's take a look at two of the most commonly used...

1.The 30% Rule

When you try to figure out how much you can afford to pay each month, it helps to start with the 30% rule. I like to base my decisions on my net monthly income in these cases. So here's how it works...

Take 30% of your net income and limit your PITI to that total.

That's it.

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So, if you have a monthly income of $6,000, your total for principal, interest, taxes, and insurance should be no more than $1,800. If you are uncomfortable with the 30% rule, adjust to your own preferences, perhaps making a 25% or 20% rule.

One thing that's missing from the 30% Rule: consideration of other debts. If you're looking for a more all-inclusive strategy, you may want to try...

2. The 28/36 Qualifying Ratio

Some mortgage lenders use this ratio to determine whether or not you can access the best interest rate on your mortgage loan. As I said, it's more complicated than the 30% Rule, but not too much so.

Basically, it states the following

  • Your mortgage should not account for more than 28% of your monthly income and...
  • Your total debt payments (all consumer debt plus your mortgage) should not exceed 36% of your income.

Using the example above -- where you have $6,000 of income per month -- the 28/36 qualifying ratio limits your principal and interest to $1,680 a month. However, your other debt is also considered. In this case, your total debt payments should be no more than $2,160 per month.

If you want the entire $1,680 for your mortgage and interest payment, you can’t have other debt payments (car loans, credit cards, student loans) totaling more than $480 ($2,160 - $1,680). If you have higher debt payments, your mortgage amount might be reduced to bring in you line.

[If you're ready to buy a home, use our Mortgage Calculator to see what your monthly principal and interest payment will be.]

Of course, if you are willing to pay a higher mortgage rate, you don’t have to follow these rules of thumb. Some lenders don’t consider the 28/36 qualifying ratio. Some will even approve you if your mortgage accounts for 50% of your income each month or brings your total monthly debt payments up to 60% or more of your income.

You just have to be willing to pay the price in interest.

The Rules Are A Bit Different For Investment Property

Realize, though, that this rule might not apply if you are buying investment real estate. Instead, you might base your monthly payment on what you can reasonably expect to receive in rent.

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Say you want to buy a duplex, and you can expect to rent each side for $1,100 a month, for a total of $2,200 a month. In that scenario, you might feel comfortable with a total monthly payment of $2,000 -- leaving a couple hundred extra to go into a fund for maintenance and repairs.

It might also make sense to go even lower, perhaps $1,500 if possible, so that you have profit or so that you can afford to hire a management company to help run the property and manage tenants.

The Investing Answer: The bottom line is your comfort level. Many savvy home buyers are uncomfortable with the idea of having a large chunk of monthly income tied up in a house. Instead, think about what you can do with the extra money. Could you invest it for a better return? When you buy a home, get a mortgage that is manageable if you experience a setback, and consider other uses for the money as well.

And if you are in the market, check out our chart below, powered by Bankrate.com. It'll help you find some of the cheapest mortgage rates in your area.