The Second Step: How Much House Can You Really Afford?

Pre-qualification, based on numbers you supply to a lender, is an indication of the range of what you can afford. Getting pre-qualified is neither a commitment to loan you money, nor is it an obligation by you to borrow from a particular lender.

Lenders typically use one of two guidelines when evaluating a loan request. Most lenders will limit the loan amount to a percentage of your gross monthly income or to a multiple of your annual household income.

As a general rule, individuals or families can usually handle a housing payment that amounts to 25- to-28 percent of their gross monthly income. Following this guideline, if gross monthly income is $3,500, monthly payments (inclusive of taxes and insurance) in the range of $875 to $980 are considered reasonable. Some lenders use an alternate ratio that allows 36 percent of total monthly income for housing expenses and other long-term debts, such as car loans, credit card payments and obligations for child support. (Monthly living expenses for utilities, groceries, entertainment, medical and auto insurance are not calculated in this formula.)

Another guideline, based on gross annual household income, assumes most borrowers can afford up to 2.5 times their gross annual income. This means a borrower with total income of $40,000 may qualify for a loan of up to $100,000.

Whether using a "multiplier method" or a "percentage method," prospective home buyers should allow for closing costs and moving expenses. (Closing costs are the fees and taxes that are paid when the deed is transferred. These usually amount to 5-to-10 percent of the mortgage amount. Moving expenses include costs for movers, as well as "move-in" deposits for utilities and other "necessities").

Many lenders provide work sheets and charts to help you calculate your borrowing power, along tables so you can compare payments at different rates and for different loan periods. (Some real estate brokers and financial institutions even have "mortgage calculators" on their Internet site to help you determine what you can afford.)

Your borrowing power can be increased with favorable interest rates and terms. With lower rates, you can borrow more money. Different types of loans and the duration of the payback period will influence the interest rate that will be applied to your mortgage. In general, the shorter the term of the loan, the lower the interest rate.

There are dozens of different types of mortgage programs from a wide variety of financial institutions, including mortgage companies, saving and loan associations, commercial banks and credit unions. Prudent consumers will find it pays to compare options to find the right loan for their particular situation.

Step 1: "Pre-Approval"

Step 3: "Types of Home Loans"