Somewhere between dreaming of a new house and making an offer on one, every prospective home buyer must weigh needs against price and determine what is affordable. To empower you to make an informed final decision, here are two different methods of calculating your maximum purchase price. The first will discuss assessing your financial situation and finding what you are comfortable paying. The second will outline how your mortgage lender determines your maximum purchase price. Please note that while both are based on the same information, they may come to different conclusions.

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Method 1: Find What You Are Comfortable Paying

This method works backward from your desired monthly payment to your maximum purchase price. To keep everything simple, a free online mortgage payment calculator and a pencil and piece of paper are all you need for this guess-and-check technique.

This process is best learned by example, so let’s begin by assuming that the current 30-year fixed-rate mortgage rate is 4%, that you’ll make a down payment of 10% of the purchase price, and that you’ll need an additional 2% of the purchase price annually for real estate taxes and homeowner’s insurance.

Now, let’s say that you are comfortable paying $2,500 per month for housing. This is the total monthly payment we will be trying to reach using different home prices as a starting place. We will then adjust our guesses up or down, depending on the monthly payment amount our calculator determines.

Our first guess is a home price of $500,000. For this home price, our down payment will be $50,000 (10% of the home price) and our combined yearly taxes and homeowner’s insurance will be $10,000 (2% of the home price). If your calculator requires that taxes and insurance be given separately, just divide this total in half between the two. And, if your calculator requires a monthly value, divide the necessary amount by twelve.

After all the values have been input, we calculate the monthly payment to be $3,061.70. Since this is too high (we were targeting a monthly payment of $2,500), we will adjust our next guess downward.

So, let’s guess $400,000 this time, with a down payment of $40,000, and a combined yearly tax and insurance value of $8,000. This time, the calculator yields a monthly payment amount of $2,465.36. This is below our target, but not much. So, if we prefer a nice round number, we could stop here and conclude our maximum purchase price is $400,000. Or, we could continue to work until we hit our target exactly.

Now, this process may seem a bit tedious. But, it does you the service of keeping you grounded in the reality that you are taking on an obligation that must fit within your overall budget. And, if you do this early in the home-buying process, you will have an idea of what your are comfortable paying before you hear that you’ve been pre-approved for a loan that would put you beyond this amount.

Method 2: Determine What Your Income-Level Can Afford

This method, used by lending institutions, is conceptually very similar to the preceding one. The notable difference is in how the target monthly payment is determined. Rather than choose a value based upon a general sense, lenders calculate two ratios based upon your income and your debt.

The first ratio, your ‘front-end debt-to-income ratio’, compares your proposed housing payment (including principle, interest, real estate taxes, homeowner’s insurance, and any association fees) to your monthly income. Most lenders like to see no more than 28% of your monthly income devoted to housing payments.

But, astute readers may notice that this ratio is not enough to determine what is affordable. Many people have considerable debt in other areas (such as credit cards, child support, alimony, and car payments), making 28% too high. Thus, lenders also calculate your ‘back-end debt-to-income ratio’, comparing your total debt (including the proposed house payment) to your income. While banks prefer a back-end ratio of 36% or less, some allow a value of up to 45%.

No One Knows Your Budget The Way You Do

In the end, actually calculating your maximum purchase price is easy compared to determining how much of your monthly budget you are willing to devote to housing payments. While the bank can give you an excellent view of the numbers, only you know your goals and how a new home fits within them.