Matthew Frankel

The Motley Fool

It's important to know how much home you can afford before you start the house-hunting and mortgage approval processes. Doing so can help limit your search to realistic options, and help you avoid disappointment when you find a house and then apply for financing. With that in mind, here is a six-step process you can use to determine how much you have to work with.

1. Know your lender's ratios

The first important point is that you're not necessarily limited by the price of the home you can buy but by the mortgage payment you can afford to take on. For example, a home with a high homeowner's association (HOA) fee will cost you more per month than a similarly priced home without an HOA, so your lender will take factors like this into consideration.

Mortgage lenders generally use two methods to calculate how much they're willing to lend to you, and you are limited by whichever produces the lower monthly payment amount.

The front-end ratio simply means your new mortgage payment as a percentage of your gross (before-tax) income. The back-end ratio is a bit more complicated to calculate, and refers to your total monthly debt as a percentage of your gross income.

The industry standards are a front-end ratio of 28% and a back-end ratio of 36%, although these are not set in stone. Depending on your credit, employment situation, and your lender's policies, these percentages can be significantly higher. For example, 45% of gross monthly income is a common back-end ratio for high-credit borrowers.

2. Calculate your front-end ratio maximum payment

For the purposes of this article, I'll use front- and back-end ratios of 28% and 36%, respectively. If your lender has informed you that they use higher ratios, use those instead when doing your own calculations.

To calculate your front-end ratio, divide your annual pre-tax income by 12, and then multiply this amount by 0.28. As an example, if your salary is $60,000 per year, dividing by 12 gives a gross monthly income of $5,000, and multiplying this by 0.28 gives a maximum mortgage payment of $1,400 per month. Note that this refers to your total mortgage payment, not just principal and interest. Most people pay property taxes and hazard insurance along with their monthly payments, so these are included when a lender assesses your mortgage's affordability, as is private mortgage insurance (PMI) if it applies to you.

3. Add up your monthly debts

Before you can calculate your back-end ratio, you need to add up your relevant monthly debts. I say relevant because not everything you pay each month is included. For example, your lender generally doesn't consider your monthly electric bill, pest control cost, or cable bill. If you're currently paying rent, this is also typically not included, since you won't be paying it anymore once you buy your home.

In a nutshell, your lender will consider all of the monthly obligations that show up on your credit report, which include, but are not necessarily limited to:

Car payments

Student loan payments (Note: Different lenders consider student loans differently. If you're on an income-based repayment plan, your lender may consider the amount you're actually paying each month, while some lenders will consider what your payment would be under the standard repayment plan. Ask your lender how they consider student loan debt.)

Credit cards -- typically, only the minimum payment amounts are considered.

Lines of credit -- required monthly payments

Other loan payments

Child support obligations

4. Calculate your back-end ratio maximum payment

To calculate the maximum mortgage payment you can afford under the back-end ratio, take your annual income, divide it by 12, and then multiply by 0.36 (or whatever your lender's back-end ratio is). Subtract your monthly debts from this amount to determine your maximum monthly mortgage payment under the back-end ratio.

Continuing our previous example, let's say that you earn $60,000 in annual salary, and that your other monthly obligations add up to $500. Dividing your salary by 12 and multiplying by 0.36 gives $1,800. Subtracting your $500 in other monthly obligations gives a maximum mortgage payment of $1,300.

5. Use the lower of the two payments to set your budget

Your lender will use the lower of these two ratios as your upper limit. In our example, we calculated a front-end ratio of $1,400 and a back-end ratio of $1,300. Therefore, you would be limited by the back-end ratio to a maximum mortgage payment of $1,300 per month.

Because mortgage rates change constantly, and each home you consider will have different property tax and insurance rates, it's tough to set a maximum dollar amount for your budget. Instead, use a mortgage calculator like this one along with current mortgage rates which you can find here to determine the monthly mortgage payment you can expect. Be sure to find out whether a property is part of a HOA or not, and include this monthly expense if applicable. Also don't forget about the cost of private mortgage insurance (PMI) if you plan to put less than 20% down. Or, contact a local lender, who can pre-approve you for the maximum amount they're willing to lend you.

If you want to get a general idea of your budget before you go shopping, here's a guide to the average property tax rates by state, expressed as a percentage of the home's value. The national average homeowners' insurance rate is about 0.5% of the home's value (so, $500 per $100,000 of home price), so you can use this information, along with the available funds for a down payment you have, to estimate your budget.

6. Make sure your payment is actually affordable to you

As a final thought, it's important to realize that these are just guidelines. Just because you can qualify for a certain home doesn't mean you can afford it. Be sure to make sure your new mortgage payment is a realistic fit in your budget and lifestyle before you make an offer.

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