Pieces of the Payment
Each month, most of your payment will go towards the mortgage loan principal and interest. This is also called P+I. However, your monthly payment is also likely to include amounts for property taxes and homeowner's insurance. Because of these extra payments, your monthly P+I payment is sometimes called your P+I+T+I payment.

If your down payment is less than 20% of the home purchase price, you will also have to add an additional amount to your payment each month for private mortgage insurance (PMI). Why? Lenders require PMI to insure against the higher risk of default that occurs with loan-to-value (LTV) ratios greater than 80%.

Still confused? Simply put, if you contribute a down payment of less than 20%, you have less ‘skin in the game’ and belong to a traditionally higher-risk group of customers. Give 20% or more for your down payment (if you can!), and not only will you have a lower mortgage, but you’ll also be considered a lower risk by the lender.

Figuring out what you can afford
Once you know your monthly payment, you will want to figure out your housing and debt ratios. These ratios help you to get an idea of home affordability. Lenders rely on these ratios to help in their decisions to approve mortgage.

Calculating your housing ratio
Your housing ratio is equal to your total monthly payment divided by your gross monthly income. Typically this ratio should be no higher than 28%.

Example 1:
Monthly payment = P+I+T+I = $1,700
Gross monthly income = $4,800
Housing ratio = $1,700/$4,800 = 0.354 or 35.4%

This ratio is higher than the recommended 28%, meaning that the house may be beyond affordability for the prospective buyer in this case. Now, let’s drop that monthly payment a little and see what happens:

Example 2:
Monthly payment = P+I+I+I = $1,300
Gross monthly income = $4,800
Housing ratio = $1,300/$4,800 = 0.271 or 27.1%

This ratio is under 28% and the payment is therefore more affordable for the prospective buyer.

Calculating your debt ratio
Find out your debt ratio by adding together your expected monthly payment (P+I+T+I) and any other credit card or loan payments. Divide this total by your monthly gross income.

Your debt ratio will in most cases be a higher percentage than your housing ratio, because most people have other loans and/or credit card debt. A rule of thumb to follow here is to keep your debt ratio at 36% or lower.

Let’s calculate a debt ratio now:

Monthly payment = P+I+I+I = $1,300
Other loans & debt = $350
Total monthly payment - $1,300 + $350 = $1,650
Gross monthly income = $4,800
Debt ratio = $1,650/$4,800 = 0.344 or 34%

At 34%, this debt ratio is within the guidelines.

How lenders use these ratios
Mortgage lenders regularly use these 28% and 36% ratios as guidelines. Keep in mind, though, that the ratios change depending on the economy. When the economy is strong, lenders usually raise the ratios, making it easier to get approved for a loan. As expected, then, when the economy is weak, you guessed it: lenders will lower the ratios, making it harder to get a loan. Another factor to throw in: a weaker economy leads to lower interest rates, which makes it somewhat easier to qualify.

Clear as mud? Here’s a guideline to consider: Depending on your situation, you may find it prudent to limit our house search to home prices that allow you to obtain a mortgage loan amount that is conforming. A conforming loan amount is within the annual limits set by Fannie Mae and Freddie Mac, two government-sponsored enterprises that focus on investing in residential mortgages.

For 2003, the conforming loan amount for Fannie Mae- and Freddie Mac-sponsored loans is $322,700 (twice that in Alaska and Hawaii). A conforming loan allows you to avoid private mortgage insurance (PMI) if you make a down payment of at least 20% on the home purchase price.
Furthermore, if your mortgage is conforming, you should find it easier to find a lender than if it is a non-conforming or “jumbo” loan. Bonus: interest rates on conforming loans are usually lower as well.
Help! I don’t have a down payment!
How much of a home you can afford also depends on the amount of down payment you have saved, since the more you can offer up front, the lower the amount of your mortgage. But what if you haven’t got a lot saved? Here are some options:

• Private mortgage insurance (PMI): If you can scrape together a smaller down payment (but don’t have enough for 20%), this could be a good option. PMI will add to your mortgage but allows you to make a down payment of as little as 5% of the home’s purchase price.

• Investments. Some financial institutions offer mortgages that are backed by the value of your investments. By borrowing against your investments, your investment portfolio basically serves as the collateral for your mortgage.

• 401(k) plan. Most employers allow you to borrow against the value of your company-sponsored retirement plan. Keep in mind that if you leave your job, you will probably have to pay back the loan in full immediately.

• IRA. Although you cannot borrow from your IRA, you can withdraw, penalty0free, up to $10,000 from an IRA if you are a first-time home buyer. Keep in mind, though, that you will owe income taxes on whatever amount you withdraw.

• Federal government mortgage-financing programs. The U.S. Dept. of Housing and Urban Development (HUD) and Dept. of Veterans Affairs (VA) run loan programs for first-time homeowners and veterans of the armed forces which require little or no down payment.

• State government housing programs. Do some checking, since most states have programs to help residents buy their first homes.