The first critical step to buying a home is figuring out how much you can afford to spend. Almost no one buys a home with cash. Instead, homebuyers get a loan called a mortgage from a bank. They pay off the loan in fixed monthly payments based on the total amount of the loan and the interest rate. Before you even begin looking for a house, you need to talk with a bank -- or several banks -- to get pre-approval for a mortgage.
The bank will ask you a series of financial questions to determine how much you can afford to pay each month. That number will determine the price range of affordable houses. The main numbers the bank wants to know are how much you earn in income and how much you owe in debt (credit cards, student loans, car loans, etc.). While these numbers give a solid big picture of your finances, you also need to check your budget.
A good budget includes all of your monthly income minus all of your monthly expenses: food, gas, debt payments, entertainment, etc. A complete and accurate budget is the best way to figure out exactly how much money is available every month for a mortgage payment. If that number is lower than the bank's, play it safe and go with your calculations.
Notice that there's a difference between getting pre-qualified and getting pre-approved. Pre-qualified means that you've told a lender your income level and your debt and credit information, and the lender estimated what you can afford. Pre-approval, however, means that the lender has done the legwork of pulling your credit report, checking your debt-to-income ratio, and running a more in-depth analysis of your financial situation. The result is an official pre-approval letter than can be help seal the deal when negotiation with a seller. Sellers know that a pre-approved offer is more likely to result in a completed sale, which might convince them to accept a lower price.
Throughout the pre-approval process, there are some key facts to remember. The monthly mortgage payment is only part of the expense of buying a house. In most cases, you're expected to make a down payment of at least 20 percent of the home price to secure the loan. (First-timers can take advantage of programs that allow them to put down significantly less money.)To do that, you'll need a significant sum of cash on hand. There are also a number of additional costs that are not included in the standard calculation of monthly payments. Ask your lender about property taxes in your area, the cost of mortgage insurance and the average closing costs for homes in your price range.
Read How Mortgages Work for an in-depth review of the whole home financing process.