How Much House Can You Afford Now?

The era of the McMansion is over, but how far exactly is the next step down?

With the real estate market still in flux after the subprime mortgage crisis, many potential home buyers are confused over which listings they should be scouting. That's because the math that once guided their decisions about what buyers can afford has been through the ringer and back again.

There are more than 1.5 million cautionary tales for getting in too deep. That's how many U.S. properties received a foreclosure filing during the first half of 2009, according to RealtyTrac. And as of December, one in every five American mortgage holders owed more on their mortgage than the value of their home, according to First American Core Logic. With the market still fluctuating, real estate is far from a sure bet as an investment.

Of course, for those with an appetite for risk, there are plenty of opportunities. Interest rates are low, and so are prices. The S&P Case-Shiller 20-city index of home prices suggests they are roughly at 2003 levels. Although the decline has started to slow, in an uncertain market, the question of how much house you can afford may be more important than ever before.

The old guidelines were fairly loose and straightforward. Spend roughly three and a half times your annual salary on the house, and make monthly payments somewhere between 25% and 33% of your monthly salary. In the years leading up to the bust, easy credit left a lot of wiggle room here.

Now, after all of the ups and downs, those basic guidelines are the same, but the gatekeepers have grown stricter about making you stick to them. Lenders have tightened mortgage criteria in the new, post-bubble housing market. Even if your own financial situation hasn't changed, you may find you're not able to access as much credit as you might have a couple of years ago at the height of the boom.

Given the current low prices, these tighter standards may represent an overcorrection from the excesses of the subprime boom, says Ryan Tomazin, COO of Integrated Asset Services, a privately held default real estate and mortgage-service provider. "Affordability is almost as high as it's ever been, but what the banks are allowing people to purchase is still far more conservative than what people could afford," Tomazin says.

Others maintain that lenders' tighter standards represent a return to more traditional ideas about home buying that bypass the boom-time assumption that incomes and real estate values rise without bound. Once again, lenders are requiring a down payment, documentation of income and assets, and good credit scores, says Keith Gumbinger, the vice president of HSH.com, a mortgage market analysis firm based in Pompton Plains, N.J.

"The world is very largely a fixed-rate world," Gumbinger says, but in an uncertain economy, with some economists predicting that unemployment could go as high as 25%, the certainty of a fixed monthly payment is a good idea anyway.

Online calculators will offer you a ballpark figure of how much house you can buy based on your income and other debts. However, buyers should use that estimate as a starting point for a careful examination of their budget and overall financial goals, particularly in today's economy.

"For a person that likes to spend, if you give them a rule of thumb, they will always take it to the max," says David Hefty, a certified financial planner and chief executive at Cornerstone Wealth Management in Auburn, Ind. He recommends going through a quantitative assessment of your real expenses and a qualitative assessment of your priorities to come up with a number that represents the house you can really afford.

Even in a market where low housing prices mean you can get a bigger house for your buck, "sticking to that number is key, so you can get a bigger house, but you're not overextending yourself financially," Hefty says.

Don't just take a lender's word for it when they tell you how much of a monthly payment you can afford. If you're now renting, use your rent as a starting point and be wary of lenders that assume you can suddenly start paying much more in housing costs, says Liz Freeman, a mortgage expert for ShopRate.com, and a former loan officer.

Consider questions like, "Am I starting a family? Would I like to take a trip around the world? Do I spend my weekends jumping horses?" Freeman says. Make sure the house you're planning to buy fits in with your overall financial plan.

Real estate isn't a get-rich-quick scheme, but that doesn't mean that buying a home can't be a good investment for those willing to look at it in the long term. "You'll be building equity slowly and over time," Gumbinger says, "just like your parents did."