The Two Mortgage Limits You Must Follow

Lending Limit #1

Now let's determine how much you can borrow. Lending Limit #1 states that your monthly mortgage payment (including taxes and insurance) must not exceed 28% of your income. Since your income is $60,000 (or $5,000 per month), the maximum you can spend on a mortgage payment is $16,800 per year $1,400 per month).

To translate a monthly loan payment into a loan balance, look at Figure 1. It shows how much money you can borrow based on different interest rates. As you can see, the higher the interest rate, the less money you can borrow. If you choose the 7% fixed-rate loan, the maximum amount you can borrow is $210,431, while you can borrow up to $260,794 if you choose the 5% ARM.

So, by adding your loan amount to the $35,000 cash you have, you can buy a home that costs up to $245,430 (if you choose the 7% fixed rate) or $295,794 (if you choose the 5% ARM).

Lending Limit #2

But we're not done yet, because Lending Limit #2 states that your mortgage payment plus other monthly debt payments must not exceed 36% of income. Since your income is $60,000, your limit for both a mortgage and other debts is $1,800 per month. This presents you with a problem, because your total monthly debt payments are $2,200 to include your new $1,400 mortgage payment.

Therefore, you must either reduce the size of your mortgage (meaning you borrow less money, which forces you to buy a lower-priced house), or you must pay off some of your debts.

Let's say you choose to lower the size of your mortgage. That means your monthly payment cannot exceed $1,000 (because $1,000 plus your current debt payments total $1,800 -- which is the maximum that Lending Limit #2 allows). Based on a $1,000 monthly payment, then, the most you can borrow under the fixed-rate loan is $150,307, or $186,281 under the ARM loan. Combined with your $35,000 in cash, that means you can buy a house worth as much as either $185,307 or $221,281.

Now you begin to see why ARM loans are so popular: Their lower initial rates allow you to qualify for bigger loans, which in turn allows you to buy a more expensive home. The danger with ARM loans, of course, is that the first year's low rate could vanish in the second year. If interest rates rise in the economy, what could happen to your ARM over the next four years:

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This is exactly why lenders have these two lending limits. Left unchecked, buyers would borrow beyond their ability to pay. And while it might seem that you're able to carry a larger payment than the $1,000 determined by our calculations above, lenders know better: They know that your mortgage does not represent the total cost of home ownership.

Indeed, you will incur many additional costs that renters avoid — including taxes, insurance, utilities, maintenance and repairs, improvements, and decorating.

You need to set money aside for these expenses, and that means you should not buy as expensive a home as you think you can afford.

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