Don't start house hunting until you seriously consider how much you can afford to pay. A little advance planning will save you time and money later, by preventing you from bidding on unattainable houses or applying for loans that are out of your likely range.
How Much House Can You Afford?
Lenders have developed a formula that says you can afford a house worth about three times your total (gross) annual income. Don't rely solely on this formula, however -- it's much safer to look at your own budget, and figure out how much you have to spare and what the monthly payments on your new house will be (not just on the mortgage -- factor in taxes, insurance, maintenance, remodeling plans, and more).
According to institutional lenders, you should make all your monthly payments -- toward your house as well as other debt obligations -- using no more than 28% to 44% of your monthly income. In other words, if your monthly income is $2,000, the lender would want you to pay no more than $880 (.44 x $2,000) toward all your debts.
For a sneak peak at how much of a mortgage you'll be able to qualify for, see Nolo's calculator on qualifying for mortgages.
Check Your Credit History
When reviewing loan applications and making financing decisions, lenders typically request that the credit bureaus reporting your file -- Equifax, Experian, or TransUnion-- provide your credit score (also known as your FICO score). This seemingly mysterious number represents a statistical summary of the information in your credit report, including things like your history of paying bills on time and the level of your outstanding debts.
The higher your credit score, the easier it will be to get a loan. To get a low interest rate, conventional lenders generally want to see a credit score of at least 740 (though this varies from lender to lender). If your score is lower than 620, you may not qualify for a conventional loan at all.
If you routinely pay your bills late, expect a lower score, in which case a lender may either reject your loan application or insist on a very large down payment or high interest rate (to lower its risk). For more information, see Nolo's article on Credit Scoring. Even if you've paid your rent late -- no matter that it was for a justifiable reason -- this may count against you, as explained in Nolo's article Rent Payment History on Your Credit Report? What Tenants Need to Know.
Because your credit history has such an important effect on the type and amount of mortgage loan you'll be offered, check your credit report and clean up your file if necessary -- well before, not after, you apply for a mortgage.
Loan Preapproval vs. Loan Prequalification
Once you've done the basic calculations and completed a financial statement, you can ask a lender or loan broker for a prequalification letter saying that loan approval for a specified amount is likely based on your income and credit history.
Prequalifying lets you determine approximately how much you'll be able to borrow and how much you'll need for a down payment and closing costs. The lender will not review of your credit report or verify your financial information when prequalifying you for a loan, but rather will simply provide an estimate of how much you might eventually be approved for based on an overview of your finances, including your income, assets, and debts.
It's best to do more than prequalify for a loan: You should also try to be preapproved for a specific loan amount. This means a lender has already indicated a willingness to approve you loan based on having checked your credit and evaluated your financial situation, rather than simply relied on your own statements. Preapproval isn't an all-out guarantee that the lender would actually fund the loan, but it's as close as you're going to get to one, and your home seller will want to see it. The lender will make actual loan approval conditional on an appraisal of the property, a title report, and other conditions.
For detailed information on how much of a loan you can safely take on, and successfully qualifying for the loan, see Nolo's Essential Guide to Buying Your First Home, by Ilona Bray, Alayna Schroeder, and Marcia Stewart (Nolo).