How much home can you truly afford?

This is the key puzzle facing first-time homebuyers as they pore over Real Estate Weekly listings. Most Canadians have a rough idea of the level of mortgage payments they would be comfortable with, but it is easy to get swept up in excitement of house hunting. It is best, therefore, to take a hard look at the state of your personal finances before you have to lay it all out in front of a lender.

A general rule of thumb is to multiply your gross annual income by 2.2 to arrive at the home's approximate price level. For instance, if a married couple gross a total of $72,000 annually, they can probably afford a home priced at $158,400, which is quite close to the average price of a resale house in Canada.

A good step in house hunting is to start improving your financial health in the weeks prior to buying. Pay down that charge card and pay off a department store credit. When you feel you are in better shape, apply for a pre-approved mortgage. The pre-approval will not only be a reality check, it will also assure that you will know exactly what your house price limit is. Also, the pre-approved mortgage rate will remain in effect for up to 60 days 'sometimes longer' should the mortgage rate increase while you are looking for a home to buy.

Lenders generally follow two simple rules to determine how much you can afford in monthly housing costs and they will use the same criteria with a pre-approved mortgage as with the real thing.

The first rule is that your monthly housing costs shouldn't be more than 32 per cent of your gross monthly income. Housing costs include monthly mortgage principal and interest and taxes, known as PIT. If applicable, this sum also includes half of monthly condominium fees and the annual site lease in the case of leasehold tenure. Some lenders will also factor in heating costs.

Lenders add up these housing costs to determine what percentage they will take of your gross monthly income. This figure is your Gross Debt Service (GDS) ratio.

With an $72,000 gross income or $6,500 per month, about $1,800 per month ($6,000x 32 per cent) could be used for housing costs.

The second affordability rule is that your entire monthly debt load shouldn't be more than 40 per cent of your gross monthly income. This includes housing costs and other debts such as car loans and credit card payments. Lenders add up these debts to determine what percentage they are of your gross monthly income. This figure is your Total Debt Service (TDS) ratio.

In the example above, if the couple had total debt payments of $650 per month, they could actually apply about $1,750 a month to cover housing costs, based on the TDS ratio. In most cases they should be probably be aiming slightly lower. It really depends on a buyer's personal debt comfort zone.

If you are self-employed, as a growing number of Canadians are, your lender may calculate your GDS and TDS on net income rather than gross income.

Keep in mind that the lower your debt load, the more affordable your home and lifestyle will be. And the better you will sleep in your new home.

It helps to keep in mind that, in the long run, home owning has been traditionally a much better investment than renting. And when you finally sell, the capital gain on your Canadian private residence is tax free.