How much house you can afford depends on how much cash you can put down and how much a creditor will lend you. There are two rules of thumb: If you are self-employed you can afford a home that's up to 2 1/2 times your annual adjusted gross income plus any items allowed to be added back or deducted. If you are not self-employed you can afford a home that's up to 2 1/2 times your annual gross income.

Your monthly payments (principal and interest) should be 1/4 of your gross pay, or 1/3 of your take-home pay.

The downpayment and closing costs - how much cash will you need?
Generally speaking, the more money you put down, the lower your mortgage.  You can put 3% down (depending on the loan), but you'll have a higher interest rate.  Furthermore, anything less than 20% down will require you to pay Private Mortgage Insurance (PMI) which protects the lender, against any default payments. 

Also, you should expect to pay 3% to 6% of the loan amount in closing costs.  These are fees required to close the loan including points, insurance, inspections and title fees.  To save on closing costs you may ask the seller to pay some of those costs; if that is the case, the lender simply adds the amount of the closing costs to the price of the house and you finance them with the mortgage.

One thing to remember: a lender may also ask you to have two months' mortgage payments in savings when applying for a loan.

The mortgage - how much can you borrow? A lender will look at your income and your existing debt when evaluating your loan application. They use two ratios as guidelines:

Housing expense ratio. Your monthly PITI payment (Principal, Interest, Taxes and Insurance) should not exceed 28% of your monthly gross income.

Debt-to-income ratio. Your long-term debt (any debt that will take over 10 months to pay off - mortgages, car loans, student loans, alimony, child support, credit cards) shouldn't exceed 36% of your monthly gross income.

These are just guidelines, lenders aren't always inflexible.  If you can make a large downpayment or if you've been paying rent that's close to the same amount as your proposed mortgage, the lender may bend a little.

Courtesy: Century21.com