Everybody I know that has bought or will soon be buying a home spends countless hours searching for the perfect home. Few, if any, spend much time searching for the perfect mortgage. Make no mistake; finding the right first home is important. But your dream home could be for naught if you end up in a less-than-ideal mortgage. If you’re in the market to buy your first home, make sure you master the art of how to find the best mortgage for you before you set foot in your first open house.
All mortgages are not created equal. In fact, there are as many varieties of and options on mortgages that they mind as well be cars. If you don’t know what you’re doing when you’re shopping for a mortgage, you can expect loan officers to try to take advantage of you. (Mortgage brokers and loan officers, like car salesmen, work for big commissions).
First Things First
You’ll never find the best mortgage for you if you don’t know where you stand. You must enter the mortgage market knowing two things:
- Your creditworthiness and how it will affect your interest rate, and
- How much home you can afford.
In today’s recovering credit market, you should have a credit score of at least 700 (check yours now). You may be able to get a mortgage with a lower score, but you’ll pay higher interest that will amount to tens of thousands of dollars more over the life of the loan. If you’re buying a home with your spouse or partner, lenders may look at the lower of the two credit scores. (For more, read: His Credit’s Good, Hers is Bad: Can You Get a Mortgage Anyway?)
As a rule of thumb, you can afford a home if the total monthly housing payment (including mortgage, taxes, and insurance) is no more than 28% of your gross monthly income (before taxes). I recommend you keep it under 25%. And remember, that’s how much you can afford. Just because that’s the maximum you can afford doesn’t mean it’s smart to spend it all (although mortgage officers, looking for a bigger check, may tell you otherwise). You’ll be able to afford more house if you have at least 20% saved for a down payment. Anything less than a 20% down payment, and you’ll need to pay private mortgage insurance (PMI), which will reduce the amount of your monthly housing payment that actually goes towards the house.
Types of Mortgages
Got your credit and housing budget in check? Next it’s time to decide what kind of mortgage is right for you: Fixed rate, adjustable rate, or interest only. (Hint: Stick with the first one. All the best mortgages are fixed rate.) Fixed rate mortgages lock you in to the current interest rate for the life of the loan. Since rates are low right now, this is good. You’ll know that your interest rate and, subsequently, your monthly payment, will never go up. When interest rates are higher, you risk rates going down, but you can always refinance if that happens. Fixed rate mortgages usually come in 30- or 15-year terms, although other terms may be available. Lenders will most likely recommend a 30-year term because it lets you afford more, but you’ll pay far more interest. Dave Ramsey recommends his finance-savvy flock only take on 15-year fixed rate mortgages, period, and I agree.
An adjustable rate mortgage (ARM) offers a low introductory interest rate (giving you low initial payments) but will then adjust to a higher rate (and higher payment) after so many years. ARMs get a lot of home buyers into trouble because they can afford the initial payment but not the payment after the rate adjusts. Unless you put a large amount down and are absolutely sure you will sell the home before the rate adjusts, stay away from ARMs. Interest only mortgages allow you to make monthly payments that only pay down interest and not the principal of the loan (for a set period of time). This is bad because you never build equity in your home; you’re essentially gambling that the home’s value will go up.
Mortgage Interest Rates, Points, and Prepayment Penalties
Most mortgages carry a simple annual interest rate like any other loan. Generally, the better your credit and the shorter the term, the lower your rate will be. Some mortgages, however, also charge “points”. There are two kinds of points: Discount points (more common) and origination points (less common). Discount points are simply interest charges that are prepaid at the closing (rather than paid monthly as you pay down the loan). Generally, paying for points reduces the interest rate by a certain amount. For example, a half a point on a $200,000 is equal to 0.5% prepaid interest, or $1,000. Two points on a $350,000 mortgage would be $7,000. Either the buyer or the seller can pay the discount points, and the amount is tax-deductible. Although their may be some circumstances in which you’ll want to pay discount points (for one, if you know you’ll stay in the home for 20 or 30 years), you’ll want to stay far away from origination points. Origination points basically cover costs of obtaining the loan (like a fee). Origination points don’t provide any benefits and are not tax deductible.
A final word about mortgage basics: Check your mortgage for prepayment penalties. A good mortgage should not charge you anything additional for paying down the principal of the loan faster (i.e., making additional payments).
Are you ready to go shopping for the best mortgage for you? Always get more than one quote. A site like LendingTree can help by consolidating several mortgage offers in one place, but it will also pay to visit one or two local banks or credit unions and meet with real-live loan officers. The key to finding a fair mortgage is doing your homework. You probably wouldn’t buy the first house you walk into without seeing any others; you shouldn’t take the first mortgage you’re offered, either!