Unless you have hundreds of thousands of dollars in cash to spare, buying a home probably means taking out a mortgage.
And getting a mortgage may be among the most complex things you’ll ever do at a bank.
Interest rates, down payments, credit scores, pre-approval, closing costs, property appraisals… there’s a lot to consider!
And with so much money at stake, learning as you go isn’t always the best approach.
Borrowers who control the mortgage process can avoid the surprises that make buying a home stressful, or worse, the surprises that derail your application, costing you time and money.
Getting a mortgage can take a while, so you should start preparing before you find your dream home.
Common Steps to Getting a Mortgage
Experiences vary for people in different situations, but the traditional path to getting a home loan looks something like this:
Getting Your Credit in Shape
I’ve known a few first-time home buyers who found a great home in the perfect neighborhood. The schools were within walking distance and had great online reviews.
The neighbors were super nice and welcoming. They’d already been invited to the next block party.
Everything was lining up perfectly, until… they applied for a mortgage to finance the home and learned they couldn’t qualify for a loan because of their credit score.
Sometimes, even if you do qualify, a lower-than-ideal credit score can raise your interest rate, and as we’ll see later, a high-interest rate can place an otherwise affordable home out of your price range.
A solid credit history makes home buying easier, and it opens opportunities to save tens of thousands of dollars, and sometimes more, over the life of your loan.
Why Do Credit Scores Matter So Much?
If you were loaning someone $188,000, which is the median price of a home in the United States this year, wouldn’t you want to know whether he or she would pay you back?
Lenders feel the same way, and since they don’t know you personally, they have to rely on credit scores to determine your approach to personal finances.
The lower your credit score, the higher your risk of non-payment. Banks do not like taking chances on someone with a low credit score.
For someone with an average credit score, a lender may hedge its bets by increasing your interest rate.
Your credit score helps determine a lot of the conditions of your loan:
- What type of loan you qualify for: subsidized or private, for example. (We’ll get into this more below.)
- How much of the home’s buying price you’ll be required to pay up front, usually measured as a percentage of the loan.
- How much you’ll pay in interest.
That last bullet point is a biggy: An interest rate of 4 percent on a $175,000 loan for 30 years means you’d pay a total of $300,000 if you paid the house off on schedule.
Increase that rate to 6 percent and you’re looking at $377,000 over the next 30 years if you pay on schedule, a difference of $77,000.
An extra $77,000 will add about $2,500 a year to your payment even though you borrowed the same amount.
How Can I Fix A Bad Credit History?
You’ll need patience and diligence to increase your credit score and pave the way for a more favorable mortgage loan in the future.
The good news?
It’s easier than ever to find your credit score and start working on improving it.
Generally speaking, paying your bills on time and paying down excessive debt, especially credit card debt, puts you on the right track.
Steer your finances in the right direction, then be patient.
It can take months or sometimes years to start seeing your score increase.
Stay on top of it, though. Sometimes a credit reporting error can lower your score. When you’re paying attention, you can identify and fix these kinds of problems right away.
Preemptive Credit Watch
Because it takes a while to repair credit problems, and because your score impacts your mortgage so much, we’ve put “Getting Your Credit Score Under Control” first on this list of how to get a mortgage.
Even if you expect it’ll be a few years until you’re ready to buy a house, you can be super prepared by getting on the road to better credit right now.
With this approach, you’ll be in great shape, credit-wise, when it’s time to apply for that mortgage loan.
Finding Your Home Price Range
Most of us know how much money we can spend this month on groceries or whether we could afford to move into a bigger apartment next year.
We may not know exactly how much house we can afford.
Real estate prices vary throughout the country. If you’re buying in Manhattan or San Francisco, the $188,000 median home price may buy you a storage closet. (Shop around enough and you may find one with the light bulb included!)
In other markets, $188,000 may get you 2,500 square feet of house on a couple acres.
What matters, though, is this:
Could you afford a $188,000 mortgage?
If not, what is your price range?
How to Find Out How Much House You Can Afford
Everybody faces different financial challenges and has different demands on their monthly budgets. Only you can know for sure about your situation.
However, many financial advisors recommend spending no more than 25 to 28 percent of your annual income on housing.
Let’s take this idea for a spin: We’ll say you earn $96,000 a year.
25 percent of $96,000 = $24,000 a year for housing
$24,000 a year divided by 12 months = $2,000 a month for housing.
Most people like to include homeowners insurance premiums and local property taxes into their housing budget. Let’s go with $200 a month for insurance and $200 a month for property taxes for a total of $400 a month.
$2,000 a month housing budget – $400 for insurance and taxes = $1,600 a month for a mortgage.
You can buy a lot of house in many markets for $1,600 a month.
Remember, though: This 25 percent rule may not work for you if you have significant demands on your monthly budget.
If you borrowed $100,000 to get an advanced degree from an elite university, or if you already have heavy debt from other property purchases, adjust your estimates accordingly.
Your ultimate goal will be to find out how much house payment you can afford, reliably, every month for up to 30 years. Your number may be only 15 percent of your income; it may be 35 percent.
I say “up to” 30 years because you can get mortgages with a variety of terms, and these terms have tremendous influence over how far your house money will go.
We’ll go into these details next.
Knowing the Right Kind of Mortgage
Mortgages vary widely. This can be good or bad for you, the consumer.
It’s good when you have learned about the market and you find a product to fit your exact needs. It’s not so good, though, if you wind up with a mortgage that doesn’t match your needs.
In fact, getting the wrong mortgage can be devastating to your personal finances.
If, for example, your interest rate increases after the first couple years because you got a variable rate, your house payment could suddenly become unaffordable.
Interest rates aren’t the only variables you should know about:
You may hear the word “term” when you’re investing, getting a mortgage, or even getting a new life insurance policy. It usually refers to a specific amount of time.
In the case of your mortgage, your term is the length of time during which you’ll owe money on your house, assuming you pay it off on schedule.
A 10-year mortgage spreads your debt across 10 years. If you take the same debt and spread it across 30 years, you’ll have a lower monthly payment.
But by hanging onto the debt longer, you’ll pay more in interest.
How much more?
Let’s take a look at a $175,000 mortgage, which is a little below the median mortgage size this year:
- 30-year fixed term: At 4 percent interest, you’d pay $835 a month but also pay $125,000 in interest charges over the life of the loan. Your $175,000 house would cost you about $300,000.
- 20-year fixed term: At 4 percent interest, you’d pay $1,060 a month and pay $79,500 in interest charges over the life of the loan. Your $175,000 house would cost you about $254,500.
- 10-year fixed term: At 4 percent interest, you’d pay $1,772 a month but pay only $37,615 in interest over the life of the loan. Your $175,000 house would cost you about $212,600.
As you can see, a shorter term costs more in the short run but saves tremendously over time. The difference between a 10-year and a 30-year mortgage in our example above is about $87,400.
Which is why finding the right term matters so much. If you can afford the payments on a 10-year loan, by all means, take advantage of those long-term savings.
If you can afford only a 30-year loan, that’s OK too.
Yes, you’re paying more, but at least you’re getting a foot in the door of a more stable financial future without blowing up your monthly spending plan.
Later on, you could refinance with more favorable terms.
We’ll get more into that idea later in this post.
Fixed vs. Adjustable Interest Rate
So far we’ve discussed only loans with fixed interest rates. With a fixed rate loan, your interest rate — and, as a result, your monthly payment — remains the same throughout the life of the loan, even if it’s 30 years or longer.
Not all mortgages have fixed rates, though. You can also get a loan with an adjustable interest rate. As your interest rate changes, usually in, response to a specific rate index, your payment will rise or fall accordingly.
This sounds scary, and it can be, but an adjustable rate mortgage (ARM) is not a total free for all. With most ARMs, the rate stays the same for a specified amount of time, then begins to change each year.
A 3/1 ARM, for example, keeps its introductory interest rate for three years, then the rate adjusts annually. So it’s not like your mortgage payment would be a moving target month to month.
Even so, not knowing year to year how much you’ll be paying creates too much instability for many homeowners. Sticking with a fixed rate keeps things simple.
You may be wondering who would want an ARM, anyway?
- When you plan to sell the property quickly: Most ARMs offer introductory rates below a fixed rate. If you plan to sell the property before the introductory rate expires, you can save month to month while you own the property. This may be the case if you plan to flip the house.
- When you expect to have more money in the near future: An ARM’s lower introductory rate (and resulting initial lower payment) can help you buy a more expensive house than you may be able to afford with a fixed rate. If you’re expecting to start earning more in the next few years, an ARM can give you this flexibility. An ARM may also be a good fit if you’re about to pay off another loan, creating more flexibility in your monthly budget.
- If economists expect a decrease in rates on the horizon: These things can be too hard to predict, but if you’re buying a house during a period of high-interest rates and you think rates could be going down soon, an ARM could set you up to enjoy lower rates in future years without having to refinance. You should check with a financial advisor to get the best idea about future rate projections.
Remember, too, that an ARM doesn’t have to leave you completely exposed to the whims of the market. Many adjustable rate loans offer caps on rate fluctuations or caps on payments.
These caps work pretty much like you’d expect. With a cap on your monthly payments, for example, even a skyrocketing interest rate will increase your payment only up to the maximum amount allowed by the loan’s cap.
Be careful with these caps, though. Just because you’re insulated from excessive payments doesn’t mean you’re insulated from the interest charges.
Sooner or later you’ll have to pay those charges. Chances are your bank would add them to your mortgage balance, meaning what you owe could keep increasing even as you make your scheduled payments.
Conventional vs. Government Loan
So far we’ve discussed conventional loans which banks, credit unions, and mortgage finance companies offer. You fill out an application, the loan officer checks your credit score, and you usually need to put some money down.
Not everyone can qualify for a conventional loan. Maybe your credit score isn’t quite high enough yet. Maybe you can’t come up with a five-figure down payment.
Enter the federal government, which helps homebuyers through a variety of programs, giving people with lower credit scores and people with limited financial flexibility another route to home ownership:
- FHA Loans: With an Federal Housing Administration loan, the federal government removes the risk to the mortgage lender. If you defaulted on your mortgage, the federal government would re-pay the bank. (You’d still lose the house, but the bank wouldn’t lose money.) Because of this guarantee, banks can offer borrowers with lower credit scores lower interest rates, lower down payments, and lower closing costs.
- USDA Loans: The federal Department of Agriculture also guarantees mortgages, leading to favorable terms for eligible borrowers. These loans often come with income requirements and a higher standard for credit scores than an FHA loan.
- VA Loans: The Department of Veterans Affairs backs mortgages for active duty military personnel along with veterans and immediate family members of veterans. These loans often require no down payment, no credit minimum to apply, and the ability to negotiate the payment with help from the VA if necessary.
This list simply hits the high points for government loans.
Other programs include loans to help make your home more energy efficient and loans to help Native Americans buy a house. You can find a more comprehensive list here.
The question is, should you get help from Uncle Sam to buy a home?
When you need the help, it’s a no-brainer. If you’re living paycheck to paycheck and just can’t find a way to save $20,000 for a down payment, these programs can help get you in a home so you can stop paying rent and start building equity.
If you can get a conventional loan, though, you should be aware of some drawbacks to federal programs:
- Caps on loan amounts: If you’re spending more than $424,000, you’ll have to go conventional.
- Private Mortgage Insurance: With a conventional loan you can avoid paying for PMI by putting down 20 percent of the new home’s value. You can also stop paying PMI when you’ve paid off at least 20 percent of the home’s value. FHA loans require PMI for the life of the loan.
- Must be owner occupied: You couldn’t turn your property into a rental — at least not until you pay off the mortgage — if you got a federally subsidized loan.
- Condition requirements: If you’re buying a fixer-upper, a federal loan may not approve your purchase because of problems like lead-based paint that may be present in older homes. I’ve heard of home buyers having to get a house painted before the government would OK the loan. Not a deal breaker, but a potential hassle.
When you need help getting into a home, and you plan to live in the home, a federally backed loan program is a great benefit.
If you don’t need the help and you’d like more control over the process, go for a conventional loan first.
Finding the Right Mortgage Lender
Surveys consistently show about 75 percent of recent homebuyers have one thing in common: They applied for only one mortgage loan.
These same new homeowners probably wouldn’t have bought the first smartphone or the first pair of boots they came across in a store.
So why take the first mortgage that comes along?
I have a hunch the answer has something to do with how hard it is to apply for a mortgage. All the paperwork and the income documentation and the disclosure of personal financial records.
Who wants to do that over and over?
Why Does it Matter Who Loans the Money?
Here’s another reason people often apply for only one loan: They think the mortgage lender will sell their loan to another bank anyway.
And they’re right.
Many loans get kicked around between three or four banks before they’re paid off.
To me, though, this is a reason to get the most favorable terms you can find, which you can do by applying for several loans.
Why? Because while your lending institution may change as the years go by, the lending terms will remain the same: your interest rate, your term length, etc.
How to Shop Around for Lenders
Thankfully, the good ‘ole Internet makes comparing mortgages a lot easier. You can find details, get quotes, compare features, etc., without going to all the trouble of applying for the loan.
Many different kinds of financial institutions offer mortgages, so first things first: narrow down your choices.
Remember, you’ll be talking about your income, sharing bank statements, and talking about your future plans:
- Do you want to sit down and talk about your options? If so try a neighborhood bank.
- Are you OK handling the transactions entirely online? An online-only bank or lender like Rocket Mortgage can offer great rates.
- Do you plan to get a federally subsidized loan? Be sure you find a lender authorized to handle such a loan.
- Do you want to deal with people you already know? Go to your primary bank.
- Are you searching for the best rates at a neighborhood bank? You may find them by joining a local credit union.
When you know what kind of organization you’d like to deal with, compare three or four different organizations.
Some institutions may have special programs if you’re a first-time buyer, an investor, planning to make the property environmentally self-sustaining. Other places might have promotional rates or may be able to waive the loan origination fee.
Basically, treat your new mortgage with the same scrutiny you’d expend on new curtains or your next summer read.
Getting Pre-Approved for Your Mortgage
After you have found the right lender, it’s time to start the pre-approval process, assuming, of course, you’re ready to move into home ownership.
Some homebuyers skip this step and simply apply for a mortgage after finding the right house. I wouldn’t call that wrong or irresponsible, especially if you’ve bought homes before.
However, if you appreciate more certainty in life, a pre-approval from a mortgage lender will be right up your alley.
Once you’re pre-approved you’ll know how much money your lender will let you spend. You’ll have a much better idea about your monthly payments, too.
For many buyers this can be helpful knowledge as they tour homes and consider variables. For example, if you loved a particular home but it needed a new roof, knowing your pre-approved limit could help you negotiate with the seller.
It’s kind of like grocery shopping. When you know exactly how much money you can spend on food, you tend to make more informed shopping decisions.
Remember this while you’re shopping, though: Your pre-approval amount may exceed your actual budget. Just because your bank says you can finance up to $200,000 doesn’t mean you could afford the payments on a $200,000 loan.
Ramp Up Your Home Search
You know about financing, interest charges, and fitting a house payment into your budget.
Now for the fun part: shopping for your new home.
How would you like to go about it?
- Drive around neighborhoods you like looking for sale signs?
- Use real estate Web sites to narrow your search?
- Check foreclosures in your area for great deals?
- Hire a Realtor to guide you through the process?
Any and all of these approaches would serve you well. I’d go so far as to recommend using all of them simultaneously to get the most thorough canvass of your market.
Here are some things to keep in mind as you search:
- Think about the future: Will your family grow while you’re living in the new home. Try to think about how you’ll be using the home in five years. Will you need more bedrooms, a home office, a guest room, a three-car garage?
- Pretend you’re the seller: Eventually, you will likely decide to sell the home you’re thinking now about buying. How hard would that be? If there’s a wacky addition on the back of the house that you’re not crazy about but can live with, future buyers may not be so forgiving.
- Talk to would-be neighbors: Someone who has lived in the neighborhood a few years has insight even a Realtor may not have. Your would-be neighbors will probably share the ups and downs of the area if asked.
- Don’t expect HGTV standards: Do you watch “Flip or Flop” or “House Hunters?” Not all houses on the market, depending on your price range, will live up to those standards. If glistening appliances, quartz countertops, and double vanities get your blood pumping, you may want to lean toward new construction.
Should I Get a Real Estate Agent?
Realtors make a living by handling real estate transactions. They are experts on the nuances of their markets.
Yet I routinely meet buyers who aren’t all that eager to hire a Realtor. Often, they cite the agent’s commission as an unnecessary fee since they can search up houses online for free.
Give this some serious thought before deciding, though. A good agent can be your advocate throughout the buying process, protecting you from issues you may not even be aware of yet.
And about that commission: If you’re looking at listed properties (not for sale by owner properties), the seller has an agent who will be earning a commission from what you spend.
When you also have an agent, the two agents will split the same commission. So, you’re going to be paying the same commission anyway. Why not let half of it go to someone who has your back instead of the seller’s?
Offers, Counteroffers, and Contracts
Every real estate market can be different, and your local market will also fluctuate from year to year. Sometimes the market favors buyers; other times it’s sellers who have the most influence over transactions.
If you’re shopping for a home in a seller’s market, you may face some fierce competition from other buyers.
So how can you make an offer that will get the seller’s attention amidst a flurry of other offers?
Other than making a cash offer exceeding the asking price, which is hard to beat, you could:
- Have a mortgage pre-approval: The seller will know you’re serious if you already have your financing in order.
- Make a reasonable offer: You may enjoy some back and forth in your negotiations, but don’t start so low that the seller doesn’t take your offer seriously. If the asking price is $200,000, don’t start with $120,000 unless you think the house really is worth $120,000 or so.
- Be flexible on closing costs: In a buyer’s market you can get away with drawing the line against paying any closing costs. If it’s a seller’s market, though, a buyer will likely have to take on some, if not all, closing costs.
- Mix and match: If closing costs are a big issue and you really need the seller to pay them, make a higher offer on the house itself. Or, if you’re making a lower offer, consider taking on the closing costs as a way to sweeten the deal. Again, if it’s a buyer’s market, ask for the moon.
Your Realtor can guide you here by providing specifics about your market. He or she may know in advance how the seller’s agent would be inclined to respond to your offer.
A Counteroffer is a Good Thing
When you’ve made an offer and the seller counters with a higher offer, you know you’ve gotten the seller’s attention. Let the negotiations begin.
Discuss with your Realtor whether you should accept the counter offer or make another offer of your own.
Once you and the seller agree on terms, it’s time to enter a contract.
Going Under Contract
With a contract, you’re agreeing to buy the house under the agreed-upon terms (from the offer) as long as certain conditions remain true. Likewise, the seller is agreeing not to sell to anyone else while under contract with you.
The seller or her agent may ask for earnest money. This is not a down payment on your loan, but it will go toward the purchase of the home assuming you close.
Essentially, the money — usually $500 or $1,000 — shows you’re serious.
If something happens and you do not buy the house, make sure you ask for the money back.
Negotiations Continue While Under Contract
At this point in the process, you’ll need to hire an independent home inspector to explore every corner of the house, from the pillars to the roof vents.
Your Realtor, of course, may suggest some home inspectors, but consider finding one for yourself. This is your long-term investment.
You stand to gain or lose money. So you’ll want to know for sure that the inspector is looking out for you.
About your home inspection
Read your home inspection report thoroughly. If you’re buying an older home, don’t be surprised if the inspector uncovers some minor problems with the plumbing or the insulation or the duct work.
Issues like those shouldn’t prevent you from buying the house, but you may want to consider asking the seller for a concession.
You could ask for a $500 discount on the home to fix a problem in that price range, for example.
Or you could ask the seller to fix the problems before closing.
The inspector may also find serious flaws with the home. If the inspector questions the structural integrity of the home, either because of foundation problems or some kind of extensive rot, it may be time to seriously consider moving on to a different property.
The same is true for safety issues. Old wiring or an ancient or poorly installed heating system could spell disaster down the road.
Yes, such problems can be fixed, but the cost and the amount of work may prove too big a hassle if you have other home options on your list.
As you can tell, you’ll be plenty busy during these few of weeks between agreeing to an offer and closing on your home. Don’t forget, you’ll also be packing and preparing to move.
And, there’s still work to do at the bank.
Applying for Your Mortgage Loan
Wait a minute. Didn’t we already talk about mortgage loans?
Yes, but only for a pre-approval. When you have a house under contract and you fully intend to see the purchase through, you’ll need to make the loan application official.
With your pre-approval, the bank would have made some assumptions. Specifically, it assumed the information you shared about your income, your employment, your bank balances, and such, was true.
Now it’s time to prove it.
Don’t be surprised if the lender calls your place of employment.
It may feel as though nothing is sacred by the time you finish the application.
Don’t sweat it, though.
As long as your fiscal house is in order and you can document it, you should be fine.
As you apply, it’s time to decide about your loan’s terms.
Can you afford a 12-year or a 15-year mortgage? Should you play it safe with a 30-year loan? (Scroll up to the types of mortgage session for a refresher on this subject if you need it.)
Your lender will be doing some work of its own during this time that you’ll want to be aware of:
- An appraisal: The bank will hire someone to appraise the value of the property you’re buying. If the loan amount exceeds the appraised value of the property, the bank could pull the plug on your loan. Why? The bank is thinking ahead. If it repossessed the property because you failed to pay, the bank would become the property’s seller, and it would need the sale to re-pay your defaulted loan. That’d be harder to do if it loaned you more than the value of the home. (This protects you as well, especially if you needed to re-sell the property within the first few years of the loan.)
- A title search: The lender wants to know for sure whether the seller owns the house and has the right to sell it to you. To find out, it will hire someone to research the history of the home you’re buying. The search should reveal names of previous owners, dates of ownership, prices paid during previous transactions, etc. The result of this search can be interesting, especially if you’re buying an older home.
If all this, along with your financial documentation, checks out, you should be good to go. The lender will issue a loan commitment, which means you’ve got the financial backing to make your homeownership dream come true.
Preparing for Your Closing Date
Your contract should include a closing date, which may be scheduled a month, or even longer, into the contract period.
Until after the closing, either party could back out of the deal, so people tend to think of closings as stressful.
In reality, you should know days or even weeks before your closing date whether everything will happen as planned.
Call a Lawyer
Your real estate attorney (your Realtor can recommend one or you can hire an attorney yourself) should be experienced and have a knowledgeable staff.
When you’re in good legal hands, even the most complicated parts of your transaction will seem easy. Your attorney will find out about any past due taxes on the property and make sure you’re not held responsible for property taxes accrued before closing.
Your attorney will do a separate title search and be able to show you any encroachments on your new property.
If a neighbor, for example, has placed a storage building across the property line, you’ll find out.
You’ll hand over your down payment if you haven’t already, and the money from your mortgage lender.
Then, you’ll sign document after document after document until they all begin to look the same.
You Have More Work, Too
Before the closing, you still have a few things to take care of on your own:
- Homeowners insurance: You will need a homeowners policy in place and ready to go into effect as soon as you make things official at the closing. Shop around for a policy that will meet your home’s precise needs. Your policy will have a big job to do: protecting your new investment from a wide variety of perils.
- Transferring utilities: If you’re renting, be sure to tell your landlord that you’re under contract on a home of your own. If possible, give yourself a week or two after closing before your lease ends so you can move your stuff without as much stress. And don’t forget to cancel the Internet, water, electricity, etc., at the old place.
- Hiring movers? Maybe you have a couple friends who own trucks? If you can afford it, though, professional movers can make life a lot easier. Be sure to read reviews on Trustpilot or Facebook before hiring a company. Try to call companies a couple weeks before moving day to get on a schedule, and look into the costs beforehand. You don’t want to be surprised by a $1,000 moving bill.
Opening an Escrow Account
Your closing attorney will most likely mention an escrow account for insurance and taxes. You don’t have to go this route, but many homeowners find it helpful.
Here’s how it works: Each time you make a house payment, part of your payment goes into a separate, escrow account.
The money builds up as the months pass, then when it’s time to pay your property taxes or the insurance premium, you have the money available.
Your lender will maintain the escrow account and even pay the tax and insurance bills.
Other than monitoring it once in a while, it doesn’t require much thought from you.
Looking to the Future as a Homeowner
- Is There A Faster Way to Pay It Down?
- Should You Payoff Your Mortgage Quicker?
- What About Mortgage Life Insurance?
- Should You Ever Refinance?
- What Are Second Mortgages?
All the work you’ve done to prepare for homeownership — all the saving, the research, the applications — should seem worth it when you leave the attorney’s office with your house keys.
Decide what your first meal in your new home will be.
Show the kids or your pets around the place.
Introduce yourself to the neighbors.
Get settled in.
Take time to enjoy the win because, soon enough, you’ll start to become acquainted with the challenges of homeownership.
Of course, there’s the huge mortgage balance to get paid off, so we’ll start our “New Homeowner Frequently Asked Questions” here:
Are There Shortcuts to Paying Off the Mortgage?
Yes! The more you pay on your loan’s principal, the less interest you’ll pay in the long run and the faster you’ll be out of debt.
You probably saw a “truth in lending” disclosure at your closing. The form should have shown you exactly how much money you’d spend on the loan if you paid on schedule.
For example: If you have a new, 30-year, $175,000 mortgage loan at 4 percent interest, you’d pay about $125,000 in interest charges over the next three decades. So, you’d actually be paying $300,000 to buy your $175,000 house.
It’s annoying, I know, but such is the mortgage lending business. Banks don’t help you buy a house for free.
However, by reducing the length of your loan, you can reduce the amount you pay in interest. How do you reduce the length of your loan?
By paying extra on the principal of the loan.
“Principal” refers to the actual balance.
In the example above, the $175,000 would be the principal. For this to work you need to pay your scheduled payment which will automatically include interest charges, then make an additional payment on principal.
Your lender’s online payment system should offer a way to designate the extra payment to principal. If it doesn’t call the lender to ask about it. Unless the extra payment gets properly designated, you may be simply paying the next month’s scheduled payment.
What is the effect of paying extra on principal?
On the $175,000, 4 percent, 30-year loan from above, by paying an extra $100 a month you’d save about $25,000 over the life of the loan and have the house paid off five years sooner.
Should I Pay Off the Mortgage Right Away?
Like a lot of great questions, the answer here isn’t as simple as you’d think.
Yes, your mortgage is a big debt, and yes, it would be better to own the house outright and cut back on some of those interest charges.
But a singular focus on paying off the mortgage can also cost you.
For example, you shouldn’t rack up a bunch of credit card debt because you’re making three house payments a month. Or, some people may benefit from saving for retirement each month instead of paying extra on the house.
Even if you can afford to pay down the mortgage quickly without making sacrifices elsewhere, some tax professionals think you can benefit more by writing off your mortgage interest at tax time, which you can’t do after you’ve paid off the mortgage.
Long story short: There’s no one-size-fits-all answer to this question.
Consider your individual circumstances and ask a financial advisor for help.
What is Mortgage Life Insurance?
The emails and postcards may already be flooding in. Since you’ve bought a house, insurance companies will be offering you mortgage insurance which would pay off your loan if you died.
That way your family wouldn’t have to worry about paying off the house or selling it.
It sounds like a sensible precaution, but like a lot of unsolicited offers, you can probably do better.
If you’re worried about protecting your investment and your family’s overall financial security if they suddenly did not have your income, you’re not alone.
There’s an entire industry set up to address that need. It’s called life insurance. A term life policy may suit your needs better than mortgage life insurance.
Mortgage insurance would pay off the balance of your loan if you died. Term life would pay your beneficiary (your spouse, partner, adult child, etc.) if you died.
Your beneficiary could then use the money as he or she saw fit rather than having it automatically go to your mortgage lender.
What About Refinancing?
You’ll also get offers to refinance your loan.
When you refinance, you’re getting a new mortgage on the same house. The new mortgage pays off the existing mortgage, then you start over paying off the new loan under its terms.
If you can get significantly better loan terms by refinancing, then go for it. Here are some questions to ask yourself:
- Can you lower your interest rate by a couple percentage points? If you’ve resolved some credit issues since buying your home, you may now qualify for a much better interest rate on a refinanced loan. This could save you thousands of dollars.
- Can you now afford a significantly higher payment? Maybe you’ve gotten a new job or a big raise and can afford a much higher payment then when you first bought the house. If you’re going from a 30-year to a 12-year mortgage, you can save a lot in interest charges by refinancing. (You can achieve a similar effect by simply paying more on principal each month.)
- Are you worried about your variable rate? Did you get a variable rate mortgage and now you’re coming to the end of the introductory rate period? Depending on the climate for interest rates, you may want to lock in a fixed rate by refinancing.
- Did you get a subsidized loan and now need more flexibility? Subsidized loans are great, but they can limit how you use your property. If you wanted to turn your home into a rental property, your federal loan may not allow it. Refinancing with a conventional loan can open up more possibilities.
Usually, when you refinance, you need to pay closing costs again. Be sure the new loan will save enough money to justify a second round of closing costs.
What is a Second Mortgage?
To understand how second mortgages work, you need to know about equity. Equity refers to the amount of the house you actually own.
If your house is worth $200,000 and you still owe $150,000 to your mortgage lender, you own $50,000 in home equity.
You can tap into that $50,000 by getting a second mortgage or a home equity line of credit.
After doing so, you’ll still have your original mortgage to pay and you’ll have a second mortgage to pay each month.
A lot of people got into serious financial trouble in the late aughts when the housing market plummeted and their equity, which they’d already borrowed against, vanished.
So, don’t overdo it.
Save this option for home improvements, even when you’re tempted to pay off credit card debt or a car loan with a second mortgage.
By investing your equity back into your home, you can increase the home’s value. But don’t go too far here either. It is possible to invest beyond the value your local market can re-pay.
Your home’s location has a big say in its value. No matter how nice your new appliances and cabinetry may be, your home’s overall value will still be constrained by the local market.
A home equity line of credit works similarly, but rather than having a fixed amount, you can borrow against your equity as needed.
Think of it as a cross between a second mortgage and a credit card.
A Big Investment in More Ways than One
When people say your home is your biggest investment, they’re not talking about only money.
You’re also investing time, patience, and knowledge.
And your knowledge investment can make your financial investment go even further.
Knowing how to determine your price range, how to avoid excessive interest charges, and how to interpret a home inspection report, for example, can protect you from costly mistakes.
Knowing how to make an attractive offer and how to back away from a counteroffer will serve you well in your local market.
Take your time and learn about the process. Research your loan options, even after you’ve closed on the home. Consider the long- and short-term effects of each option.
With the right knowledge, you can do home-buying your way.