Before you start house hunting, you should have a good idea what size and type of mortgage you want and can afford. Thinking about mortgages early on in the process, and getting either prequalified or preapproved for a mortgage, will improve your house-hunting efficiency and your ability to close the deal once you’ve found the house you want.
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There’s a big difference between the mortgage you could get and the mortgage you should get.
- What size mortgage can you get? Unless you have a history of bankruptcy or bad credit, lenders generally will approve you for a mortgage with monthly payments that amount to no more than 33% of your monthly pre-tax income. So if your pre-tax income is $6,000, you could get approved for a mortgage with a monthly payment of $2,000.
- What size mortgage can you afford? Just because you can get approved for a mortgage doesn’t guarantee you can actually afford it. To decide whether you can afford a particular mortgage, you need to evaluate your current financial situation and your worst-case future scenario. Consider your savings goals, your job prospects, your plans for children and aging parents, and so on. These factors determine just how much risk you can take on and help you decide, for example, whether you should even consider an adjustable-rate mortgage.
One rule of thumb is that you can probably afford a mortgage worth 200 times your current rent. So if your current rent is $800 a month, you can likely afford a mortgage of:
200 × $800 = $160,000
The length of the mortgage’s term affects both the total cost of the mortgage and the size of the monthly payments.
- Longer mortgage terms have lower monthly payments: Because they stretch out the mortgage over more time, longer-term mortgages offer lower monthly payments than shorter-term mortgages.
- Shorter mortgage terms result in lower total costs: Because they generate less total interest over time, shorter-term mortgages offer lower total cost than longer-term mortgages.
The table below shows monthly payments and total costs for two mortgages with the same principal ($200,000) and the same interest rate (6%) but with 15- and 30-year terms.
Which Term Should You Choose?
Whether you should choose a longer- or shorter-term mortgage depends on your particular financial situation. If you can definitely handle the higher monthly payments of a shorter-term mortgage, that’s probably the better way to go. If you can’t (and many people can’t), a longer-term mortgage is the better choice.
The numerous “percentage rates” on mortgages that lenders quote you can be tricky and confusing. For instance, a lender might advertise a 6.9% interest rate that looks great next to a 7.1% rate from another lender but actually has hidden costs that effectively make the rate much higher. To avoid all this confusion, pay attention to the annual percentage rate (APR) when comparing two mortgages.
The APR, by law, includes all costs in a single rate. If you see one 30-year fixed rate with an APR of 6.9% and another with an APR of 7.1%, you can feel confident that the one with the lower APR has the lower total rate.
Fixed-Rate vs. Adjustable-Rate Mortgages
The most important factor that should influence whether you choose an ARM or a fixed-rate mortgage is how long you plan to live in the property.
- If you plan to stay put for a long time (more than 5–7 years), a fixed-rate mortgage is usually the better choice.
- If you plan to move on relatively quickly (within 5–7 years), an ARM can provide very good value due to its lower initial rate. At any point within the fixed-rate period, you can sell—giving up the mortgage—to avoid higher rates when the rate adjusts.
Though the low monthly payments of adjustable-rate mortgages and interest-only loans are enticing, you should approach them with caution. Many people choose ARMs and interest-only loans over fixed-rate mortgages in order to take advantage of the lower initial fees and “reach” for a house they wouldn’t ordinarily be able to afford. This tactic is a dangerous financial risk because a shift in rates can lead to much higher monthly payments and, in the most dire cases, foreclosure. Never use an ARM to “reach” for a house you can’t afford.
If You Choose a Fixed-Rate Mortgage . . .
Just as you would comparison shop for any other product, you should shop for the best mortgage you can find. When shopping for a fixed-rate mortgage, look for a mortgage with the term you want at the lowest APR you can find.
If You Choose an ARM . . .
ARMs are a little more complicated than fixed-rate mortgages. The index and margin of a given ARM determine how the loan will adjust when the fixed-rate term expires. The formula for calculating the adjustable interest rate on any ARM is: interest = index + margin.
- Index: The interest rate for an ARM is based on one of several reference indexes (such as the interest rate of U.S. Treasury bills). When the interest rate of the reference index upon which a particular ARM is based rises or falls, so does the interest rate of that ARM. When you’re shopping for an ARM, it’s best to compare rates based on the same index.
- Margin: The margin is the markup the lender adds to the interest rate of the index. Most lenders add a 2–4% margin. So if the index is at 5%, the mortgage you get would likely range from 7–9%. Always look for an ARM with the lowest margin.
In addition, there are two other factors to consider when shopping for ARMs: the slowest adjustment frequency and the tightest caps.
- Adjustment frequency: Once the fixed-rate term expires, ARMs adjust interest rates at certain intervals: one might readjust every six months, another every two years. Of two ARMs with the same rate, the one that adjusts less often is the better choice.
- Caps: These are limits on the highest overall interest rate an ARM can have and the maximum amount that rates can adjust between two intervals. The caps limit a mortgage holder’s risk. Of two ARMs with similar interest rates, the one with stricter caps is better. Never take an ARM that doesn’t have a rate cap.
More Mortgage Tips
- Pay more than your monthly payment if possible: If you can afford to, it’s a good idea to pay more than your monthly mortgage payment each month. When you pay more than your monthly amount, that extra money goes toward paying off your remaining principal, which lowers the overall interest you pay throughout the life of your loan. Note that this approach does not apply to interest-only mortgages.
- Avoid prepayment penalties: Some lenders try to stop you from paying off your mortgage early (and thus cutting into their profits) by including a prepayment penalty in the mortgage. This penalty is a fee charged if you pay down the principal of your loan early. Never accept a mortgage that includes such a penalty.
- Understand points: Lenders often offer a lower mortgage rate in exchange for an up-front payment of some percentage of your total loan, called points or origination costs. For example, a mortgage with two points means that you have to pay 2% of the total mortgage up front to your lender. In most cases, the costs of paying more up front outweigh the benefits. You should pay points only if you’re sure you’re going to live in the home for a long time (15+ years) without ever refinancing.
Mortgage Prequalification and Preapproval
Once you know the type and size of mortgage you’d like to get, the next step is to get prequalified or preapproved.
- Mortgage prequalification: To get prequalified, you first describe your income, debt, and credit situation to a mortgage lender. Based on your description, the lender provides you with an estimate of what type of loan you may qualify for. Prequalification can give you an advantage once you do start bidding for houses. When a seller is faced with bids from two different buyers—one prequalified and one not—the prequalified bidder usually has a definite advantage.
- Mortgage preapproval: During the preapproval process—a step beyond prequalification—the lender conducts a thorough analysis of your financial documents. Preapproval makes you even more attractive to sellers.
Be aware that though prequalification and preapproval indicate that you’re likely to qualify for a mortgage of a particular type and size, neither guarantees that you’ll be approved when you apply later on in the process.