A mortgage is a type of loan created specifically for home buyers. Most Americans dream of owning their own home, and the U.S. has a well-developed mortgage system in place to help you achieve your home ownership goals. Most of us have some idea of how mortgages work and of what owning our own home involves. But if you want to make your home buying experience a positive one, there are a number of less-known facts that you might want to become familiar with.
We at GET.com have put together a list of the basics to help you understand when it makes sense to buy, how mortgages work, what home financing and refinancing options are out there, and how to protect your investment with homeowner's insurance.
Important Things You Should Know About Mortgages
If you are thinking of buying your own home, take a look at this basic guide to mortgages. Here we explain the differences between fixed rate mortgages, adjustable rate mortgages and hybrid adjustable rate mortgages. You can also find simple tips that can help you get the best mortgage rates and potentially save you thousands of dollars.
What Should I Know About Mortgages?
First of all, let's clarify what a mortgage is.
Basically it's another word for a home loan that you can get from a bank or other financial institution. As a general rule a mortgage is a long-term loan. If you borrow $50,000 to buy a house and pay that $50,000 back in 1 year, the loan would probably be defined as a personal loan or a short-term loan.
In a typical mortgage, the property which you buy serves as collateral in case you default on your loan. In other words, if you don't make your payments on time, you can lose your new home. In the worst case, you may end up losing your home and paying back the balance of your loan to boot.
That's why it is very important that you take your time and find a mortgage that's realistic for your financial situation, with some allowance for unexpected changes to your financial setup.
First of all, you should understand the different types of mortgages available:
1. Fixed Rate Mortgage
A Fixed Rate Mortgage (FRM) is one of the safest mortgage options, and usually comes with 15 year and 30 year tenures (the time during which you repay a loan). Your interest rate is fixed, meaning that you will have the same interest rate until you've paid off your mortgage.
For example, if you get a 3.50% interest rate when you take out your 30 year fixed-rate mortgage, you will still be paying only 3.50% interest in 25 years, even if interest rates have gone up to 6% by that time. Of course if rates were to go down in a big way, you will be stuck with the high interest rate you agreed on.
Although mortgage rates have remained steady, generally going up slowly with occasional drops, there are exceptions. A fixed rate mortgage can make it easier to calculate exactly how much your home will cost you, and protect you from inflation or spikes in interest rates. But if interest rates for fixed rate mortgages are high compared to other years, then it may be wise to wait, or to consider an adjustable rate mortgage (more on that coming up).
If you had taken out a 30-year fixed rate mortgage in August of 1981, you would have been stuck with a huge 18.45% interest rate until you paid off your house in 2011. Compare that with the average of less than 3.50% in 2015 and you can see why a fixed rate mortgage is not always the best solution.
An FRM is usually the best choice if you plan to rent your home out to pay your mortgage. Because you know exactly what you will pay in interest over the life of the mortgage, you can easily calculate exactly what amount of rent you should charge to cover the full cost of the mortgage.
2. Adjustable Rate Mortgage
An Adjustable Rate Mortgage (or ARM) has an interest rate which changes every year based on the market. With this kind of mortgage, it's more difficult to predict exactly how much interest you will pay for your home loan. But if rates are high (like they were in the early 80s) and you expect them to come down in the near future, then an ARM is a good alternative to an FRM.
Although ARMs usually come with lower interest rates than FRMs, they leave you vulnerable to interest rate hikes and can be a financial rollercoaster ride. After all, a lot can happen in 15 or 30 years.
A hybrid ARM may have a fixed rate for a certain amount of time, after which the rate will adjust to the market rate. This type of mortgage gives you some security, but still usually comes with lower rates than FRMs. You might start off with a 5 year fixed rate, and only after that will the rate adjust based on the market rate.
A hybrid ARM provides a good way to take advantage of low rates in the market for a few years, if you don't plan on paying off a mortgage over a long period of time. For example, if you are buying a property with the intention to sell it within several years, then a hybrid ARM could give you the low interest rate you need for the short amount of time before you sell the property.
15-Year Or 30-Year Mortgage?
If you can afford it, a 15-year mortgage usually makes more sense.
Not only will you get that mortgage behind you faster, but since you will be making payments for twice as long with a 30-year mortgage compared to a 15-year mortgage, you will actually end up paying a lot more interest over the 30-year tenure.
Rates are flexible, and at times you may get lower interest with a 15-year mortgage than you could get for a 30-year mortgage. If paying off your mortgage in 15 years would use up too much of your income and leave you financially vulnerable, then getting a 30-year mortgage with monthly payments that easily fit into your budget is a better choice.
Other options include 5-year and 1-year ARMs, both of which usually come with relatively low interest rates. There are also several other mortgage types and if you don't feel that the standard 15 or 30 year FRM or ARM models really fit your situation, then have a look at these lesser known mortgage options.
Should I Wait Until I Have Enough For A Down Payment?
This can make buying your home a lot more expensive. But if you find an exceptionally good deal on a property, or are paying a high rent, then getting your mortgage right away may be worth it.
What Should I Do To Get The Best Mortgage Rates?
There are many different reasons why a mortgage is easy to get sometimes, and difficult to get at other times. Most of these, like the overall economic situation, housing demand, and Federal Reserve actions, are out of our control. But there are things you can do to up your chances of getting approved for a mortgage.
Much like the APR on your credit card, the interest rate you get with your mortgage will depend on your creditworthiness. Aside from the obvious, like your income and ability to pay the down payment, lenders will review your credit score and your assets to figure out if you are a safe investment.
What's My Credit Score?
When you take loans and make payments, your credit behavior is recorded by credit bureaus. There are a lot of credit bureaus around, but the 3 biggest are currently Experian, TransUnion and Equifax. Your credit history (records of how promptly you paid your bills) is compiled to create your credit score. One of the most widely used credit scores nowadays is the FICO® Score.
This score takes into account your payment history, money you owe, the length of your credit history (how long you have been using credit), new credit you take on (another credit card, for example), and how many types of credit you use (utilities and phone bills that you pay for at the end of the month rather than prepaid, credit cards, personal loans, etc.).
Besides paying your phone bills, rent, water and electricity bills on time, you can also up your credit score by using a credit card to make at least part of your purchases, and then making your payments on time every month.
Most credit scores range from 300 to 900, and FICO scores use ratings between 400 and 800, with the highest number being the best (and the lowest number the worst).
If you want to get the lowest available interest rate for your mortgage, you will want to have a top credit score. Avoid taking out loans, and don't carry credit card balances (pay in full each month). Having a good credit score can mean the difference between getting a prime or subprime loan (or no loan at all).
If you want to keep track of your credit score month by month without paying for the service, you can get free access to your FICO® Credit Score on monthly statements, online and on mobile using a Discover credit card.
How Much Debt Can I Have?
Nobody wants to lend money to someone who's already in over their head. If you want to get the best possible rates on a mortgage, then start by paying off your other debts if possible.
A mortgage is probably the biggest loan most of us will ever borrow, so getting the best possible interest rate on your mortgage is very important.
Most lenders won't even consider you for a mortgage if your debt-to-income ratio (DTI) is more than 43%.
What this means for you is that if more than 43% of your monthly or annual income is going toward paying for things like taxes, rent, child-support payments, auto loans and credit card balance repayments, you shouldn't even bother applying for a mortgage. The only lenders that might consider you good for the money will usually charge exorbitant interest rates.
Besides bringing up your income, the best way to prepare for a mortgage application is to pay off any existing debt (car debt or credit card debt) as quickly as possible. A balance transfer credit card can provide an immediate solution to consolidate and pay off your debts.
What Legal Documents Should I Have?
Before you apply for a mortgage, make sure you have the documents you need. Lenders are now required by law to review your financial situation diligently before accepting you for a mortgage.
When it comes time to make your application, you will want to have these documents on hand:
- A complete list of your assets. Since you want to impress the potential mortgage provider with your wealth and ability to pay off the mortgage, you will want to present bank statements showing your savings and investments, as well as mutual fund statements, brokerage statements, title deeds to real estate or vehicles and any other records proving that you own assets or investments of any kind.
- A complete list of your debts showing your minimum monthly payments. Remember that debt not only includes student loans, credit card payments, and car loans, but also child support payments, rent, and recurring bills.
- Recent canceled checks for rent payments, to prove that you have been diligent in paying your rent, and to give the lender a clear idea of what part of your income goes to paying rent. If you already own a home, bring proof of mortgage payments.
- Your latest federal tax return is a must. Remember the lender wants to get a clear picture of your total income. If you can show your tax returns for the past 2 or 3 years, that could make the process easier.
- Recent paycheck stubs are a must (if you collect a paycheck), as they provide lenders with a clear guide to your monthly income.
- W-2 forms are another must, if you collect a paycheck. Bring your forms for at least the previous two years. For those of you who aren't familiar with W-2 forms, these are forms which you receive as an employee, which show the amount of your salary which your employer doesn't give you because it will be used to pay some of the federal taxes you will owe come tax time.
- 1099 forms or profit and loss statements. If you own your own business, you will need to provide these forms to show how much money you made (or lost) in recent years.
You can find more mortgage tips for first-time buyers here.
How Do I Get The Best Mortgage Rate I Can?
Upping your income, slashing your debt, raising your credit score and getting your documents together is a good start. At some point you will probably have done all you can do to raise your income and credit score. Once you are sure that you can afford the home you want, including the full cost of paying for a mortgage, it's time to find the mortgage you want.
Where Should I Look?
Checking out mortgage rates offered by your local banks is a good first step, and if you live in a community where people address each other on a first name basis, your reputation for integrity can certainly help tip the scales.
But for most of us, the best place to look is online. Use a mortgage comparison tool like the one offered here at GET.com to find and compare the best mortgage offers.
You may want to use several comparison tools and do some additional research both online and at bank offices near you. If you know people who have gotten good deals and are satisfied with their mortgages, ask them for advice. Remember, getting the right home can be a matter of home-sweet-home or homeless.
Should I Lock In The Rate?
Most lenders offer rate lock-in periods of 30, 45, 60 or 90 days. So if you apply for a mortgage when rates are exceptionally low and lock-in the rate for that period, you will get the agreed upon rate when your mortgage is processed.
Without locking in your rate when you apply, you will get the rate that applies at the time when your mortgage application is accepted. So if rates go up in a big way between the time you apply and the time that your mortgage actually materializes, you could end up paying a much higher rate than the one you applied for.
So locking in your rate when you find a mortgage with the rate you want is usually a good idea.
When Is Refinancing My Mortgage A Good Idea?
Refinancing a mortgage is similar to making a balance transfer to a new credit card. You find a new lender that offers more suitable terms for your mortgage, that lender pays off the debt you owed to your previous lender, and you make payments to the new lender on new terms.
Refinancing your mortgage can be a good idea in certain situations.
(a) When You Find A Much Lower Rate
Let's say you have 15 years to go before paying off your Fixed Rate Mortgage with MegaHomeLoans at an interest rate of 9%. You then find a lender offering a rate of 4% for 15 years FRMs. Refinancing your mortgage to this lender could save you a lot of money over the 15 years.
But it isn't as simple as switching your mortgage to a new lender for quick savings - because every time you refinance a mortgage, you will pay fees that come to anywhere from 3% to 6% of the entire balance you still owe on your mortgage.
If you still owe $50,000 from your mortgage, you would pay something in the range of $1,500 to $3,000 in fees to refinance. Of course in the above scenario, it would still make sense to refinance, as you would pay more than $130 less each month, and get total savings over $23,000 by the time you pay off your 15-year refinanced FRM.
Even a 1% lower rate can save you a lot of money over 30 years. But it may not be worth it to refinance your loan for a rate that's a fraction of a percent lower than what you have.
(b) To Convert Your Mortgage From An ARM To An FRM
Adjustable Rate Mortgages often come with a fixed rate period for a certain amount of time (normally up to 5 years). During these introductory fixed rate periods, you will usually pay a very low interest rate. After that fixed rate period is up though, you will pay rates that follow the market. That means you may get very high rates after your fixed-rate period is up.
Fixed Rate Mortgages let you keep the rate you have to begin with for the life of your mortgage. If you get the mortgage when rates are low, you can enjoy the same low rate until you have paid off your home in full.
Refinancing gives you the chance to enjoy the best of both worlds by starting off with an ARM which offers a low introductory fixed rate, and then switching to a FRM with a reasonable interest rate once your ARM's introductory fixed rate period is over.
(c) To Avoid Wasting Money On Private Mortgage Insurance
A private mortgage insurance (PMI) is the lender's way of making sure they get their money. If you fail to pay off your mortgage as agreed, your home will usually be repossessed, but that's no guarantee that it will sell for a price that covers your full mortgage (with interest payments).
So you are required to get mortgage insurance when you buy a home and pay less than 20% in down payment (unless you get an FHA home loan).
A private mortgage insurance can cost up to 1.5% of your mortgage per year, though it may cost as little as 0.3% depending on the provider and your circumstances. So if you take out a $300,000 mortgage, you might pay as much as $4,500 annually in mortgage insurance payments. Multiply that over the life of a 30-year mortgage and you will be paying $135,000 for insurance that brings almost no value to you whatsoever.
You then are required (by the Federal Housing Administration) to keep this insurance for the full life of a mortgage, which adds another huge cost to buying a home with a mortgage.
But if you have paid off at least 20% of your mortgage already, you may be able to refinance your mortgage to another plan without being required to get mortgage insurance (because you have at least 20% equity in the property) and get rid of that wasteful mortgage insurance for good.
(d) To Get A Low Rate For Your Expensive Debts
A cash-out mortgage refinance is a loan that is secured by your equity in a property.
For example, if you have already paid off $100,000 of your $300,000 home, you can get a refinancing plan that lends you the full cost of the property, including the $100,000 you have already paid on your property.
So you get to use that $100,000 as you see fit, but then you are back to square one as far as paying off your mortgage goes.
Getting this type of refinancing only makes sense if you can use that money for investments that bring guaranteed returns. For example, if you have debts (like credit card debt, personal loans, auto loans) with high interest rates, you can use the money you borrow to pay off these loans. You would then repay the money through the refinanced plan at a much lower rate.
Let's say you owe $90,000 in consumer debts, with an average interest rate of 10%. You can use part of the $100,000 you get from your refinance plan to pay off this debt.
You would then pay back this money to the mortgage lender instead, but with the low mortgage interest rate. If your mortgage rate is 4%, you can save a lot of money on interest payments over the long-term.
Compare rates across major US mortgage lenders here:
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