Purchasing a new home is one of the biggest life milestones you’ll encounter. It could be a wise investment. But there are also costly mistakes that can be made in the process. Following are some common pitfalls people experience when obtaining mortgages. It’s important to understand each before taking the plunge into home ownership.
Contributing Little to No Down Payment
It may seem appealing at first. But making a down payment of less than 20% of the home’s value will require you to take out a private mortgage insurance (PMI) loan in addition to your mortgage. That means higher monthly payments and possibly higher interest rates. In the unfortunate situation where your home value decreases while you still own it, you could end up owing more than your home is actually worth. These “underwater” mortgage situations can result in extreme difficulty to resell your home. (For more, see: Mortgages: Fixed-Rate Versus Adjustable-Rate.)
Not Thinking Through Mortgage Type
Many people assume the standard 30-year fixed-rate mortgage is the only way to go. This could be a huge mistake. While longer terms may result in lower payments, you’ll pay considerably more in interest over the lifetime of the loan.
Do some research on the exact financial implications behind a 15-year and 30-year loan for your particular mortgage. Also, analyze the difference between a fixed-rate mortgage or adjustable-rate mortgage (ARM).
If you can’t afford the monthly payments of a 15-year mortgage, consider getting a 30-year loan that allows prepayments. That way, you can pay more than you need to each month. You could even make an extra payment at the end of the year. Trust me—it will make a huge difference in interest and in the lifetime of your loan. (For more, see: How Interest Rates Work on a Mortgage.)
If you don’t plan on being in your home for long, an ARM could be the best choice in order to lock in low interest rates for a few years. If you foresee yourself in your home for the long term, it’s probably best to obtain a fixed-rate mortgage. That way, it won’t change with our country’s fluctuating interest rates.
Not Getting Pre-approved Before You Start House Shopping
It’s important to have all your ducks in a row before you get your heart set on a particular home. The pre-approval process may seem time and labor intensive, but you’ll thank yourself later when your credit score, employment, financial health and tax returns are already deemed credit worthy by a lender. The major advantage to getting pre-approved for a loan is that you’ll know exactly how much home you can afford. It will also make you look more appealing as a buyer if you’re bidding against others for a home. The seller will know you can put your money where your mouth is.
Buying More House Than You Can Afford
Sure, it’s tempting to look at homes beyond your price range. It’s fun to dream, right? The more you look, however, the more you may be feel compelled to actually get a mortgage that’s outside your budget. Ask yourself whether it’s worth feeling financially strapped in order to buy a home you can’t afford. Some financial experts recommend spending no more than 25% to 30% of your gross monthly income on housing. Remember, that includes both property taxes and insurance. (For more, see: Mortgage Basics: The Amortization Schedule.)
Instead of just taking that broad guideline into account, however, analyze your own financial situation. What other monthly bills do you have? Once you add them all up, including the cost of prepping your old home for sale and setting up your new one, 25% to 30% of your income may still be too much to spend. Buying less home than you can afford instead of overspending will give you a layer of protection in case of emergencies and also allow you to build up savings.
Not Shopping Around for a Mortgage
You may be surprised that there is a wide range of options out there when it comes to mortgages. Different lenders use different assessments when analyzing your financial situation. Depending on where you go, you may be offered significantly different interest rates. That’s why it’s important not to settle for the first one you come across.
You should definitely check with your own bank, as they may give you a discount on the interest rate since you’re a customer. But it’s important to also shop around at other banks, as well as credit unions and independent mortgage brokers. The latter option will offer you a wide range of different loans and can be helpful if you have less than stellar credit record. Mortgage brokers can also give you more individualized attention than a bank may provide. (For more, see: How to Shop for Mortgage Rates.)
Not Researching Your Credit Score
You may not realize what kind of an impact your credit score has on the interest rate lenders will offer you. If you fail to find yours out, you may be in for an unpleasant surprise why trying to obtain a mortgage for a reasonable rate.
On the other hand, if you find out your score is low you can spend time raising it back up before going through the time-consuming home buying process. Credit scores can be boosted by fixing errors in your credit record, paying bills on time and reducing your overall debt-to-income ratio.
Check out the following example:
If you were borrowing $200,000 via a 30-year fixed-rate mortgage, and you had a top credit score in the 760 to 850 range, you might get an interest rate of 3.3%, with a monthly payment of $880 and total interest paid over the 30 years of $116,717. If your score was 630, your rate would be 4.9%, with a monthly payment of $1,064, and total interest of $183,174. That’s $184 more per month — $2,208 per year — and a whopping $66,457 more in interest.
The Bottom Line
The home buying process isn’t something that should be taken lightly. Obtaining a mortgage is a big deal that requires a lot of patience, research and diligence on your part in order to secure the best fit for your particular situation. By avoiding the above pitfalls, you’ll be in a much better position to make an educated choice on your home purchase. (For more, see: How Interest Rates Affect the Housing Market.)