Slowly but surely, the fine folks on the Federal Open Market Committee have been raising the benchmark fed funds rate, and while that doesn't move other interest rates in lockstep, it does have a pretty strong influence on the rates consumers pay to borrow money. Meanwhile, U.S. home prices broadly have climbed back above where they sat when the real estate crash, the foreclosure crisis, and the Great Recession sent them through the floor. All of this makes it harder to buy, and more important than ever that if you're going to, you do it right.
So, in this segment of the Motley Fool Answers podcast, co-hosts Robert Brokamp and Alison Southwick have invited back Austin Smith of our new personal finance-focused website, The Ascent, to talk about the three key aspects to landing a good mortgage, three benchmark numbers to help you figure how much of a home loan you can actually afford, and more.
A full transcript follows the video.
This video was recorded on Aug. 7, 2018.
Alison Southwick: Mortgage interest rates are on the rise and so is the average home price. Oh, it's a fun one-two punch...
Robert Brokamp: What a great combination!
Southwick: ... to think that even more important that you need to try to get the best mortgage for you. And joining us to help improve your chances of getting a great mortgage is Austin Smith. He works over on The Ascent. It's a new website we created, here, at The Motley Fool. Austin, thanks for joining us!
Austin Smith: Thanks for having me! It's good to be back!
Southwick: It's always nice to have you back. So Austin, remind everyone again. What is The Ascent?
Smith: The Ascent is a new site that's been launched by The Motley Fool to help you live life more richly by providing transparent, impartial advice for every financial product you can imagine. Whether it's auto insurance, credit cards, mortgages, savings accounts; we're out there reviewing all of these products, testing them ourselves when we can, and providing you with the most transparent feedback we can muster.
Southwick: There we go. And, of course, the advice is free...
Southwick: ... and so everyone can head over to TheAscent.com. Today we are tackling mortgages. Here's a fun fact. Home prices are climbing above levels we saw before the housing bubble burst in 2006. The twenties and thirties are supposed to be when it's your time to buy a house; but, millennials can't even afford one. How are they supposed to be able to build wealth if they can't buy a house? It's so hard out there.
Smith: Penny stocks.
Southwick: Penny stocks. There we go. You actually live in Denver and Denver has gotten just as bad as D.C. as far as competitive housing, right?
Smith: Denver has become quite spicy. We moved out there a few years ago from D.C. We were thrilled at how much more affordable it was, and some of the Fools who are migrating their way westward now are finding that they're actually not saving all that much. And D.C. is a pretty pricey market, so it's become a lot more expensive and a lot more competitive.
Southwick: That's why we brought you in here -- to talk about how to get a great mortgage. What do we mean when we talk about a good or great mortgage?
Smith: Over at The Ascent, we believe that there are three key aspects to a good mortgage. One, it has to be affordable; two, it has to be the best term; and three, it has to be the best rate. Now, all three of these factors are specific to you, but let's unpack them.
Let's look at the first aspect of what we deem to be a good mortgage, and that is that it's affordable. First, figure out how much you personally can afford each month, and you can do that by heading over to TheAscent.com and checking out our mortgage calculator. And remember, this is your limit. The way we see it is you should never overburden yourself to buy a home, especially in an environment like this where as you said, interest rates are on the rise. Home values are on the rise. Things are pretty expensive.
So, the affordability, you should generally consider that your upper limits. Let's say your affordability calculator looks like you can afford a $300,000 home. Maybe start shopping in the $250,000 to $300,000 range. That doesn't mean to see if you can piece together enough to afford a $320,000 mortgage because life throws curveballs at you and we like to have that margin of safety. We talk a lot about that on the investing side. You can also do it on the mortgage side, and one way to build in a margin of safety is to have a more affordable home given your situation.
Southwick: What you are approved for is not what you should aim for.
Southwick: We got approved for an insane amount of money...
Southwick: ... for our first mortgage. We're like, "No! What? No!"
Smith: That is actually what I meant by your limit -- not the mortgage calculator on The Ascent -- but what your bank will approve you for is generally not the amount of money that you should borrow. You should see that as your red flag that you do not go over.
Brokamp: Right. And you might be encouraged by various people within the industry because there are some conflicts of interest there to take on a bigger mortgage, and sometimes they will oversell different things like the tax benefits of a mortgage, for example, and run numbers by you that are not really accurate, especially with the new tax law, so keep that in mind, as well.
Smith: Yes. Borrowing money to save money is generally a bad recipe.
Smith: A couple of numbers you can keep in mind in determining what an affordable mortgage is for you. Three standard numbers are going to be 20%, 28%, and 36%. 20% is going to be the down payment you need to put together to avoid PMI [or private mortgage insurance]. You need at least this much money to buy a home. Even if you get approved up to a $300,000 home but you don't have $60,000 for a down payment, you shouldn't be buying a $300,000 home.
A simple way to think about this is banks lend a lot more money in the course of a day than you end up borrowing, so they're the experts in this equation and they're going to account for that risk of you not having enough down payment by charging you a higher interest rate or putting PMI on it. So one number to keep in mind is 20%. That's at least the amount of money that you should be putting for a down payment on a home.
Southwick: Unless you're a first-time homeowner and you want an FHA loan. That's what we did.
Smith: But you paid for it with a higher interest rate.
Southwick: Yeah, we did, but then we were able to pay it off and then get refinanced. I just don't know how people can buy a house, anymore, if you have to put down 20%. It's terrifying.
Smith: It can work, but generally you have to be in an appreciating market and the things that have to go right for that situation that makes sense for you end up getting stacked on top of each other, and so any little hiccup in that equation can mean you're losing your home or losing equity and it becomes a dicey situation. And putting that 20% down protects you from a lot of uncertainty in the future.
Southwick: How about 28%?
Smith: 28% is your front-end ratio: your mortgage payment, including taxes and insurance, should not exceed 28% of your pre-tax income. Similar to the amount that you're approved for by a lender, consider this your upper limit. It should not exceed 28%. Aim for 25% or even 20%. 28%, again, just like the amount you're approved for is your outer limit, here.
Southwick: And then 36%? Why should I care about that number?
Smith: This is the back-end ratio. This is your entire debt load, including your mortgage payment, car payments, credit cards, student loans, and other monthly payments should not exceed 36% of your pre-tax income. I will say it one more time. This is your outer limit, so it should not exceed 36%, so aim for a more modest amount like 30% or 25%.
The three standard numbers you need to keep your mortgage affordable for you personally are going to be 20% to guarantee you get the best rate possible and you can afford that down payment.
Southwick: 20% down.
Smith: 28%, which is your front-end ratio. You should not exceed that. And 36% for your back-end ratio, which you should not exceed. And if you're able to do all three of those things, your mortgage will generally be affordable for your situation.
Southwick: Now the second aspect of getting a good mortgage, you said, was getting the best terms.
Smith: Yes. A key part of getting the best term on your mortgage is understanding the various mortgage types and picking the best one that fits your situation. There's fixed-rate mortgages. There's adjustable-rate mortgages. There's 15-year terms. There's 30-year terms. There's even 25-year terms and 20-year terms which a lot of people generally don't get quoted when they go to a bank, but you can save 0.25% on your interest by getting one of those shorter terms. Getting the best term for you means figuring out what your specific situation is.
If you are only going to be in your home, let's say, less than seven years, an adjustable-rate mortgage could be a great way to go. If you're a teacher and you're moving to a city to maybe teach at a university, you know you're going to be there for four or five years but it's not your long-term home, and property is really affordable; an adjustable-rate mortgage could be a great way to go. You'll generally get a lower rate upfront and if you know you're not going to stay beyond that point where the rate adjusts upward, you can find yourself saving, maybe, half a percent or three-quarters of a percent by doing an adjustable-rate mortgage.
On the flip side, if you know this is your long-term forever home, a fixed-rate mortgage is generally the best way to go, and we advocate for going for the shortest term you feel comfortable affording. People default to a 30-year mortgage as being standard; but, again, you can get a better rate by going with a 25-year mortgage or a 20-year mortgage, and if the difference in the monthly payment is not so much that it stretches your affordability, those are ways that you can save a substantial amount of money over the life of your mortgage [sometimes tens of thousands of dollars] just by dropping a 30-year to a 20-year. And if you're living in an affordable part of the country, that may not raise your monthly payments that much, but you will be out of your mortgage five or 10 years faster, and tens of thousands of dollars wealthier.
So getting the best terms for you -- here's the rules of thumb. If you are highly confident you're going to be in that property for less than seven years, and it makes sense for you to buy because it's affordable and you have a down payment, look at an adjustable-rate mortgage. If you believe you're going to be in a property longer than that, look at a fixed-rate mortgage and go for the shortest term you feel comfortable supporting.
Southwick: And the third aspect of a good mortgage is getting the best rate.
Smith: Yes. We talked about some ways to get the best rate, like going with a shorter term, but namely you're going to want to clean up your credit score. The difference between a 650 and a 750-credit score can be as much as 0.5% a year on your rate, which on a $300,000 mortgage is $1,500 in the first year alone, and of course that carries forward through the life of the mortgage at a slightly degrading rate, but that ends up being a lot of money [over $30,000].
So if you are planning on buying a home within the next year, you should reduce the number of credit inquiries that you have. Don't take out any new credit cards. We talk a lot about credit cards at The Ascent. We don't advocate that you apply for any new ones if you know you are taking out a mortgage within the next year because every little inquiry [whether it's an auto loan or credit card] will ding your score.
We also recommend going for online lenders vs. big banks. There's a bias for people to go to the bank where they've been banking for 10 or 15 years. They have a bricks and mortar location. They know the banker and they go there to get their mortgage and they don't shop around.
We found that online lenders tend to be 0.25% to 0.30% less or more affordable than traditional bricks and mortar banks because they don't have as much infrastructure to support and they have to win your business. So for my last three mortgages I've only gone through online lenders. They have, by a mile, been more affordable than the Wells Fargo, the Chase, the banks that were only a mile from my house.
Southwick: That was a lot of information. How about you sum it up for us, here?
Smith: So the three things you need to know to get the best mortgage for you is it needs to be affordable for your situation and to do that remember the 20% down payment, the 28% and the 36% rule. It needs to be on the best term for your situation, so figure out how long you plan on being in the home. And it needs to be at the best rate, and in order to do that make sure you keep your credit score clean and you look at online lenders which are generally a bit more affordable.
Southwick: And for anyone who is shopping around for a mortgage [maybe to buy a new house or refinance], what can they get at The Ascent?
Smith: They can get everything.
Southwick: Everything your heart desires.
Smith: Everything. We will actually give you a home. We have mortgage calculators. We have affordability calculators. We have a list of all the documents you'll need for when you're applying for a new mortgage vs. refinancing. We have all sorts of material on rules of thumb about how much you can afford, how to best negotiate your mortgage. Everything. Head over to TheAscent.com. It's all there.