Interest rates have been inching up, with the 30-year fixed mortgage rate recently approaching 4%. According to the Federal Reserve and general expectations, they'll continue rising in the coming years. That can have you thinking about buying a home sooner rather than later. Go ahead, but be careful, as some classic mortgage mistakes can really cost you.
Here are three dumb mortgage moves to avoid.
Dumb mortgage move No. 1: Ignoring your credit score
Many people don't realize just how influential their credit score is when it comes time to borrowing money. Lenders place a lot of importance on it when they decide what interest rate to offer you -- so if your score isn't very high, it can be worth spending some time and effort beefing it up before starting to buy a home. Three key ways to increase your score are fixing errors in your credit record, paying bills on time, and reducing your overall debt load.
To appreciate the kind of difference your credit score makes in the interest rates you're offered, consider sample rates from the folks at FICO, which generates the most frequently consulted scores. When I checked recently, they showed that if you were borrowing $200,000 via a 30-year fixed-rate mortgage, and you had a top FICO score (in the 760 to 850 range), you might get an interest rate of 3.9%, with a monthly payment of $944 and total interest paid over the 30 years of $139,972. If your score was 630, though, your rate would be very different, at 5.5%, with a monthly payment of $1,135 and total interest of $208,718. That's $191 more per month ($2,292 per year) and a whopping $68,746 more in interest.
|FICO Score||APR||Monthly Payment||Total Interest Paid|
Here's another eye-opener: To appreciate how rising interest rates can affect you, note that only a few months ago, the top FICO scores could get you an interest rate of 3.3%, a monthly payment of $880, and total interest paid of $116,717. Today's higher rate will cost you almost $770 more per year and more than $23,000 in total interest paid.
Dumb mortgage move No. 2: Getting a bigger mortgage than you should
If you ask a lender how big a loan you qualify for, don't assume that that figure is your home-price limit. You may be able to buy a $500,000 house, but that doesn't mean it's a smart move. Buying too much house can leave you stretched thin financially.
Some suggest spending no more than 25% to 30% of your gross monthly income on housing (including property taxes and insurance), but instead of relying on that broad guideline, take the time to figure out just what you can afford. Take into consideration your regular household expenses, such as food, utilities, transportation, insurance, travel, entertainment, auto maintenance, debt payments, contributions to savings accounts, and so on, and factor in other expenses, too, such as medical or automotive emergencies and the cost of prepping your old home for sale and setting up your new one. Buying less home than you can afford will give you a margin of safety -- to protect you in the event of a reduction in income or unexpected expenses -- and can help you save more for retirement and other goals, too.
Note, too, that if you're stretching to buy a pricey home, you may be opting for a down payment of less than 20% of the value of the home. That will necessitate your buying private mortgage insurance (PMI), which will add to your debt and interest payments. A low down payment can also result in a higher interest rate -- and if home values drop during your ownership period, you can be left with an underwater mortgage, where you owe more than the home is worth. That can make it hard to sell the home.
Dumb mortgage move No. 3: Choosing the wrong kind of mortgage
Finally, don't assume that a standard 30-year fixed-rate mortgage will serve you best. It might, but consider alternatives, too.
For starters, you need to decide between a 15-year or 30-year loan (other time frames are also available) and between a fixed-rate mortgage or adjustable-rate mortgage (ARM). Longer terms will give you lower payments, but you'll pay much more in interest over the life of the loan. For example, imagine two $200,000 fixed-rate mortgages. One is for 15 years at 4% and the other for 30 years at 4.5%. Your monthly payment will be lower with the longer loan -- about $1,013 vs. $1,479 -- but your total interest paid will be almost $100,000 greater.
If you're not comfortable with a 15-year mortgage's steeper payments, consider getting a 30-year loan that permits prepayments and then aim to pay significantly more than you need to each month, in order to shorten the life of the loan. In fact, you could make payments equal to what you'd pay with a 15-year loan.
If you're not planning to be in the home long, an ARM could serve you best in today's low-interest rate environment, as it can lock in low rates for a few years. If you think you'll be in the home for decades, though, it can be better to lock in a low rate for the expected long life of the loan -- especially because interest rates have started inching up.
If you're a savvy home buyer, you can end up saving tens of thousands of dollars or more over the life of your loan.