Are you getting ready to take out a mortgage? Before you commit to a loan you'll pay for over the next three decades or so, make sure you know exactly what you're getting into.
Homeowners who don't understand their mortgages could get into big financial trouble, but you can make certain you're not one of them by confirming you know the answers to these six key questions.
1. What is the interest rate?
A third of mortgage holders in the United States don't know the interest rate on their loan. This is a big mistake. Your interest rate makes a huge difference in the monthly payments and total interest you'll pay.
If you borrow $318,000 -- around the average loan for buyers as of April 2017 -- and pay an average rate of 4.23%, your monthly payments would be $1,561, and the total cost of your loan would be $561,833.
If your rate were just a little lower at 4%, your payments would be $1,518 per month, which means you'd be saving $516 a year. The total cost of your loan, $546,545, would be more than $15,000 lower than what you'd pay at the higher rate. On the other hand, a rate of 4.5% would cost you $600 a year more -- and more than $18,000 more over the life of the loan -- than if you'd taken out that 4.23% loan.
With even small changes in interest adding up to thousands in extra costs, know exactly what your rate is. If it's higher than the national average, find out why. Unless that high rate is justified -- perhaps because of bad credit -- shop around for a more affordable lender.
2. Is the rate adjustable?
Adjustable-rate mortgages (ARMs) were a major contributing factor to the 2008 mortgage crisis, because many homeowner's couldn't pay their mortgages when rates were adjusted upward. Too many of these homeowners didn't understand their loans. You don't want to make that costly error.
Mortgage paperwork must specify whether a loan is a fixed-rate loan, which means the interest rate cannot change throughout the mortgage term, or an adjustable-rate loan, which means the rate will change along with the prevailing interest rates. Adjustable-rate mortgages are not necessarily bad, especially given that their initial rates are lower than those of fixed-rate loans. But don't take out an ARM unless you know you can afford the costs even if rising interest rates lead to higher payments.
Lenders must disclose the timeline for when rates begin to adjust -- usually your initial rate is guaranteed for five to seven years -- and the formula used to calculate new rates. The paperwork must also specify how frequently the rate can adjust and the absolute maximum rate.
If you can still afford your loan in the even your rate goes up, then an ARM is OK. But don't assume you'll be safe from increases because you plan to move or refinance before your rate goes up. Plans change, property markets collapse, and selling or refinancing could become impossible. Don't get trapped in an ARM you can't afford, especially if you can qualify for a fixed-rate mortgage with reasonable rates and payments you can swing on your salary.
3. Am I paying any points?
Mortgage borrowers have the option to lower interest rates by paying discount points, which are essentially pre-paid interest. You pay more up front to buy down your interest rate. Points cost 1% of the mortgage amount, so you'll pay $1,000 to buy a point for every $100,000 in borrowed money. A point on a $318,000 loan would cost $3,180.
Each point lowers your rate by 0.25%, which saves a lot in interest if you'll be in your home for a long time. On your $318,000 loan, buying one point on a 4.23% mortgage would bring your rate down to 3.98%. This would lower your monthly payment to $1,515 from $1,561 and cut your total loan costs to $545,226 from $561,833. Given the savings of $552 annually, you'd take a little over five years to make back the $3,180 cost of the point, and the additional savings over the remaining 25 years would be gravy.
You need to understand how points work to decide whether to buy them and to make sure you're comparing apples to apples when shopping for a mortgage. If one lender offers a rate of 4.23% with one point paid, and the other offers 4.23% with no points, you're far better off with the second lender.
4. What closing costs will I have to pay?
Homebuyers usually pay between 2% and 5% of a home's purchasing price in closing costs. This is a big range, and you don't want to pay more than necessary. Read mortgage paperwork carefully to find out what you're being charged for loan origination, appraisals, application fees, courier fees, private mortgage insurance, and underwriting fees.
Some mortgages -- especially cash-out refinance loans -- incorporate closing costs into the loan so you borrow more than you need, and the excess pays your fees. Alternatively, lenders may charge higher interest rates to give you credit toward closing costs so the up-front fees are lower. Both options mean you're stretching out the payment of closing costs over the life of the loan. Don't agree to this unless you know what your costs are, you're OK with paying them over time, and you've compared expenses across different lenders.
5. Is there a pre-payment penalty?
If you want to pay off your mortgage early or refinance with a different lender, you want the flexibility to make those financial choices. Unfortunately, some mortgages have prepayment penalties, which means you'd pay extra for the privilege of paying back what you owe. The reason they do this is to keep you paying interest on the balance for as long as possible.
If a loan you're considering includes a prepayment penalty, look for a different lender who won't deprive you of the ability to make the right financial decisions for you.
6. How long do I have to pay off the loan?
Most mortgages give you 30 years to repay the balance, although 15-year mortgages are also somewhat common. Options like 40-year mortgages are available from a limited number of lenders, but it's not usually a good idea to stretch out payments for this long, unless you want to struggle to pay a mortgage during retirement.
Other loans, like a balloon mortgage, may give you a short time to repay -- usually around five to seven years -- but your monthly payments will be similar to those of a 30-year mortgage. This means your monthly payments will be low, but you'll have to repay the remaining balance all at once at the end of the five- or seven-year term. This is risky, and these mortgages are almost always a bad idea.
As you consider repayment terms, remember that a longer loan means you pay more in total interest but have lower monthly payments. It's up to you to decide what makes the most sense for your financial goals.
The Motley Fool has a disclosure policy.