by Christy Bieber | Updated July 30, 2021 - First published on July 26, 2021
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Knowing the answers could save you from getting the wrong loan.
Before you borrow any money, it's important to educate yourself on your loan options. This is especially true when you're taking out a mortgage loan. That's because you're borrowing a huge amount of money, and it will take a very long time to free yourself of this debt.
To make sure you're truly ready for your purchase, be sure you know the answers to these questions.
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When you shop for a loan, you're going to have to decide if you want a fixed-rate loan or an adjustable-rate mortgage (ARM).
With a fixed-rate mortgage, your interest rate doesn't change at all during your payoff period. Your payments won't change either, nor will your total borrowing cost. You know exactly what costs you're looking at going in and can make sure you're able to cover them.
Variable-rate loans, on the other hand, can adjust after the initial starting rate ends -- which could be just a few years after you borrow. For example, if you take a 5/1 ARM, then you'd get your starting rate for the first five years only and then it could adjust once per year.
An ARM may seem attractive when you see interest rates compared with fixed-rate alternatives. That's because ARMs usually have lower starting rates than their fixed-rate counterparts. But the key thing to know is that's just the starting rate.
Rates adjust with a financial index. And there's, unfortunately, a good chance they could rise. This could lead to higher monthly payments and higher total loan costs which could become a huge financial burden.
That's not to say ARMs never make sense. If you get a great rate and plan to refinance or sell before it starts adjusting, it's a solid option. But you need to understand you're taking a much greater risk with this loan type and make sure you know the difference before you opt to borrow this way.
PMI stands for private mortgage insurance. You'll probably have to pay it if you don't make a down payment that is at least 20% of your home's value. So if you were buying a $300,000 house and made less than a $60,000 down payment, PMI would most likely be required.
PMI is usually a percentage of your loan, such as 1% or 1.5%. It's often paid as part of your monthly bill. And despite the fact you're covering the costs of it, it doesn't actually protect you. You're required to buy it to ensure your lender doesn't lose money if you stop making payments and they have to foreclose on your house.
If you decide now is a good time to buy a home but can't come up with the down payment for a home, you may decide paying PMI is worth it. But it's still a good idea to know what you're paying for and how much it costs before getting a mortgage that requires it.
Make sure to understand the relationship between the loan repayment time and total costs.
Many people choose a 30-year loan just because that's most common and familiar. But you have a choice of many different payoff times including 15-year, 20-year, and 30-year loans.
If you choose one with a shorter timeline for paying off your mortgage, you are going to have much higher monthly payments. But your interest costs over time are going to be a lot lower. That's because you're likely to pay interest at a lower rate and because you won't pay interest for as long.
The table below shows how much each $100,000 in mortgage debt would cost you with different payoff terms, based on average mortgage rates as of June 4, 2021:
|Loan Term||Interest Rate||Monthly Payments||Total interest costs|
To help you make informed decisions, use a mortgage calculator and see what numbers you come up with. Tying up a lot of money in a high monthly payment isn't easy, but the benefit is you won't end up paying nearly as much money for your house over time. Ultimately, you need to understand this relationship between loan term and payoff costs and make the decision that's right for you.
Once you can answer these three questions, you'll be in a good position to decide what kind of loan is best for your situation. You can borrow with both eyes open and hopefully pay off your mortgage while enjoying your new home.
Chances are, interest rates won't stay put at multi-decade lows for much longer. That's why taking action today is crucial, whether you're wanting to refinance and cut your mortgage payment or you're ready to pull the trigger on a new home purchase.
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