7 Home Financing Mistakes to Avoid at All Costs

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Applying for a home loan? Here are seven home financing mistakes you cannot afford to make.

You'll likely be paying off your mortgage for decades. It will almost certainly be your largest debt. And your home can help you build wealth, or it can destroy your credit and net worth. It depends on your choices.

Fortunately, it doesn't have to be difficult to make smart choices about home financing. You just need to avoid seven big mortgage mistakes.

1. Borrowing without a generous down payment

Traditionally, lenders required around 20% down before they'd approve you for a loan. That hasn't been the case for a long time. But if you make a smaller down payment, you'll have to pay for private mortgage insurance (PMI).

You can get a home loan with as little as 3.5% down -- for example, with an FHA loan. But that doesn't mean you should. Borrowing almost the entire value of your home means you run the risk of owing more than your home is worth if the value falls even a little. That makes refinancing impossible. It could even leave you unable to live anywhere else, unless you can afford to pay off your loan in order to sell for less than your house is worth, or you’re willing to ruin your credit with a short sale or foreclosure.

A down payment gives you equity. Even if property values fall, you won't be in dire trouble if you sell. It can also make your mortgage rate offer lower. So aim to save for a 20% down payment if you can, and you’ll reap these benefits and avoid PMI. If you can't hit that target, you may still want to wait until you've got at least 10% of the home's value to put down so you can minimize your chances of ending up underwater (owing more than your home is worth).

2. Borrowing more than you can afford

Homeownership is expensive. You pay upfront closing costs, plus ongoing costs including your mortgage, property taxes, insurance, homeowners association fees, and home maintenance and repairs.

If you stretch yourself too thin, you may not be able to repay your loan, and you could lose your house and ruin your credit. Even if you can just barely make your payments, you could add stress to your life and render yourself unable to accomplish key financial goals.

To avoid that, aim to keep total housing costs -- including your mortgage and other expenses -- to around 30% of your income or less.

3. Taking out a loan you don't understand

There are lots of different types of mortgages. The simplest, and arguably best for many borrowers, is a 30-year fixed rate mortgage that provides fixed monthly payments for the life of your loan. But there are other types, including adjustable-rate mortgages and those that charge a balloon payment (a large payment at the end).

There may be times when it makes sense to look beyond the basic 30-year loan. But be sure you understand every detail about the financing you're taking on -- including how high your payments will climb. Otherwise, you could find yourself facing surprise expenses you can't easily cover, and that could lead to dire consequences.

4. Failing to shop for the best rate

When borrowing a lot of money over a long time, even small differences in the rate of interest can add up to thousands of dollars in extra costs. Since you commit to borrowing hundreds of thousands of dollars over several decades, you need to do all you can to keep your home financing costs as low as possible.

The good news is that mortgage rates today are at record lows. But it's still up to you to do your due diligence to find the most affordable loan. One of the best ways to do that is to shop around, because one lender may offer a much better deal than another.

Most lenders allow you to get pre-approved quickly and find current rates online from the comfort of home. Take advantage of that, and get quotes from multiple mortgage providers including banks, credit unions, and online lenders.

Not doing so could mean passing up a much better deal, and that could be costly.

5. Not comparing apples to apples

When you compare mortgage loans, make sure you look at all the details, including loan repayment terms, whether you have to pay for discount points to buy down your interest rate, and whether your loan is a fixed or variable rate loan.

One easy way to compare total costs is to look at the annual percentage rate (APR) of loans, because it takes fees and interest into account. By looking at the big picture, you can avoid costing yourself money. Don’t opt for a loan that looks cheaper on the surface, but actually isn't the best deal.

6. Failing to get pre-approval before shopping for a home

Getting pre-approved not only enables you to compare interest rates, it also makes you a more competitive homebuyer. When you submit an offer, most homeowners want to see a pre-approval letter so they know you have a good chance of securing financing.

Getting pre-approved also helps you avoid wasting time looking at homes you can't afford -- or worse, fall in love with one that's out of your price range.

7. Making big financial changes before closing on your loan

Once you've been pre-approved for a loan, you don't want to do anything that jeopardizes that approval -- such as changing jobs, or taking on new debt.

And it can be especially important not to do these things after you've gotten final approval on your loan and are waiting to close. If you make changes, your lender could determine that you aren't a qualified borrower after all. This could delay closing on your loan, or even cause the whole deal to fall apart.

Don't set yourself up for failure

Avoiding these seven mistakes can make the process of securing a mortgage simpler, whether you're a first-time homebuyer or a seasoned pro looking to refinance a home loan. By making smart choices, you'll maximize the chances your home purchase will go smoothly -- and that your loan will be the most affordable one possible.

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