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Buying Your First Home: Down Payments And Mortgages

Editor’s Note: This is the first of two articles adapted from “Buying A Home,” Chapter 8 of The High Achiever’s Guide to Wealth. Pick up your own copy here to read more on this topic, and many others.

Buying a home is among the largest purchases most people will ever make. It can represent the achievement of a long-term financial goal, the beginning of a new life chapter, or an external sign that you are ready to put down roots.

There is not a right or wrong answer to whether you should buy a home at all. While many people consider homeownership a mandatory life milestone, the truth is that it isn’t right for everyone. The decision comes down to a mix of personal, lifestyle and financial factors. If you do want to become a homeowner, the process may seem daunting, especially for first-time homeowners. But if you approach the path to homeownership as a series of achievable steps, there is no reason you can’t proceed with confidence.

How Much Home Can You Afford?


The process of settling on a price range should happen well before you start attending open houses and talking to real estate agents. For nearly all buyers, this means thinking about a mortgage.
Typically, you should expect to put about 20% down when you purchase a home. There was a time when you might not have been able to secure a mortgage at all without 20% down (or more). These days, many lenders have relaxed this standard. That said, a bigger down payment means borrowing less, which in turn means paying less interest. Some lenders compound this advantage by offering a lower interest rate to borrowers who put a full 20% down. A larger down payment means a lower monthly payment, too. You will also start out with more equity in your home, lowering the chance you could owe more than your home is worth if property values decline.

Keeping your down payment at or above 20% also means avoiding private mortgage insurance, or PMI. Many lenders require borrowers to pay for PMI if their down payment is smaller than the standard amount. This is bad news for borrowers, since PMI increases monthly payment amounts to protect the lender. PMI premiums range from 0.5% to as much as 5% of the mortgage loan. Usually the lender will require you to pay PMI until your mortgage’s principal balance is less than 80% of your home’s original appraised value or its current market value, whichever is less. Some borrowers take out “piggyback” loans to avoid the PMI requirement. However, borrowers are typically subject to higher interest rates on these secondary loans than they can expect from single mortgages.

Borrowers who meet certain criteria may be able to borrow with less than 20% down through the Federal Housing Administration. These criteria are strict, and borrowers should expect more paperwork and a higher interest rate than a traditional mortgage would entail. FHA loans are also generally more expensive over the course of the entire term, especially for buyers with relatively strong credit. However, for those who qualify, an FHA-insured loan can facilitate homeownership with a down payment as small as 3.5%.

In addition to the size of your down payment, you should consider your ongoing monthly costs when determining a budget for your new home. Depending on where you live, you may have heard an estimate that your overall monthly housing costs should not exceed either 25% or 30% of your gross income. This is a useful rule of thumb, though you should consider your housing costs in the context of your overall financial situation.

Be aware that mortgage lenders will also look at your debt compared to your income. Lenders may consider the “front-end ratio,” which includes mortgage principal, interest, insurance and taxes, as well as the “back-end ratio,” which adds in any other recurring debt obligations, such as student loans or car payments. Historically, lenders looked for a front-end ratio of 28% or less and a back-end ratio of 36% or less. While these are not hard-and-fast rules, they still serve as useful guidelines for evaluating whether your budget is realistic.

Don’t forget to budget for one-time closing expenses, too. These may include paying for a home inspection or getting quotes from contractors for any necessary repairs. You will also need to pay mortgage origination fees, escrow fees, and fees charged by the realtors and lawyers involved in setting up your mortgage. You can expect closing costs to be around 2% to 5% of the home’s value. When deciding how much you can afford, don’t forget these upfront obligations.

Prequalification


Many homebuyers feel pressure to get prequalified for a mortgage. Prequalification is essentially an estimate of how much you may be able to borrow based on a credit check and other financial information. Note that this is different from preapproval, which is a more formal process. In preapproval, you complete a full mortgage application. If you are preapproved, the lender will issue a letter that serves as an offer (though not a commitment) to lend you a specific amount within a short period, often 90 days.

Preapproval is often wise, because it can make a seller or agent more inclined to accept an offer, especially in tight housing markets. Prequalification, on the other hand, is designed to give you an idea of how much you can borrow. Be wary of letting prequalification lure you into exceeding your budget. Many buyers fall into the trap of borrowing as much as they can without determining whether they afford a house at that price point in the long run. Don’t buy more house than you need simply because you can stretch your finances to make it work.

Types Of Mortgages


Not every mortgage works the same way. Beyond determining your budget, you should understand all your mortgage options before deciding which is right for you.

Fixed-Rate Mortgages


As the name implies, fixed-rate mortgages lock in an interest rate over a relatively long period. Generally, these mortgages are available in 15-year or 30-year varieties.

If you are interested in rapidly building equity, a 15-year fixed-rate mortgage is an attractive option. While monthly payments will be higher than many alternatives, you will build your net worth faster and will be done with monthly mortgage payments sooner. Buyers who are able to afford higher monthly payments may find the prospect of owning their home outright earlier an attractive incentive. You can usually make additional payments at any time without prepayment penalties if you decide you wish to build equity or repay the loan even faster.

For many – if not most – buyers, a 30-year fixed-rate mortgage remains the gold standard. If you are buying your “forever home,” or at least a home in which you plan to stay for many years, a 30-year fixed-rate mortgage locks in an interest rate for decades. At this writing, interest rates are low by historical standards, which makes it an especially great time to set a permanent rate. Since the loan term is longer than the 15-year option, monthly payments are also typically lower. The major drawback of a 30-year fixed-rate mortgage compared to a 15-year loan is that you will pay more in interest overall. In both cases, however, you know that your housing costs will be relatively fixed over the course of your loan (or until you refinance).

Adjustable-Rate Mortgages


Adjustable-rate mortgages, sometimes called variable-rate mortgages or floating-rate mortgages, offer relatively low interest rates for a fixed term. After this period, often five or 10 years, the interest rate becomes variable. Buyers who know they plan to sell before the end of the fixed term may find these mortgages especially attractive, since the initial monthly payments are usually lower than a fixed-term mortgage. Buyers can also refinance when the term ends, though there is no guarantee that interest rates will not rise – perhaps significantly – over time. Some adjustable-rate mortgages offer rate caps that will limit either the amount a rate can change from year to year, or the amount the rate can increase over the life of the mortgage. Others include a payment cap that restricts the monthly mortgage payment amount to a certain maximum dollar value.

You will usually see adjustable-rate mortgages expressed as two numbers, such as 3/27 or 5/5. In most cases, the first number is the number of years that the fixed interest rate applies. The second number can indicate a variety of information, depending on how the loan is structured. For example, a 3/27 ARM offers a fixed rate for three years and a floating rate for the remaining 27 of a 30-year loan. The 5/5 ARM starts with a five-year fixed interest rate and then adjusts the variable rate every five years. A common setup is a 10/1 ARM, in which the interest rate is fixed for 10 years and then adjusted annually.

Other Types Of Mortgages


In an interest-only mortgage, the borrower pays only interest for a certain amount of time. During this period, often five or 10 years, none of the payments go toward the loan principal. As a result, early payments are substantially lower than later ones, when the interest-only period is over and you must repay principal as part of the monthly payment. Most borrowers should avoid interest-only mortgages. They involve taking on substantial risk, since you are not building any equity at the beginning of the loan term. A decline in the property’s value can therefore quickly become a disaster. If you owe more on your mortgage than your property is worth – called “going underwater” or “going upside-down” on your mortgage – then selling or refinancing can become difficult or impossible.

Borrowers should also be wary of loans that include a large lump sum at the end, often called a “balloon payment.” In this sort of loan, the monthly payments are lower because the loan’s full value isn’t amortized over its term. But unless you save carefully, the final payment can sneak up on you. If you are unable to pay it in cash, you will need to sell your home (assuming property values have not dropped) or refinance at potentially higher rates.

Which mortgage is right for you depends primarily on how long you intend to own the property. You may also want to factor in other financial goals, such as becoming debt-free sooner or saving the most money overall. Do not choose a mortgage based on the monthly payment amount alone.

How To Get A Mortgage


When you are ready to start the mortgage process, the first step is to find a lender. You can borrow from a local bank or credit union, but they are not your only options. Many companies specialize in mortgage lending, including some companies that are online-only. If you already do business with a bank, check out its offerings. Ask friends and family for recommendations. If you are using a real estate agent you like, he or she may also have suggestions. Mortgage brokers specialize in helping borrowers find the best mortgage; some brokers are paid by the lender and others by the borrower. Whether this service is worth the fee will depend on your situation.

Whether you use a broker or go it alone, it is wise to talk to more than one lender to compare offers. After researching various companies, narrow it down to your top three and apply for preapproval to all of them. This will allow you to compare offers directly. When you do, be sure you are clear on the difference between an interest rate and the annual percentage rate, or APR. APR is the rate, as a percentage, that you will pay each year for borrowing, including fees and additional costs. APR essentially controls for differences in upfront and annual fees between lenders. This makes it a more useful way to compare offers than interest rate alone.

The rates lenders offer will depend on your credit score and your debt-to-income ratio. So before you apply for a mortgage, check your credit reports for errors and promptly correct any you find. You should also avoid applying for new credit cards or auto loans just before applying for a mortgage, as recent credit inquiries from other lenders can temporarily bring down your score. Even relatively small differences in credit scores can make a big difference in your mortgage terms.

Preapproval is not approval, so once you have selected a loan offer, you will need to go through the application process. Even though preapproval will speed things up, expect to dedicate some time to shepherding your paperwork through the steps your lender requires. Before you sign, make sure you understand all your mortgage’s provisions. For example, be sure your loan does not include penalties for prepayment. There should be no surprises for anyone at closing.

Lenders sometimes offer borrowers the option of paying “points” at closing. You pay fees upfront, and in exchange the lender lowers the interest rate. Each point costs 1% of your total mortgage amount. In most cases, you should avoid the temptation to pay points. Even though they lower your monthly payments, points transform interest into a sunk cost. If you sell your property before the mortgage ends, you cannot recover any money you paid in points.

Even after you close, buying a home can reshape your finances. This article is part one of a two-part series; part two, arriving in April, will cover property taxes, homeowners insurance and more.

Owning a home is a big commitment. But there is a reason why it has traditionally served as a cornerstone of the stereotypical American dream. If homeownership is right for you, and your approach the buying process sensibly, your home can serve as one of your greatest assets – as well as a place to call your own.

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