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If you’re one of the 17 million Americans who said they plan to buy a home this year, you know from experience that you often shop for homes with your heart as much—or more—as with your head. That’s because, for most of us, homeownership is more than a financial goal—it’s a personal one, tied up in all sorts of emotions.
But when it comes to financing your home purchase, your emotions need to take a backseat. Lenders will be happy to offer you mortgage options to get you into that home you’ve fallen in love with—even if you can’t really afford it.
So what kinds of mortgage options should you be wary of? There’s no way to list them all, but here are a few of the worst offenders:
Designed to help homebuyers who don’t have a 20% down payment avoid private mortgage insurance (PMI), the piggyback mortgage is actually two loans: a mortgage that covers 80% of the home’s purchase price and a line of credit fills the gap between the buyer’s down payment and the remainder of the purchase price.
So for a buyer with a $10,000 down payment on a $100,000 home, a piggyback would give him a mortgage for $80,000 and a line of credit for $10,000. The piggyback allows him to buy a more expensive home without having to pay the PMI lenders require when the borrower can’t put 20% down.
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Why isn’t it for me? We’re in complete agreement with the idea of avoiding PMI, but don’t take out two loans to do it! If you want to avoid PMI, keep it conservative and buy a home you can put 20% down on. If you don’t have enough savings to afford the style of home you want, keep saving until you do!
The ARM (Adjustable Rate Mortgage)
Adjustable rate mortgages (ARMs) generally come with a low initial interest rate that resets after a certain number of years. A lower rate means a lower monthly payment—a hook millions of buyers fall for every year.
The ARM’s fixed-rate period can be anywhere from three to 10 years, and the rate adjusts every year after that. The rate can go up or down based on the prevailing interest rates at the time of the adjustment.
Why isn’t it for me? Let’s look at some numbers. The initial monthly payment on a 30-year, 3-1 ARM for $100,000 with a 4% interest rate is $477. After the first three years, we’ll say the rate bumps up by just a quarter percent each year and caps off at 8%. By the last year, your payment is up to $656, and at the end of the loan’s term, you’ll have paid more than $115,000 in interest alone. That’s $22,000 more than you would have paid on a 30-year mortgage with the rate fixed at 5%.
With an ARM, you’re taking a chance on whether interest rates will go up or down. The bank is betting they will go up and you’ll pay more. Who’s more likely to win in this situation?
The FHA (Federal Housing Administration) Loan
For years, FHA loans have been the most popular lending choice for a couple of reasons. Homebuyers like them because they can buy a home with as little as 3% down. Lenders like them because they are guaranteed by the government—even if the borrower doesn’t make their payments, the bank won’t lose money.
Why isn’t it for me? New regulations require all homebuyers with an FHA loan to pay PMI premiums for the life of the loan. PMI costs about $100 a month per $100,000 borrowed—that’s $36,000 on a 30-year, $100,000 mortgage.
What’s the Right Choice?
If you’re going to buy your home with a mortgage, be smart about it.
—Get a conventional, fixed-rate mortgage for no more than 15 years.
—Have a down payment of at least 10%, but as we mentioned above, putting 20% down will keep you from having to pay PMI every month.
—Keep your monthly payment to 25% or less of your take-home pay. A mortgage payment higher than that will eat up too much of your income and keep you from your other financial goals like saving for retirement.
Thinking about a 30-year mortgage for a lower payment? Don’t do it! You’ll pay thousands more in interest over the life of the loan—plus, who wants to be in debt for 30 years?
Get Help Finding the Right Home at the Right Price
The key to keeping your mortgage affordable is finding a home you love in the right price range for you. That’s where an experienced real estate agent can be a huge help. A real estate professional will not only help you locate homes that fit your family’s needs and budget, they’ll also help you negotiate with sellers to get you the best possible deal.
Finding an agent who will do all that while respecting your budget can be a challenge. Let us put you in touch with a real estate agent in your area who has earned Dave’s recommendation for providing trustworthy advice and excellent service.