Do you know how to be mortgage smart? It’s home buying season once again and the housing market is starting to come alive after a few years of tough times. In fact, as I write this, I’m in the middle of emailing documents and wiring money to buy a rental house. But that’s a subject for a later article.

Anyway, when it comes to buying a home and getting the right mortgage, you have to be wise. If not, it’s very easy to find yourself in a huge bind that you didn’t expect because you didn’t take the time to fully understand what you were getting into.

Learning to Be Mortgage Smart

Today I’m going to show you how to be mortgage smart when buying a house. I’ll cover what I believe are the best mortgages you can get, as well as the worst.

Let’s start with the worst first. These mortgage pitfalls are very easy to get into because they sound attractive, but can cause you big problems in the long run.

  • No Down Payment Mortgage. A 100% mortgage with no down payment is very risky. It comes with a higher interest rate as well as the privilege of paying Private Mortgage Insurance (PMI) which costs around $100 per $100,000 borrowed. You end up paying a ton of interest and PMI because you didn’t save up for a down payment. That causes you to waste tens or even hundreds of thousands of dollars over the life of the loan. Anytime you buy a house and you don’t have any money, you’re putting yourself at risk. You really can’t afford the house.
     
  • A Low Down Payment Mortgage. These are only a little better than a 100% down mortgage. You still pay PMI and a higher interest rate. The only difference is that you put a little skin in the game in the form of a small down payment (maybe 3%). Because of this it takes a loooong time to really gain any equity. These types of mortgages include VA loans and FHA loans. They sound good on the surface, but aren’t ideal in the long run because of the higher interest rates, fees, and PMI
     
  • Interest Only Mortgage: These loans are attractive for the low payments. The problem is that the first few years of payments go toward paying back interest before any equity is paid. Because of that, it could literally take over a decade of paying interest before you start gaining any equity in the property whatsoever. Think about it, a decade of payments with nothing to show for it. This is bad, bad mojo. Never do an interest only loan, you’ll live to regret it.
     
  • Adjustable Rate Mortgage (ARM)- With an ARM, they hook you in with a low interest rate in the beginning. But after a certain time period, the rate you pay fluctuates according to market conditions. The result is that your house payment can go up by hundreds of dollars very suddenly, putting you in a huge bind. Don’t do this kind of loan, EVER!

How to Be Smart About Getting a Mortgage

Now that you know what to avoid, let’s talk about how to be smart about getting a mortgage that won’t put you at a major financial disadvantage.

Of course, preaching against debt like I do, I believe the 100% down plan (paying cash) is best. But hey, even though more people do it than you might think, it’s not something most people are willing to tackle.

If you can do it great. If not, it pays to be mortgage-wise and do a few basic things.

  • Have a Substantial Down Payment. Why? It proves you are disciplined enough to save your money and keeps you from having to borrow as much. Your down payment should be 10% at the very minimum, but 20% is much better. 20% allows you to avoid PMI payments as well as thousands in interest over the life of the loan.
     
  • Get a fixed Rate Loan. You should get a fixed rate loan of no more than 15 years. Less if possible. The shorter the term of the loan, the more money you save. Compared to a 30 year loan, a loan of 15 years or less will save you tens of thousands to over a hundred thousand dollars during the life of the loan.
     
  • No More Than 25% of Your Take Home Pay. Your house payment should be 25% of your monthly take home pay or less. Any more than that can drain money away from other necessary things in your budget. It also gives you a some leeway if your income goes down for a period of time.

Know What You’re Getting Into

Remember, buying a house is usually the largest purchase you will ever make. If you use a mortgage to finance that purchase, it pays to be mortgage smart and know what you’re getting into. It will save you tons of money and potential stress in the long run, guaranteed!

Ever taken out a mortgage you regretted later? Leave a comment and tell me about your experience.

Article originally published on Celebrating Financial Freedom. Used with permission.

Dr. Jason Cabler is a Christian personal finance blogger, author, and speaker. He teaches how to get out of debt and live a debt free lifestyle through his Celebrating Financial Freedom blog and self study course. His book How to Budget: The Quick and Easy Guide to Making a Budget That Works is now available (more info here). He can be reached for interviews or speaking engagements by email, and can be found on Twitter, Facebook, and Google +.

Publication date: July 17, 2013