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How to Choose the Right Mortgage

Buying a property often feels overwhelming. It's a significant investment that will likely take many years to pay off. Before looking at properties, most people elect to get pre-approved for a mortgage. This process involves providing the bank with some basic, unverified information about your financial situation. The financial institution will then provide you with a pre-approval letter saying that if your finances are truthful and you don't accrue any more debt, then the bank would agree to give you the mortgage.

There are many choices to make with mortgages and finding the right one can get stressful. There are a few critical concepts that you need to keep in mind when applying for a mortgage.

Try to Have a 20% Down Payment

In the United States, if you have less than 20% down, you will pay private mortgage Insurance (PMI) in addition to your regular mortgage payment. PMI rates vary from 0.3% of the home's value per year to approximately 1.5%.

For example, if the PMI rate was 0.5% and you purchased a $300,000 house with 10% down, you would be paying $1,350 annually for this insurance. While it is tax deductible, the only purpose of this coverage is to protect the bank. You get no benefit from it. It's effectively wasted money.

Also, you must keep making the PMI payments until you reach 20% equity in the house. Once you have 20% equity, you can call the bank and ask them to cancel the insurance payments.

In the hypothetical mortgage, assuming it was a 30-year fixed at 4%, you would not be able to stop these payments until approximately six years into the loan. That's an additional $8,100 in expenses on your $300,000 home!

If you have less than 20% down, consider an FHA mortgage if you qualify. FHA mortgages do not have PMI payments and as such are cheaper for those with a down payment that is under 20% of the value of the home.

Paying Points

Points are one of the least understood concepts of mortgages. You may read advertisements for mortgages that showcase a rate of 4% APR with 2 points. The meaning of this is relatively straightforward. You will get a rate of 4% by paying 2% of the loan's value up front. Each point is worth a 0.25% rate reduction. The equivalent zero-point loan would be at 4.5%.

Suppose you were to take a $100,000 30-year mortgage using these rates as an example. Without the points, you would pay $82,407 in interest over the life of the loan. With the points, you would pay $71,870 in interest in exchange for an extra $2,000 up-front at closing time. That's an incredible $10,537 in interest savings for just $2,000.

Superficially it seems like a great deal to save some interest. The catch is to consider how long you will remain in the home. If you are buying a home that you envision living in for the next 30 years and you can afford to buy the points, it's usually recommended to do so. If you are purchasing a home that you intend to sell in two or three years, then it's not worth it. That $2,000 you added at closing time is money you won't get back at selling time if you've only had the property for a couple of years.

Variable Rates Versus Fixed Rates

In general, fixed-rate mortgages are the best offering for most people. Some articles suggest that you would want a variable rate to save money on interest if you're planning on living in the home for a short period or if you are betting that interest rates will go down.

The reality is that buying a home is a hassle and nobody can predict the future. Many people have purchased homes thinking they would move in a few years but then elected to live in the house forever. A fixed-rate mortgage gives you security. Your payment doesn't increase for the duration of the loan. It doesn't matter if you lose your job or your home goes down in value, the amount you pay, and terms will remain the same.

However, with a variable-rate loan, there's little certainty as to what will happen at the loan's end. Maybe your home will have gone down in value, and you'll be underwater. Maybe interest rates will have gone up, and now your monthly payment is high. If you can pay for it and you want a cheaper interest rate, go with a 15-year fixed mortgage. You'll save a considerable amount of interest but still have a fixed loan duration.

Choosing the right mortgage is an overwhelming process. If you have 20% down and can afford 1 or 2 points, then a 15- or 30-year fixed-rate mortgage is usually the smartest choice for most prospective homeowners. If you don't have 20% down and can qualify for an FHA loan, then that is often an excellent option to avoid PMI.

Finally, if you know that you won't be in the home for too long, then usually the best option is to avoid paying points and go with a variable-rate mortgage. When you're applying for the perfect mortgage, consider all these factors and find the right loan for your home and lifestyle.

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