Frequently asked questions about mortgages
What are the different types of mortgages?
There are two basic types of mortgages, fixed-rate and adjustable-rate. Fixed-rate loans carry a set interest rate for the term of the loan, meaning that the principal and interest payment is fixed and never changes. Adjustable-rate loans begin at a lower rate, but are subject to increases and decreases depending on the prevailing interest rates. These type of loans are tied to an index, such as the prime rate, and adjust up or down as the index changes. This change is typically measured once a year, about two months before your loan anniversary date.
Should I get an ARM or a fixed-rate mortgage?
ARMs typically start at a lower interest rate than fixed-rate loans, but there's a risk that the rate could go up in the future. If you're planning to move or refinance again, an ARM might save you money in the short term. If you're planning to stay in your home for years, a fixed-rate mortgage may provide more peace of mind because your payments will never go up, and should interest rates go down, you can refinance again.
Should I get a 15-year or 30-year fixed-rate mortgage?
This depends on your personal circumstances and financial goals. If you are in your late 40s or early 50s and hope to pay off your mortgage before you retire, you may opt for a 15-year mortgage. However, do so only if you can afford the higher monthly payment and still meet your other goals, such as saving for retirement and college costs. If you are at all uncertain about which to choose, you can always take a 30-year mortgage and make extra principal payments. The result is essentially the same, and you still have the option to pay the smaller 30-year payment should the need arise.
How much can I afford?
Estimating how much house you can afford is much easier these days since lots of websites have calculators that will come up with a number based on interest rates and your income, debt and savings. Two that you might try are Money.com and Bankrate.com. Most stick by the so-called 28/36 rule, the lender guideline that caps total housing expenses (mortgage, homeowner's insurance, property taxes, and maintenance) at 28% of your gross income, and total debt payments at 36%. Some lenders have relaxed these rules, but that doesn't mean you should. Although these percentages don't consider that interest payments and taxes are deductible, the real savings will depend on your tax bracket. If you are in a high tax bracket, the tax savings might help you handle higher mortgage payments. If you expect substantial salary increases over the next few years, you might be able to make the higher payments without too much risk. Still, unless it's absolutely necessary, we suggest you try and stick with these percentages.
I want to buy my first home. Can I take money out of my 401(k) without paying a penalty?
While most employers do allow workers access to 401(k) money through so-called hardship withdrawals for the purchase of a home, the money doesn't come cheap: You'll pay ordinary income tax on that distribution, plus a 10% penalty. (If you're over age 59 1/2, you'll avoid the penalty.) Borrowing from your 401(k) may be a better alternative. You won't owe any tax, and you're paying yourself back with interest. The downside: If you leave your company, you'll likely have to pay the loan in full, or you'll end up owing that 10% penalty plus taxes. IRAs offer a special provision, allowing investors to withdraw up to $10,000 penalty-free for the purchase of a first home, though you'll still owe income tax. Have a Roth? You may be able to withdraw up to $10,000 in earnings tax-free as well.
Is it smart to make 26 biweekly mortgage payments rather than 12 monthly ones?
It's not a bad idea. By splitting your mortgage payment in half and paying it every two weeks, you actually add in an extra mortgage payment over the year. Prepaying your mortgage cuts down on the amount of interest you'll pay over the lifetime of the loan. Say you have a $300,000, 30-year fixed-rate mortgage financed at 6%; you'd pay your mortgage off about five years sooner, saving more than $73,000 in interest.
So what's not to like? For starters, many lenders and third parties charge for the service. An initial fee of roughly $350 and a small monthly charge of less than $10 is common, says debt expert Gerri Detweiler. You can avoid this fee by simply adding a bit more to your monthly payment instead. But here's the more important issue: Mortgage debt is relatively cheap - especially when you factor in the tax deduction on the interest - so you likely have better use for that money, like tackling high-interest credit card debt or increasing your 401(k) contribution. "Prepaying your mortgage is a little like shoveling a mountain with a teaspoon," says Keith Gumbinger, vice president of mortgage tracker HSH Associates. It adds up over time, but there may be better mountains to climb.
What's negotiable with closing costs?
Recurring costs, such as property taxes and homeowner's insurance, are not open to negotiation. One-time fees, such as the lender's attorney fees ($300 to $500), document-preparation fees ($150 to $300), the appraisal ($200 to $300) and the title search ($300 to $600), are on the table. If you're buying and you can't get the lender to budget, ask the seller to pitch in. Shifting certain costs, such as the appraisal, underwriting fees and title search and insurance to the seller is a growing trend and case save you as much as $8,000. If you are refinancing, you only have the lender to pressure. Third-party jobs, such as credit reports and appraisals, are often marked up by the lender, so you may be able to negotiate lower fees. Make sure you ask, because you are no worse off even if they say no.
Why should I refinance?
Refinancing makes sound financial sense in a number of situations. Maybe you can negotiate a lower rate to reduce your monthly payment and save money over the length of the loan. Or maybe you have a high-rate second mortgage that you'd like to consolidate with your primary mortgage at a new lower rate. Either way, you could take the money you save each month and put it to work investing more for retirement or in a college fund for your children. Other reasons to refinance could include paying off high-interest debt or shortening the term of the loan, from 30 years to 15 years. For the latter, your monthly payment will be higher, but you'll build equity more quickly and save thousands of dollars in interest over the long term.
When does it make sense to refinance?
Refinancing only makes sense if you stay in your house long enough to recoup up-front fees for the title search, appraisal and other paperwork. These closing costs typically range from 1% to 2% of the loan balance that you are refinancing. A simplistic way to calculate your "break-even period" is to divide your closing closts by the reduction in your monthly mortgage payment. This simple method works best if the term on the new loan is the same as the term on the old loan. For example, if fees on the new loan (all costs except for tax or insurance escrow amounts) are $2,100, and your new monthly payment is reduced by $70, divide $2,100 by $70 to find that it will take 30 months to recoup your costs. Of course, this doesn't consider how much interest is left to pay on your current mortgage versus what will be paid on your new mortgage, since you are essentially starting over and early payments are almost all interest. If you are switching from a 30-year loan to a 15-year loan, the break-even point is typically not the consideration since you are increasing your payments. It can be computed, but it is more complex to determine because it must consider the cost of the loan versus both increases in equity and decreases in total interest paid.
Should I refinance with my existing lender or go elsewhere?
If the term on your new loan is the same as your old loan (30 years vs 30 years), then your current lender may be willing to reduce your interest rate without going through the closing process and expense. After all, the lender already has the information about your property and your payment history. There may be a minimal processing fee, but it should be substantially less than closing costs. However, do your homework. If you can get a better rate from another lender, factoring in closing costs, you will be better off.
How do I get rid of the dreaded PMI?
For loans taken after July 29, 1999, the lender is generally required to drop PMI when equity reaches 22% of the property's value at the time you took out the mortgage. But in figuring your equity, the lender doesn't have to count any appreciation in value; only your down payment and the principal portion of your monthly payments are considered equity, and it can take ten years or more before you reach that magic percentage. One way to get out of paying PMI, if your home has appreciated significantly, is to refinance. Of course, refinancing only makes sense if the money you save by lowering your rate and eliminating PMI exceeds the closing costs on the new loan.