Shopping for a mortgage can be an intimidating process, particularly for a first-time homebuyer. There are a lot of details, unfamiliar terminology and new concepts to get a handle on. However, you can usually get through the process ok if you just focus on avoiding the most costly mistakes borrowers make.
Here are five of the most common and costliest mistakes first-time homebuyers make when taking out a mortgage.
1 - Not shopping around
This is often the biggest, and first, mistake they make. It's amazing how many homebuyers simply go directly to their usual bank, or choose a lender on the recommendation of a friend, rather than checking out what the competition has to offer.
Similarly, many will simply look over the mortgage ads in the paper, choose a lender that seems to be offering a good rate, and go with them.
Buying a home is likely to be the most expensive purchase you make in your life - unless you move up to an even pricier home later on. So the savings you can realize by being a careful consumer can be substantial.
Mortgage lenders are like gas stations - there can be a lot of variation in their pricing, even in the same town. Unlike the pricing at gas stations, mortgage pricing is very complex. There are lots of different fees that get charged when you take out a loan and these vary significantly from lender to lender - not only in what they charge for those fees, but even in what fees they charge and what those fees are called.
Your best bet is to get loan estimates from 3-5 lenders, based on your credit and the amount you want to borrow, and compare the total charges to see how they stack up against each other.
2 - Fixating on the mortgage rate
Mortgage ads love to trumpet their rates. No surprise there - it's the first thing that grabs most people's attention and has a big impact on the cost of your mortgage.
But the mortgage rate is only one of the things that determines the overall cost of your mortgage. Remember the fees mentioned above? Lenders will often add in extra fees to offset the cost of offering a lower rate. So a mortgage that' advertised with a low rate could actually end up costing more than another loan with a rate a quarter of a percent higher but with lower fees.
A good way to determine the true cost of a mortgage is to look at the APR, or annual percentage rate. This is intended to reflect the true cost of the loan, fees and all, in terms of an interest rate. The lower the APR, the lower the total cost of the loan.
3- Choosing the wrong type of mortgage for your situation
Many people just assume they're going to get a certain type of mortgage - say a 30-year fixed-rate FHA loan - and don't really consider other options. That can cost you money.
For example, while a 30-year fixed-rate mortgage is considered standard, it may not be the right type of mortgage for you if you only plan to own the home for few years. This is true even if you're a first-time "novice" homebuyer.
If you only expect to own a property 5-7 years before moving up or elsewhere, an adjustable-rate mortgage (ARM) may be a better choice. ARMs tend to have considerably lower rates than 30-year loans - often half a percentage point or more - because you're not locking in the rate for three decades. Instead, you can get a rate that's fixed for only five, seven or ten years - long enough to cover the time you'll be in the home.
Borrowers also sometimes choose the wrong loan program for their needs. For example, many first-time borrowers are currently looking to FHA home loans because of their low down payment and easier credit requirements. But that doesn't necessarily mean an FHA loan is the best choice for you if you're a first-time buyer.
FHA loans have raised their fees in recent years so they tend to be more costly than conforming mortgages backed by Fannie Mae or Freddie Mac. And while FHA mortgages allow down payments of as little as 3.5 percent, you can get a Fannie Mae or Freddie Mac mortgage for as little as 5 percent down these days if you have good credit. So you may be better off trying to come up with that extra 1.5 percent.
Of course, if you have only so-so credit and limited financial resources for a down payment, an FHA loan may be the best choice for you. But you want to explore your options first.
4 - Buying points when you're a short-term owner
Discount points offer borrowers a way to lower their mortgage rate by paying higher fees up front. They're actually considered a type of pre-paid interest. While they're one of the main tools use to advertise unusually low rates by adding in higher fees, they can save you money if you're the right type of borrower.
That type of borrower is someone who's going to stay in the home long enough to recoup the cost of the points through a lower interest rate. If you're not going to be a long-term owner - say 5-7 years or more - there's a good chance you won't own the home long enough for the lower interest rate to make up for the higher up-front cost of the points.
5 - Underbudgeting for expenses
First-time homebuyers often fall into an attractive trap. They get so focused on trying to figure out how they can afford a home, make it work within their budget, that they fail to recognize what their actual cost of living is going to be.
First, they fail to appreciate how much they're going to need to spend on maintenance and repairs. For an existing home, a good rule of thumb is to count on about 1 percent of the purchase price each year.
Second, they may make unrealistic assumptions about how much they can cut out of their present budget to free up funds for home ownership. Often, it's harder to change those old spending habits than they realize.
Third, they underestimate what they're going to have to spend on taxes and insurance (including mortgage insurance if you put down less than 20 percent). This can easily equal one-quarter to one-third of what you're paying for the mortgage itself, and perhaps more. Your lender will take these into account when qualifying you for the mortgage, but it can still throw a wrench into your own calculations.
Fourth, they don't take into account the need to set money aside for an emergency fund, such as if major repair is needed that exceeds the 1 percent average they were budgeting for above. A new septic tank and field, furnace or roof can do that.
It's difficult to go into the mortgage process completely ready and get everything right, particularly the first time you go through the process. But if you focus on the major issues such as these, you should come through in good shape.