Five Mortgage Myths
Applying for a mortgage can be an intimidating process, particularly for first-time homebuyers. It doesn't help that there's a lot of conventional wisdom out there that is either misleading or flat-out wrong.
Some of these mortgage myths can discourage borrowers from even attempting to seek a home loan by making it appear more difficult to qualify than it actually is. Others can lead them to make poor financial choices when better options are available.
The following are five of the major misperceptions that first-time homebuyers often have about getting a mortgage:
1 - You need perfect credit
You hear a lot about needing good credit in order to get a home loan. For the average person, this may evoke an image of well-to-do types with abundant financial resources who have proven their worth by regularly incurring and paying off large debts without breaking a sweat. But that's not the case.
The fact is, you get good or even excellent credit merely by paying your bills on time. If you've had one or more auto loans plus a few credit cards and haven't missed a payment in the last seven years, you probably have pretty good credit. And it doesn't matter what your income is.
Figures from the Fair Isaac Corp., which maintains the FICO credit scoring system, shows that 37 percent of U.S. consumers have credit scores of 750 or above - excellent credit, eligible for the lowest interest rates. Another 16 percent have scores of 700-750, still considered good credit and able to qualify for a mortgage at a good rate.
About 12 percent of borrowers have scores in the 650-699 range. This is considered flawed credit, but you can still get a mortgage with it. You'll pay a higher interest rate than you would with a plus-700 score though, and may face stiffer down payment requirements as well.
Once you get below 650 - which is about a third of consumers - you may have trouble getting approved. Even then, some FHA lenders will accept scores in the 600 range. Some small community banks and nonbank mortgage lenders may accept scores that are even lower, but expect to pay a steep interest rate and make a substantial down payment in order to qualify.
2 - You need 20 percent down
This is one of the more persistent myths to come out of the market crash. Even during the immediate aftermath of the crash, a 20 percent down payment wasn't so much a requirement as it was a conservative approach advocated by many financial advisers.
But even back in 2009, FHA mortgages were still available to borrowers putting as little as 3.5 percent down - which is why homebuyers flocked to those loans. If you're a qualifying veteran, VA loans require no money down unless you're buying a fairly pricey home.
Even with conventional mortgages - those backed by Fannie Mae or Freddie Mac - you can get approved with as little as 5 percent down these days. That may be a better choice than going through the FHA, which has sharply increased its up-front fees in recent years.
The main reason for putting 20 percent down on a mortgage is that it allows you to avoid the cost of private mortgage insurance, which is charged on loans with smaller down payments and is typically a charge of about one-half to one percent of your loan amount each year. But you can cancel that once you reach 20 percent equity, so many borrowers prefer to pay that fee rather than wait until they can save enough for a 20 percent down payment.
3 - A 30-year fixed-rate mortgage is best
If you're a first-time homebuyer, the changes are you're going to get a 30-year fixed-rate mortgage. Nothing wrong with that. But it's not the best option for everyone.
The standard 30-year fixed offers a lot of advantages. Low monthly payments. A favorable interest rate. Best of all, predictability - you know your interest rate and monthly mortgage payment will never change. And you can still lock in a rate that's unusually low by historic standards and have it for 30 years.
That's all well and good, but it's only a good deal if you stay in the house and don't refinance for 30 years. Most people don't do that. In fact, the typical first-time homebuyer will move again in about seven years, on average.
If you don't plan to make the home you're buying your long-term residence, you should strongly consider an adjustable-rate mortgage - an ARM. By doing so, you can often shave a full percentage point or more off the interest rate you'd pay on a 30-year fixed-rate loan.
True, the interest rates on an ARM can fluctuate - that's how they're designed. But you can get them so that your initial rate is locked in for a period of 3, 5, 7 or 10 years if you choose - however long you plan to stay in the home. That way, you're getting the lowest rate possible while you're living in the home without paying a premium to lock the rate for 30 years - a benefit you don't plan on using anyway.
If you're looking at a starter home or otherwise expect to move again within 10 years, you should give an ARM serious consideration.
4 - Always choose the loan with the lowest rate
This is something that trips up a lot of first-time homebuyers. The lower your rate, the less interest you pay, right? So wouldn't that be the best deal?
Not necessarily. The way mortgages are structured, lenders have a lot of ways to price their loans to make them look more attractive than they actually are. One of these ways is to charge a low interest rate but add a lot of fees on top, so the lender makes up in fees what they don't get in interest.
The main way to reduce a rate is by charging for discount points, which are actually a type of pre-paid interest. While buying points can make sense if you plan to have the mortgage a long time, so that the savings from the lower rate eventually exceed the upfront cost of the points, they don't work so well if you only own the home for a few years.
A good guide to see what a loan actually costs in terms of both interest rate and fees is the annual percentage rate - A.P.R. This is an approximation of the total cost of the loan in terms of an interest rate - the lower the rate, the lower the overall cost of the loan. But it's just a guideline and not a hard-and-fast rule. For that, you need to take an online mortgage calculator and determine how the costs of various loan offers actually break down over time.
5 - You can deduct your mortgage interest
While mortgage interest is generally tax deductible, there are some limitations you should be aware of before making it part of your budget planning.
First, the deduction is capped at the interest paid on up to $1 million in mortgage debt for a primary mortgage and $100,000 on a secondary loan. That's not going to be an issue for most first-time buyers.
The more relevant concerns are that you can only deduct the interest if you itemize your deductions on your federal tax return. Even then, you only benefit to the point where your total deductions exceed the standard deduction you're already entitled to.
That can be a pretty big obstacle to overcome. For 2014, the standard deduction for a married couple is $12,400 - meaning you'd need to have at least that much in mortgage interest and other deductions to even begin to save money on the deduction. To put that into perspective, you'd need a $280,000 mortgage at 4.5 percent to generate that much in interest each year.
It's easier to reach that mark if you're a single taxpayer or married person filing individually. For them, the standard deduction is $6,200 (but $9,100 for a head of household). Don't forget, too, that your interest payments shrink over time as you pay down the mortgage. So while the mortgage deduction can save you money, it may not be as much as you expect it to be.
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