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The Keys to Selecting the Right Mortgage For You

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Summary: 

The article below describes the steps you need to take in order to get the mortgage loan that is right for you. The three steps are
  1. Assess your financial strengths and weaknesses.
  2. Choose a standard product that fits a realistic time horizon.
  3. Get a quote from more than one lender, to make sure that the rate is competitive.
The article explains why these are the keys to getting the right mortgage and guides you through the process.

Key number 1: Assess your strengths and weaknesses

For the purpose of obtaining a mortgage, your financial position consists of three components:
  1. Your income, which gives you the ability to make your monthly payments
  2. Your savings, which allows you to make a down payment, cover closing costs, and keep some cash reserves to cover unexpected expenses
  3. Your management of other credit, such as car loans and credit card balances
Your strengths and weaknesses can be gauged by looking at these components relative to one another.

Savings Relative to Income

The first relationship to look at as is your savings relative to your income. Add up all of the savings you have available for a down payment, including savings accounts, mutual fund shares you plan to redeem, and gifts from relatives that will go toward a down payment. Then take this as a percent of your annual income, as in the calculator below:
Notes:
 -- This calculator uses JavaScript, which means that it may not work with all browsers. It does not transmit any data back to the Internet.
 -- Type only numbers: no dollar signs or commas
Savings:  Income: 
Your savings equal    percent of your income
If your savings amount is less than 25% of your income, then your savings are relatively deficient. For the maximum purchasing power, you probably will require a loan with a down payment of less than 5% , such as those offered by the Veterans Administration (VA) or the Federal Housing Authority (FHA). Alternatively, if you believe you have the capacity to add to your savings in the next year or two, then it may pay to wait before buying a home.
If your savings amount is more than 25% of your income but less than 75% of your income, then your savings are adequate. You probably can put down at least 5% of the purchase price of your home. However, for the maximum purchasing power, you probably will require a loan with Private Mortgage Insurance (PMI), which adds to the cost of a mortgage.
If your savings amount is more than 75% of your income, then you probably can make a down payment of 20% of the purchase price of your home. This will allow you to avoid paying the cost of PMI.

Debt Relative to Income

One way to assess your management of credit is to look at the ratio of debt payments to income. Debt payments consist of car payments, student loan payments, alimony, required payments on installment loans, and required payments on credit cards where you are paying interest, and other obligations. They do not include rent, utility bills, and the mortgage payment on a house that you are selling to buy a new home or payments on credit card balances where you pay at the end of the month without owing interest.
You want to look at your monthly debt payments as a percent of monthly income, which means taking your annual income and dividing it by 12, as in the calculator below.
Notes:
 -- This calculator uses JavaScript, which means that it may not work with all browsers. It does not transmit any data back to the Internet.
 -- Type only numbers: no dollar signs or commas
Top of Form
Annual income:  
Monthly debt obligations:
car payments:
student loans:
other obligations:
Your non-mortgage debt equals:    percent of your income
Bottom of Form
If your monthly debt payments are more than 10% of your income, then debt is an area of concern. If along with this high debt ratio you have a history of sometimes missing your monthly payments, then you may have difficulty qualifying for the best mortgage rates. Even if your payment history is clean, you might benefit by paying down some of your debts before you take on the additional burden of a mortgage.
If your monthly debt payments are between 5 and 10% of your income, then this should not prevent you from obtaining a standard mortgage. However, you probably could benefit from reducing your debt payments, and you might be able to reduce your interest costs by taking out a larger mortgage and paying off some of your other debt.
If your monthly payments are less than 5% of your income, then your debts should not cause a problem with respect to obtaining a mortgage.
To see how savings, income, and debt payments affect your purchasing power, you can try our Mortgage Affordability Calculator.

Key number 2: Choose a standard product to fit your time horizon

When you look for a mortgage, you might encounter a lender who offers a "unique" mortgage product. When this happens, you should be wary.
It is difficult, if not impossible, to invent a new mortgage product clearly better than the standard products that exist. Typically, there is a trade-off. For example, you may find a mortgage with a prepayment penalty offers a lower interest rate. However, if interest rates tumble after you take out the mortgage, the prepayment penalty will make it more difficult for you to realize the potential savings from refinancing.
One concern with "unique" products is they take away your bargaining power. If the product truly is unique to that lender, then you cannot obtain a comparable quote from another lender, which weakens your bargaining power. For this reason, consider sticking with mortgage products where you can get competing quotes from different lenders.
It is important to realize the 30-year fixed-rate mortgage is not the only standard mortgage product. You can obtain quotes from many different lenders on 5-year and 7-year balloons, 1-year, 3-year, and 5-year adjustable rate mortgages (ARMs) tied to the one-year Treasury index, and 6-month and one-year ARMs tied to the COFI index (these latter loans are more prevalent in California than elsewhere).
Your time horizon should be a major factor in choosing a loan product. The 30-year fixed-rate mortgage rate tends to be higher than the rate on nearly all other mortgage products. Moreover, the vast majority of people who take out 30-year loans pay them off in less than 30 years, either because they refinance or change houses. Thus,
The vast majority of people who take out 30-year fixed-rate loans wind up throwing away money on high interest costs.
Any of the following considerations should lead you to consider a shorter time horizon than 30 years:
  • possibility you will change employers or be transferred by your current employer
  • possibility your housing needs will change--because of children, for example
  • possibility your income will increase sharply in a few years

Key Number 3: Get a Competitive Rate Quote

Make sure you get a competitive quote on the product you select. If you take the first rate you are offered, without doing any research to compare it with other rates, you are taking a risk. If the lender thinks you are uninformed, the rate you are quoted may be a significant markup over the lender's actual cost.
If you are taking a standard mortgage product, then a little bit of research can help ensure you get a reasonable deal. While it may not be going to great lengths to try to shave the last 1/8 point off your interest rate, you should at least find out what some other lenders are charging on comparable loans.
One difficulty people have in comparing competing quotes is making the trade-off between up-front points and interest rates. A reasonable rule of thumb is to say that one point up front is worth about 1/4 point over time. Using this rule, for example, an 8% mortgage with one point costs about the same as an 8-1/4% mortgage with no points. The 4-to-1 rule is not a precise mathematical law, but it is close enough to give you reasonable comparisons.
Another roadblock to making comparisons consists of how different lenders handle fees. It is important to get a complete list of the fees lenders charge, in addition to the basic quote of interest rate and points.
One advantage of shopping for a mortgage on the Internet is online lenders realize they are in a competitive environment. You can fill out a couple of on-line contact forms and usually get quick responses with competitive quotes. See Should you get your mortgage online?.
 
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