Mistakes happen. Sometimes they are small and we learn from them. Other times though, they are large and can cost us a fortune. These common mortgage mistakes hurt the most so the best way to avoid them is through experience and education. For the first-time homebuyer, every step of the transaction is filled with potential mistakes, both small and large. Understanding mortgage terms, pre-qualification, debt to income ratios, and credit scoring rubrics is the first step to avoiding potential harm.
1. Understand that the homebuyer is the responsible party
The first step to avoiding an enormous mortgage mistake is the attitude that the home buyer(s), and only them, will be responsible for the mortgage payment, not the lender, friends or relatives, nor the agent. Therefore, all decisions should be, first and foremost, personal ones, and secondly, rooted in common sense.
2. Spending too much on a home purchase
Another way to phrase this is, “Don’t let your qualifying ratios get out of hand.” By familiarizing yourself with the mathematics behind getting a mortgage, you’ll be in a much better position to know how large of a mortgage you can afford. For conventional loans, the rule of thumb is that you should not spend more than 28% of your income on your home buying debt. Your home buying debt includes the principal, insurance, taxes, and interest (PITI). By law, this number cannot exceed 35%, but as mentioned, most lenders want it to be 28% or lower.
Do not listen to people who tell you “these rules no longer apply” or “but it’s different this time.” Many first time homebuyers fall into the trap of buying a home at the maximum approved price. They then find themselves stretched to their financial limits each month, with a little cushion for emergencies. An unexpected expense can drive them to financial ruin only to find out that there are actually many types of home loans for first time buyers.
Another important ratio is called your “back-end ratio,” or debt-to-income ratio. This ratio considers not just your PITI, but also includes all your household debt (i.e., credit card, car, student loans, etc.). According to financial experts, housing costs, including the home’s maintenance, should consume no more than 36% of your total income.
Karen and Nick have a combined income of $90,000 annually, or $5,600 a month after taxes. Based on their low debt and high income, a lender may approve them for a $600,000 loan. On a 30-year fixed-rate mortgage, this means their monthly payment would be $3,225, or more than half of their take-home pay, leaving them with little wiggle room for repairs, savings, emergencies, or investing. If we stick to the 30% rule, a $1,680 a month mortgage would be more comfortable for this couple.
3. Not shopping around for the best rates
Not all mortgage rates are created equal. It pays to shop around for the best terms when it comes to buying your first home. Different lenders may offer slightly different rates, fees, and terms. Even a small difference in rates can add up to thousands of dollars in savings over the life of the loan.
Besides shopping around for the best loan, it pays to shop around for the best mortgage type. One lender may offer a lower rate for an adjustable-rate mortgage, but you have to decide if that type of mortgage fits your lifestyle. If you plan to live in the home for more than ten years, a rate that fluctuates over time might end up being a budget buster.
Many first-time homebuyers fear that shopping around will mean multiple hits on their credit report and lower their score. Lenders expect that buyers will shop around for the best rates, so the credit bureaus allow for a 30-day window in which you can have multiple credit inquiries without affecting your score.
4. Making too small of a down payment
Want to compound the previous mistakes? Put a small down payment. Not making enough of a down payment is one of the mortgage mistakes that can cost you dearly over the loan’. While conventional advice from financial experts suggests that you make a 20% down payment on the purchase of your home, many lenders will approve you with far less than that figure. A 20% down payment on a $200,000 loan is $40,000, and many homebuyers struggle to come up with that amount. Instead, they go with down payments of far less－sometimes as little as 3%－and pay more over the life of the loan. Consider these scenarios:
Lauren and Morgan are buying a $250,000 home and are planning to put down $50,000 (20%). Their debt to income (DTI) ratio is 22%, and their credit scores are high. They are approved for a $200,000 mortgage at 3.92% for 30 years.
Lauren & Morgan’s monthly payment is $946. Over the life of the loan, they will pay $140,427 in interest.
Next, there is Jordan & Marcel are also buying a $250,000 home and also paying 3.92% interest. All other factors are the same as Lauren & Morgan, except that they are only putting down only $25,000 (10%) as their down payment. As a result, let’s see what happens to their monthly mortgage payment and the total amount paid in interest.
Jordan & Marcel’s monthly payment is $1,063. Over the life of the loan, they will pay $157,979 in interest. This is over $17,000 more in interest payments than Lauren & Morgan!
Lastly, we have Taylor & Ben, who only want to put down $12,500 (5%). As before, all other factors are the same as Lauren & Morgan. Let’s see what happens to their interest payments.
Taylor & Ben’s monthly payment is $1,122. Over the life of the loan, they will pay $166,756 in interest. This is over $26,330 more in interest payments than Lauren & Morgan!
Here is a table we built showing the difference in payments of each couple. Take note of the highlighted rows.
|Name:||Lauren & Morgan||Jordan & Marcel||Taylor & Ben|
|Total house cost:||$250,000||Same||Same|
|Down payment:||$50,000 (20%)||$25,000 (10%)||$7,500 (5%)|
|Term length:||30 years||Same||Same|
|Total interest paid:||$140,426||$157,979||$166,756|
|Additional interest %||–||+ $17,553||+ $26,330|
What’s even more alarming is that we controlled all other mortgage-related variables by assuming no private mortgage insurance (PMI), no HOA fees, no home insurance, etc. We did this to highlight the benefit of putting down a larger mortgage, but it’s a good point worth noting: as a home buyer, you will face many costs outside of just the loan principal and interest. Home insurance is very common, and so are property taxes.
Another considerable cost that the second two couples will face is private mortgage insurance, or PMI. Buyers who put down less than 20% must pay it because it protects the lender should you default on the loan. Removing PMI is relatively straightforward but it’s still something to consider. Thus, in conclusion, not only will the second two couples pay many thousands more in interest, but they will also pay much more in PMI costs. Nevertheless, the good news is that, as of December 2019, private mortgage insurance is fully tax deductible.
5. Changing your credit score before closing
So you’ve found the home, gotten approved, and you’re ready for the closing. You’ve already started thinking about the furniture, and you’re ready to start shopping. It won’t hurt to get a furniture store credit card, right? Stop! You will need a good credit score to buy a home. This is one of the most common mistakes of first-time home buyers. Opening up new credit accounts can drop your score. Remember that your qualification is based on your credit score and debt-to-income ratio (DTI), and opening new accounts change those ratios. The lender will recheck your credit just before closing, and a drastic change in your score can make the entire deal fall through. It’s best to save the shopping, pay off old accounts, and other credit issues until after you have the keys.
6. Choosing the wrong mortgage
There are literally hundreds of different mortgages, and lenders, and options available to home buyers. One can spend months learning about all the combinations and still not scratch the surface. To make matters worse, there are no right answers—the financial means and needs of each buyer are different, so it’s hard to say what is “right” for you.
Nevertheless, using your common sense can help avoid apparent disasters. For example, choosing a 30-year mortgage when you plan to retire (and move) in 10 years—or securing a fixed-rate mortgage with high closing costs and high-interest rates when market conditions indicate that rates are dropping.
Bottom line: choose the right mortgage for you. Speak with those you trust, consult with your broker and lender, and don’t be pressured into a mortgage that doesn’t fit your needs
Common mortgage mistakes are avoidable
The key to selecting the right mortgage is to find the loan that fits your budget and situation, rather than trying–or worse, hoping–to have your budget and situation magically conform to the mortgage. The road to financial ruin is littered with these examples, so be careful!
Above all, when it comes to getting the best possible mortgage for your lifestyle, it pays to be savvy, shop around, and get the best deal. Understanding your mortgage-to-income ratio, credit scores, and down payment is key to paying less overall and living comfortably in your new home. Now that you know the most common mortgage mistakes you can make, we wish you the best of luck on your home-buying journey!
Are you a Millennial in the market for your first home? Make sure to check out our mortgage guide made just for you.