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One of the most important financial decisions you will make is choosing a home mortgage.
Two main questions should be apparent when thinking of buying a home:
- How much should my mortgage be relative to my overall income?
- What type of mortgage is right for me?
The first question is by far the more important of the two. Ironically, the average person spends more time choosing between mortgage options and lenders than they do considering the proper amount they can afford.
How Much Can I Afford?
Most people answer this question based on what their Realtor or mortgage broker tells them they can afford. This is a mistake!
Just because the bank will loan us the money, doesn’t mean that it is in our best interest to borrow it. This is evident by the recent crackdown by the federal government on the sub-prime lenders.
As a general rule of thumb, I recommend your mortgage be no more than 1/4 of your take home pay. This will put you in a situation where you are still able to flourish and succeed in the other areas of your life such as retirement saving.
The amount you can afford may also be dependent on any other outstanding debt that you have. If you do have other debt on credit cards and automobile loans, then you should adjust your decision making accordingly.
What Type Of Mortgage Is Right For Me?
There are two main categories, fixed and adjustable rate mortgages. The decision of which one to chose largely depends on your specific circumstances.
Adjustable rate mortgages have rates that are set for a specified period of time but will then adjust to current market rates at some point in the future. This set period may be as little as 6 months or as long as 10 years.
A typical example of an adjustable rate mortgage is a 3, 5, 7, or 10 year arm. With a 5 year arm this means that your interest rate will be locked for 5 years, and it will then adjust to a different rate (usually higher) after the 5 year period.
The main benefit or selling point of adjustable rate mortgages is that your interest rate and payment may be lower for the initial rate lock period. However, your payment will likely increase once your rate lock period is up.
It is very important to consider the interest rate environment when looking into adjustable mortgages. Presently, there is little benefit to having an adjustable rate as fixed rates are only slightly higher.
Fixed rate mortgages come in a variety of terms, the most common are 15 and 30 year terms. With a fixed rate mortgage, your rate is locked for the life of your loan.
The bulk of your payment during the early years of your loan will be going toward paying off the interest. Conversely, the bulk of your payment in the latter years of the loan will be going toward principle.
The benefit of a fixed mortgage is the guarantee that your payment will not change throughout the life of the loan.
If your payment does change, it is likely due to an increase in property taxes or homeowners insurance that is escrowed through your loan. Escrowing simply means paying your taxes and insurance through your mortgage payment. Your mortgage company then pays those property taxes and homeowners insurance from your escrow account.
Which Is Better, Adjustable Or Fixed?
If you plan on living in your home for a short period before upgrading or moving to a new city, then an adjustable rate mortgage may be right for you. The benefit of a lower payment may be ideal, especially if you plan on moving before your rate adjusts.
For those of you who plan on staying in your home for an extended period of time, then a fixed rate mortgage may give you the security of set payments that will not increase.
Also, for those of you who do not expect your income to increase significantly over the next few years, a fixed mortgage will give you added security that an adjustable rate cannot.
An increasing number of people are keeping homes as rental homes when they move out. If you would consider doing this, you may want to lock a fixed interest rate today, which you can maintain while your renter pays your mortgage for you.
All things considered, the most important decision is choosing a mortgage that you can comfortably afford.
Read next: Interest only Mortgages
I’m a Financial Consultant and Personal Financial Representative with experience in financial analysis, strategic planning, presenting, & financial advisory services.