Purchasing a house is a life-changing event. It shows you’re ready to settle down and commit to long-term responsibilities. When you apply for a home loan, it’s important to take your time and choose the right mortgage deal.
That said, mortgage budgeting does not end once you move into your house. Most homebuyers need to cover monthly mortgage payments for 30 years. This is a long time, which means you might keep paying even during retirement. Thus, you must plan your finances carefully without leaving anything to chance.
How much should you spend on a house?
Ideally, financial experts recommend the 28/36 payment rule. This is based on the debt-to-income (DTI) ratio, which compares the total income you earn to the amount of debt you owe.
As a rule of thumb, mortgage payments should not exceed more than 28 percent of your gross monthly income. This is called your front-end DTI ratio. Meanwhile, for back-end DTI ratio, your total household debt should not go over 36 percent of your gross monthly income. This includes all your other debts, such as car loans, credit card payments, and student loans. Following this guideline, it’s imperative to limit and reduce your debts.
Keeping a lower DTI ratio reduces your chances of defaulting on your loan. Likewise, a higher DTI ratio makes it difficult to repay your mortgage, putting you at risk of foreclosure. Such scenarios are more apparent during a financial crisis. And considering the impact of COVID-19 on the economy, the best way to prepare is to plan ahead and save early.
How do you manage housing costs to maximize your savings? Here are essential mortgage budgeting strategies you should know about homebuying.
Choose a home loan with the lowest interest rate
Getting the lowest rate allows you to secure more affordable monthly payments. It also saves you interest charges over the life of the loan. On a typical mortgage, a lower rate can mean over $400 in interest savings during the first 12 months of your loan.
Obtaining a good mortgage rate involves having a good credit score. If you pay bills on time and have low outstanding debt, lenders typically offer you a lower rate. But apart from excellent credit standing, deciding where to live and which lender to choose also impacts mortgage rates.
According to Forbes, home locations in metropolitan areas usually have higher interest rates. This can affect your mortgage rate by over a third of a percentage point. It’s worth checking areas in the suburbs or any location away from busy cities crowded with people.
On the other hand, the right lender can mean a difference of three quarters of a percentage point. Homebuyers who shop around for a mortgage rate are more likely to score a better deal than those who choose the first lender they find. For instance, you may get a 4 percent interest rate with an expensive lender. But if you take time to find a less expensive lender, you can score a lower rate at 3.25 percent.
If you don’t have the time to improve your credit score, shopping around for a lower rate can help you immediately.
Save for a 20% down payment
Paying 20 percent down can help you score a lower interest rate. It reduces the amount you borrow, which lowers your monthly mortgage payments. Buyers who make a higher down payment are perceived as less risky by lenders. This increases your chances of securing the deal.
While lenders accept smaller down payments, it entails higher insurance costs. Conventional loans from non-government backed lenders are protected by private mortgage insurance (PMI). PMI is automatically required if your down payment is less than 20 percent of the home’s purchase price. Likewise, paying 20 percent eliminates PMI.
PMI usually ranges between 0.5 percent to 1.5 percent of your loan balance on an annual basis. For example, if your loan amount is $350,000 and your PMI is 1.5 percent, that’s $5,250 a year or $437.50 per month. It’s a hefty cost that could very well go to your savings. PMI is only canceled once your mortgage balance reaches 78 percent of your home’s value.
How do you save for a down payment? As early as you can, start gathering funds. A good source is your tax refund. According to Washington Post, the average tax refund in 2020 was $3,100. This is a substantial sum on its own. Other income sources include your holiday and work bonuses. You can also save inheritance funds from relatives and cash gifts from birthdays. To earn extra income, you can render overtime work or take on freelance jobs on the side to bolster your funds.
Consider taking a shorter mortgage payment term
Most U.S. homebuyers choose 30-year fixed mortgages over shorter loan terms. This is because a longer term usually comes with more affordable monthly payments. It can easily fit within your finances, allowing more room for other expenses. And for people with low credit scores, it may be the only mortgage option they can qualify for. Thirty-year mortgages also come with higher interest rates than shorter terms.
Short terms like 15-year fixed mortgages allow you to save more on interest costs. They come with lower interest rates that are 1 to 0.25 percentage points lower than 30-year mortgages. However, it means making much higher monthly payments.
Before buying a house, people don’t notice how much interest costs over the life of the loan. Thus, they pay higher interest charges the longer it takes to pay it down. To give you a better idea, let’s see the example below. Let’s say you borrowed a $350,000 home loan and compare it between a 30-year and 15-year fixed-rate term.
Mortgage loan amount: $350,000
To estimate your total mortgage payment, use this mortgage payment calculator.
The example shows that the 15-year fixed mortgage is $868.47 more expensive than the 30-year fixed term. However, in the long run, it saves you $140,825.80 in total interest costs. This is over half of the interest paid in a 30-year fixed mortgage. Moreover, you pay your debt sooner and gain home equity faster with a shorter term.
Ideally, if you can afford it, it’s better to take a 15-year or 20-year fixed mortgage. However, if you can’t, your next best option is to make extra payments on your monthly mortgage. Added payments help shorten your loan and significantly reduces your interest costs.
Make extra mortgage payments to boost interest savings
Making extra payments cuts years off your mortgage term. It saves you thousands of dollars on interest costs. This strategy also affords you flexibility. It lets you decide the amount of extra payments you can commit within your budget. Even adding $50 to your monthly payment can cut a year off your payment term.
How does this work? During the first few years of your loan, a greater portion of your mortgage payment goes toward the interest rather than the principal. Interest is the amount your lender charges to service your loan. The longer you take to pay your debt, the more interest accrues. Meanwhile, the principal is the amount you borrowed. A larger principal also generates higher interest charges.
When you make extra mortgage payments, the money helps pay down your principal. This reduces it a lot faster, especially during the first few years of the loan. In effect, the lower principal reduces interest charges. Likewise, making higher extra payments lowers your principal faster. It can shorten your 30-year mortgage by a couple of months to several years.
Here’s how added payments can cut years off your mortgage. Let’s suppose you borrowed $350,000 for a 30-year fixed mortgage at 3.9 percent APR. Compare your savings when you add $50 or $250 at the start of your monthly payments.
|Mortgage||Original Payment||Additional $50||Additional $250|
|Monthly Principal + Interest Payment||$1,650.84||$1,700.84||$1,900.84|
|Payment time||30 years||28 years, 5 months||23 years, 5 months|
|Time Saved||0||1 year, 6 months||6 years, 6 mons|
Based on the example, you’ll save $15,177.52 on total interest charges if you add $50 to your mortgage payment each month. You also remove a year and six months from your payment term. If you increase your extra payments to $250 a month, you’ll save $60,199.52 in total interest costs. It cuts your payment term down to 23 years and 5 months. You’ll save more and pay your mortgage faster if you make higher extra payments.
Ask about prepayment penalty first!
Make sure to check if your mortgage has a prepayment penalty. If you prepay your mortgage to a certain percentage, you’re required to pay a penalty fee. Before taking a loan, you can ask for a mortgage without a prepayment penalty clause. Some lenders may also allow you to prepay your loan up to 20 percent, after which they charge the penalty fee.
Prepayment penalties may offset any savings you make with extra payments. But the good news is most prepayment penalties after 2014 only apply during the first 3 years. You can wait for the prepayment penalty to lapse before making extra payments.
Set up a biweekly payment plan
Apart from making extra payments, you have the option to arrange a biweekly payment schedule. This splits your monthly payment in half, which pays your mortgage every other week. Since there are 52 weeks in a year, it’s equivalent to 26 half payments. It gives a total of 13 whole mortgage payments a year, instead of just 12 payments in a monthly schedule.
Taking our previous example, let’s calculate how much you’ll save with a biweekly payment plan.
|Original Payment||$1,650.84||Bi-weekly payment||$825.42|
|Total interest||$244,301.94||Total interest||$215,635|
|Total interest savings||0||Total interest savings||$28,666|
|Payment time||30 years||Payment time||26 years, 6 months|
|Time saved||0||Time saved||4 years, 4 months|
Based on the table, a biweekly payment shortens your mortgage term to 26 years and six months. It saves you a total of $28,666 in interest costs. Likewise, if you make extra payments, you will save a lot more and pay your mortgage sooner.
Biweekly payments can be arranged through your lender or a third-party service. However, it usually comes with setup fees and annual costs. Ask about there costs first so you can factor them into your budget.
If you cannot make monthly extra payments, another strategy is to save a lump sum which amounts to a 13th payment. You can add this to your mortgage payment each year. A large lump sum payment is also effective in reducing your principal.
The bottom line
Keep these mortgage budgeting strategies in mind when you’re buying a house. Always choose the lowest rate and save for a 20 percent down payment. This helps you save on interest charges and lowers your monthly payments. If you can afford it, it’s better to choose a shorter payment term.
Once you’ve secured your loan, budget for extra payments. Adding payments to your mortgage helps pay your debt sooner. It also helps you build home equity faster. Reducing your mortgage debt improves your credit score and allows you to qualify for future loans with lower rates.
Finally, once your mortgage debt is out of the way, you’ll free up cash flow for more important investments. Your hard-earned income can go towards sending your child to college and your retirement funds.
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