What You Don't Know About Mortgages Could Cost You

By Markets Fool.com

Getting a mortgage is a big deal -- since the largest investment(s) you ever make in your life will probably be the home(s) you buy. Thus, for maximum benefit and in order to more easily reach your financial goals, learn more about how mortgages work and how you should best go about securing one. Here are five valuable tips.

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Don't pay more than you have to when buying a home. Image source: Getty Images.

Shop around for the best rate

First off, understand that interest rates vary and a little time spent shopping around can help you get a better rate. A seemingly small difference in your rate can actually make a big difference in the long run, as mortgages involve big balances and long payment periods.

For example, imagine that you're buying a $250,000 house and taking out a $200,000 mortgage at 3.75%. Your monthly payments will be about$926. If you got a 3.6% rate, though, those payments would fall to $909 per month. That's a difference of $17, but multiply it by the 360 payments you'll make over the life of a 30-year mortgage, and it comes to $6,120 -- a rather meaningful sum.

Different lenders use different calculations when they evaluate your credit-worthiness and offer you an interest rate. Check with your own bank(s) first, as they may give you a bit of a discount on the interest rate because you're a customer. But check with other banks, too -- and with credit unions, which often offer lower interest rates. You might also consult a mortgage broker. They often offer a wide range of loans and can be especially helpful if you have an underwhelming credit record. A visit to Bankrate.com can help you zero in on the best rates in your area and beyond.

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Image source: Getty Images.

A poor credit rating can give you lousy interest rates

Don't ignore your credit record and credit rating, as they can make a huge difference in the rates you're offered for a mortgage. For example, check out these sample rates recently listed at MyFICO.com: If you're borrowing $200,000 via a 30-year fixed-rate mortgage and you have a top FICO score, in the 760 to 850 range, you might get an interest rate of 3.28%, with a monthly payment of $874 and total interest paid over the 30 years of $114,684. If your score was 630, though, your rate would be 4.87%, with a monthly payment of $1,058 and total interest of $180,899. That's $184 more per month ($2,208 per year) and a whopping $66,215 more in interest.

If you don't have a good credit score, it can be smart to spend some time boosting it before starting to buy a home. Ways to do so include fixing errors in your credit record, paying bills on time, and reducing your overall debt load.

Avoid disasters by getting a sensible loan. Image source: Getty Images.

Get the right kind of mortgage

It's also critical to get the right mortgage. You don't want to borrow so much money, for example, that it's hard to make your monthly payments. A common guideline is to spend no more than 25% to 30%of your gross monthly income on housing (including property taxes and insurance). Don't just apply that blindly, though. Consider your particular situation. How secure is your job and income? Are you carrying much other debt? Do you have a well funded emergency fund? Are your retirement funds growing according to a good plan? Buying less home than you can afford will give you a margin of safety and help you be able to save.

You also want to get the right kind of mortgage. You might favor an adjustable-rate mortgage (ARM), for example, for its lower initial rate -- but it's not a great option if you plan to be in the home for a long period, during which interest rates (and your payments) can surge. When interest rates are low, as they are now, fixed-rate loans are generally preferable -- unless you know you won't be staying in the home long.

Consider a 15-year mortgage, too, instead of a 30-year one. It will have you paying far less in interest over the life of the loan -- and you can get a lower interest rate, too. For example, if you borrow$200,000 at 3.5%, you'll pay about $900 per month over 30 years, but borrowing that at 3% for 15 years can cost you close to $1,400 per month, but you'd pay less than $50,000 in total interest, vs. more than $120,000 with the longer loan. You do face steeper monthly payments, but you save more than $70,000 in total interest. (If the steeper payments frighten you, consider buying a little less house and borrowing less.)

Finally, know that you can reduce your interest rate by paying "points" when you take out your loan. A point is equal to one percent of your loan. So if you have a $200,000 mortgage, paying a point would cost you $2,000 -- and it will typically lower your rate by 0.25 percentage points. Pay two points and you can turn a 3.75% rate into a 3.25% one. That can be a smart move -- but only if you plan to stay in the home a long time, long enough to make up in savings what you paid in points.

Image source: Getty Images.

Aim to pay 20% down

It's also smart to aim to have a down payment of at least 20% of the value of the home. Paying less than 20% down on a new home means you'll have to take on an extra loan in the form of private mortgage insurance (PMI), which will increase your monthly payment. A low down payment can also result in a higher interest rate. Another downside of a small down payment is that if home values drop during your ownership period, you can be left with an "underwater" mortgage, where you owe more than the home is worth. That can make it hard to sell the home.

Be able to prepay

Finally, make sure that any mortgage you sign up for allows you to make prepayments -- to pay more than you're required to in any month. Prepaying is a powerful savings strategy, as it can decrease your loan balance much faster than the original schedule and can save you a lot in overall interest payments. In fact, if committing to the higher payments of a 15-year loan has you nervous, you might get a 30-year one but just pay considerably more than you have to each month. Doing so can turn a 30-year loan into one that's paid off after just 15 or 20 years.

The more you know about mortgages and the smarter decisions you make when you take one out, the more you can save. You may well save tens of thousands of dollars!

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Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.