3 Mortgage Rules to Live By

By Markets Fool.com

Your mortgage is probably the biggest debt you'll ever owe. In order to handle your mortgage debt wisely, it's important to know exactly what you're getting into and how you can best take advantage of the opportunities a mortgage offers while also avoiding potential pitfalls. Below, you'll find three mortgage rules that can help make your life as a homeowner a little bit easier.

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Rule 1: Know exactly how much you can afford to pay toward your mortgage.

Many lenders have hard-and-fast rules governing how much they'll allow you to borrow. Among the most important things they'll look at are how much income you make and then compare it to all the typical costs of owning a home. These include the principal and interest on your mortgage, as well as property taxes you'll owe every year and the cost of homeowners insurance.

Lenders prefer to see borrowers spend somewhere between 25% and 30% of their gross income toward these housing costs. In some cases, you can find financial institutions that are willing to offer larger mortgages on which payments can amount to 30% to 40% of your gross income, and you might even be able to get more leverage in isolated instances. However, the danger in overextending yourself is that the higher your mortgage payment and other related home expenses compared to your income, the more vulnerable you are to potential financial setbacks.

Also, lenders will look at your other debts. If you don't owe anything else on items like auto loans, credit cards, or other obligations, then a lender is more likely to lend toward the higher end of the percentage range above. However, if you have extensive outside debt, then a careful lender won't even let you borrow 25% of your income toward a mortgage.

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Rule 2: Save by making a hefty down payment.

It's challenging to build up enough savings to put money down on a home, and many homebuyers gravitate toward loan types that allow minimal down payments. However, if you can manage it, making a large down payment of 20% or more of the cost of your home has some real advantages.

The most obvious and valuable thing that a big down payment does is that it saves you the costs of private mortgage insurance. Lenders will usually make borrowers pay for PMI if the value of the loan is more than 80% of the home's value, and it can cost you as much as 1.5% of the value of your loan every year, depending on your credit rating. Therefore, on a $200,000 home, being able to put down $40,000 or more can save you $3,000 year in and year out in what you would have had to pay for private mortgage insurance.

Rule 3: Don't use adjustable rate mortgages unless you fully understand how they work.

Most homeowners use fixed mortgages because they're simple to understand. Every month for the life of your loan, you make exactly the same mortgage payment. By contrast, adjustable rate mortgages aren't like that. With an ARM, your interest rate resets from time to time, and if interest rates have changed in the interim, then your monthly payment can change as well.

Various types of adjustable rate mortgages have different characteristics. You'll often see an ARM described with two numbers, such as a 5/1 ARM. The first number refers to the number of years during which your initial interest rate is fixed. After that, your rate will adjust periodically as measured by the second number. So for a 5/1 ARM, your rate is fixed for five years and then adjusts every year thereafter.

Rates on ARMs tend to be lower at first than corresponding fixed mortgages. However, because of the risk involved, even an initial low rate on an ARM can leave you vulnerable to paying more in interest over the entire course of the loan. Unless you're expecting to sell your home within the initial rate period, adjustable rate mortgages involve substantial risks of seeing your monthly payments skyrocket over time.

Mortgages can be complicated, and there's a lot on the line, so you need to make smart decisions. By keeping these mortgage rules in mind, you can put yourself in a better position to avoid huge mistakes and instead be happy with your home purchase.

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