Mortgages, car payments, and student loans are likely to be the three largest expenses in your life. As with most financial products, there are a ton of weird terms and rules that go along with getting a mortgage.
In this article, we want to arm you with the knowledge to get the best possible mortgage when you buy your dream home.
What is a Mortgage?
A mortgage is a loan for the specific purpose of purchasing a property.
The origin of the word “mortgage” literally means “death pledge”. It’s supposed to mean that your pledge ends (or “dies”) when you pay the money back or the bank takes your house through foreclosure.
With a mortgage, a financial institution typically lends you anywhere between 80%-95% of the money required to buy your home. The remaining 5%-20% of the cost of the home has to be put up by you through what they call a down payment.
When it comes to repaying this loan, the period is typically fairly long – usually 15-25 years.
A mortgage is considered a “secured” loan. This means that there is an asset (your home in this case) that the banks can take from you if you are unable to make the monthly payments. Some mortgage lenders may also require that you take out mortgage insurance, which would cover the remaining amount on your mortgage if you go bankrupt.
How Much Can I Borrow For a Mortgage?
There are a lot of factors that determine how much you can borrow for a mortgage. These factors include:
Here is a rough estimate of how much you can borrow for a mortgage based on your annual income assuming average debt levels and expenses.
One interesting thing to note from the table above is that a slight increase in income will result in a large increase in the size of the mortgage you can borrow. This is because there is a minimum basic level of income you need in order to survive. This includes things like buying food, water, and paying rent. All of the income above that level is considered “disposable” and can potentially be used towards paying off your mortgage.
If you want a detailed breakdown of how much you can afford, the easiest way is to go to your bank’s mortgage calculator and input all of your data.
Most banks will usually allow you to borrow more than what they show online, but they may have to do more paperwork to get the approval from head office if you’re near your maximum borrowing limit.
Even though buying a new home is super exciting, we recommend that everyone take an honest look at how much they can afford.
For most people, the purchase price of their home should be less than 3X their pre-tax household income. This means that if you make $50,000 a year, then it’s best to keep your house purchase price below $150,000.
Next, let’s take a look at the two most common types of mortgages: fixed rate, and adjustable-rate (also called variable rate).
Fixed Rate Mortgages
A fixed rate mortgage means that your interest rate will remain the same for the entirety of your mortgage term. For example, a “five year fixed mortgage at 3%” means that your interest rate will be 3% for five years. No matter what. Guaranteed.
The great thing about a fixed rate mortgage is that you will know exactly how much you have to pay every single month. If the interest rates end up rising, then you’re still sitting pretty since your rates are locked in.
The downside of a fixed rate mortgage is that the rate you get will be higher than an adjustable rate mortgage. Also, if interest rates end up falling you don’t get to enjoy the benefits of that.
Adjustable Rate Mortgages
An adjustable (sometimes called variable) rate mortgage means that your interest rate will go up and down depending on market conditions. For example, if the Federal Reserve raises interest rates, then your mortgage interest rate will likely rise with it.
People like adjustable rate mortgages because the rate is typically lower than what a fixed rate mortgage offers. This is because an adjustable rate mortgage is less risky for banks since they can change the interest rate on you at any time. If the interest rates end up falling, then your mortgage rate will fall with it.
The downside of an adjustable rate mortgage is that if rates start to rise, then your payments will rise along with it. In the past there have been examples of interest rates rising very rapidly, and forcing lots of people to lose their house. Make sure you understand how much of an interest rate rise you can tolerate before having to give up your home.
Which type of mortgage should you get? We recommend going with a fixed rate mortgage so that you’re not exposed to interest rate increases.
Three Things to Watch out for With Mortgages
People on the Credit Carrots team have all been through the mortgage process. We polled our staff, and came up with the top three things that you should watch out for when getting a mortgage.
Fees. Fees. Fees. As with any financial transaction, you can be sure that the lender is looking to maximize their profit by charging you fees. Make sure you factor in the fees before you pull the trigger. Some of the common fees are home appraisal fee, home inspection fee, lawyer fee, and the generic “application fee” (seriously we have no idea why some banks charge this).
Keep in mind that if you’re a good customer with a decent credit score, the banks will often be willing to waive most if not all of the fees. On the last mortgage that we got, the banks waived all of the fees for us.
2. Down Payment
We recommend putting a 20% down payment when you purchase a house.
Banks might try and entice you to put less than 20% down by offering you a lower interest rate, which sounds like a pretty good deal right? You can put less money down upfront and also get a lower interest rate? Sign me up!
Not so fast. Banks want you to put a smaller down payment so that the principal amount that they can charge interest on is higher. Furthermore, most banks will require you to have mortgage insurance if you put less than 20% down. If you can’t put 20% down upfront, then you should reconsider the price of the home you’re buying.
3. Breaking Your Mortgage Early
Life happens, and sometimes you have to get out of your mortgage early. Maybe you got a great job in another city. Maybe you can’t stand your job and have decided to quit it all and sell your house. Whatever the case may be, you will want to make sure you understand what’s involved with paying off your mortgage early, and what penalties you face.
Lenders don’t want you to pay your loan early because they want those juicy interest payments.
Read the mortgage penalties section of your contract carefully before signing.