Editors' pick: Originally published Oct. 10.
With the housing crisis in the rearview, but pre-crisis behavior cropping up again, there's a difference between an ideal mortgage and the first mortgage you'll be offered.
The average 2016 college graduate is carrying $37,172 in student loan debt, according to college and scholarship site Cappex. That's up 6% from last year and has a huge impact on how first-time homebuyers approach the mortgage process. According to a survey of first-time homebuyers by TD Bank, 74% of Millennials (ages 18-34) say that saving for a down payment is the hardest part of buying a home. That doesn't include the $2,000 in unexpected costs that 62% of first-time homebuyers faced during the mortgage process, according to TD Bank's Mortgage Service Index
"It's encouraging to see Millennials thoughtfully prepare to enter the housing market," says Scott Haymore, head of pricing and secondary markets at TD Bank. "With today's affordability programs, owning a home doesn't have to be a dream, it can be a reality."
Eric Meermann, certified financial planner and portfolio manager with Palisades Hudson Financial Group in Scarsdale, N.Y., notes that the Federal Housing Administration offers insured loans to buyers who can only afford very small down payments -- sometimes as little as 3.5%. That mortgage comes with a lot more paperwork and a higher interest rate than those of a traditional mortgage, but just about any lender can help you get an FHA mortgage.
Just know that any time a down payment is under 20%, you're going to have to pay private mortgage insurance (PMI), which can jack up your monthly payment. There are ways around PMI, but they aren't always pretty.
"Consider a 'piggyback' mortgage, which lets you take out a second mortgage to cover part of the down payment," Meermann says. "These arrangements avoid PMI, but typically involve higher interest rates than single mortgages."
Another option: bringing on a cosigner. Nearly 25% (including 42% of Millennials) share a mortgage with someone other than a spouse -- including parents and siblings. However, before you latch your well-being to someone else's finances, Meerman says homebuyers should figure out exactly what they want to accomplish with their mortgage. Do you want to save money, minimize interest, tamp down monthly payments, maximize equity, eliminate debt quickly?
Where you stand financially may dictate your mortgage priorities, First-time homebuyers in their late 20s to mid-30 may have it the worst, as there are many ways to determine the down payment and monthly payment you can afford. Adjustable rate mortgages (ARMs) are appealing for homebuyers who aren't looking to settle down for decades at a time, but they're trickier for folks who are in it for the long haul. With mortgage rates already incredibly low, there's a very strong chance they'll only get higher in five to ten years.
"The costs of running a household can be a shock to new home owners," Haymore says. "Monthly expenses for utilities, homeowner's association fees, cable and internet, can add up quickly. Factoring these in at the beginning of the mortgage process can help borrowers assess their overall budget and determine a realistic monthly mortgage payment."
If you're in it for more than five to ten years, the best bet is still a 30-year fixed-rate mortgage. With rates hovering around 3.5% it's a great way of locking in that rate until you pay off your home. Unfortunately, it's also a great way to pay a whole lot of loan interest, which is why 20- or 15-year fixed-rate mortgages have become more appealing.
"But a shorter term means significantly higher monthly mortgage payments, even if the rate is lower," Meerman says. "You'll also have less liquidity."Whatever you do, don't pay points on your mortgage at closing. It gets you a lower interest rate and lower monthly payments, but paying interest up front means that you'll lose they interest you're paying if you sell the house before the mortgage term is up. Also, don't go into an interest-only mortgage if you can avoid it: You build no equity at the start of the loan, and any decline in property value will be tremendous. Finally, stay away from a "balloon payment" mortgages, as it'll require you to pay out a lump sum at the end of the mortgage.
However, if you get into your late 30s and 40s and suddenly have a bit of a cushion, don't just go making extra mortgage payments because you can. Most loans don't have penalties for early payments (but check if yours does just in case), so if you're just going to stick that money in a money market or savings account, you may as well try to pay off your mortgage earlier. However, if your extra money would be headed for a 401 (k), Roth IRA or 529 college savings plan, consider making the investment instead.
"Many could pay their mortgages down faster than required, but it's not necessarily a good idea," Meerman says. "If the expected rate of investment return is higher than the mortgage interest, including the benefit of deducting that interest, you benefit from leverage."
Finally, there's the opportunity for everyone to refinance under low rates. If you're refinancing a 30-year mortgage you've held 20 years, for instance, consider a ten-year fixed-rate mortgage. A home equity loan (second mortgage) or a home equity line of credit (HELOC) can be useful if you're the kind of person who can pay it back quickly. If you're not, it can be a nightmare.
"It can be tempting to view a home like a personal ATM, but if the home's value suddenly falls, it can be a bad situation," Meerman says.