Mortgage 102: Some Common Mistakes

Prepared by Roman Shulman
Roman is a mortgage professional who brings exceptional reputation, years of experience and advanced education in several areas to the table, and has received many praises from his clients as well as other members of the trade. He holds a Bachelors degree from Northeastern University and a Masters degree from Brandeis.


 

Five Costly Mistakes Borrowers Tend to Make

Borrowers are at times guided by experiences of others (parents, siblings, friends, colleagues), but those experiences may be somewhat irrelevant to their individual situation. Borrowers should really consider their own finances, lifestyle, and changes likely to occur in the near future when deciding on the mortgage product and rate/cost option. Here are some of the most common mistakes which arise from trying to follow somebody else's path.

Selecting longer than necessary loan term

Borrowers often opt for the most popular loan product - the 30 year fixed. But many people can actually qualify for a shorter loan terms and possibly better rates which come with them, and pay less interest. Here is a sample comparison of interest paid on 30 year and 15 year loans.

Example: 200,000 loan, calculations are based on average rates seen on 03/26/2015:

Loan Product Rate Interest Paid
Over 5 Years Over Life of Loan
30 Year Fixed 3.625 $34,503 $128,356
15 Year Fixed 2.875 $24,795 $46,451
 

The borrower on a 15 year term loan would have saved $9,708 on interest over the first five years of the loan term, and $81,905 in total interest paid (assuming regular payment schedule).

Conclusion: One should optimize the loan term based on the ability to repay. You may be able to qualify for a shorter loan term and save on interest due to faster repayment and a lower rate.

Making it all about the rate at all cost

Many borrowers insist on the lower rates as if it were some kind of sport, while not paying enough attention to the other key component - their cost. Rate and cost should be viewed together, and opting for a higher rate and lower cost option may be financially more sound.

Example: 300,000 loan, calculations are based on average 30 year fixed rates seen on 03/26/2015:

Rate Charge (+) or Credit (-)
For the selected rate
Payment (P&I)
3.500 $1,875 $1,347
3.625 ($1,125) $1,368
 

The cost difference between the two options is $3,000 (3.5 comes with a charge while 3.625 comes with credit), while the payment difference is $21/mo. It would take almost 12 years to recover the additional cost of the lower rate.

Conclusion: Lower rate is not always better. Opting for a slightly higher rate can significantly cut upfront costs.

Ignoring adjustable rate loan options

Not everyone needs a fixed rate loan. A fixed rate loan is similar to having an insurance policy - you agree to pay higher rates now in order to avoid having to pay higher interest later. While adjustable rate loans do carry a risk (you may not be able to refinance and may have no choice but to pay higher interest), the worst possible outcome will not become reality for most. Many borrowers do change their mortgages every few years for a variety of reasons - changes in financial situation, opportunities to refinance into lower rates, sale, etc.

Loan Product Rate
Interest Paid Over 7 years
30 Year Fixed 3.625 $45,529
7 Year ARM 2.875 $35,491
 

The borrower on a 7 year ARM in this example would save 10,078 over the first 7 years.

Conclusion: One may be able to save on interest opting for an adjustable rate product, although it requires some risk tolerance

Making emotional decisions when faced with rising rates

Rates always make normal up and down fluctuations, reacting to various news. Rarely rates take off and don't return for a very long time. Yet, most borrowers tend to assume just that upon seeing a few days of rising rates while preparing for a transaction. Imagine - your offer is accepted, you are doing an inspection and then moving to the purchase agreement while watching rates rise by 0.375% over a few days. You start panicking and lock immediately as you and the seller sign the P&S, just to find rates subsiding two weeks later. In 90% of situations that's exactly what happens, and you would have been better off waiting and not locking outright. Of course, there is a risk - what if you happen to fall into the not so lucky 10% category? You might still want to wait, and if the market does not return or continues to worsen, consider doing the opposite of what your family and friends might be telling you - select a zero closing costs option, albeit with a higher rate. More likely than not the market will still be returning to its prior levels, only it might take a bit longer. You'll refinance into a lower rate then and will have saved on upfront costs of the original loan. And if it happens that the market never returns, well, you'll still have a great rate for which you didn't encounter any upfront costs. A word of caution: while this approach has worked most of the time, prior statistics do not guarantee future results.

Utilizing all available savings to maximize down payment

It's true - higher down payment does result in better loan terms. Someone putting 25% down will see a slight price improvement on many loan products compared to the terms with 20% down payment, all other factors being the same. But if this causes your savings account to approach zero as a result, your furniture and window shades purchases will be charged to a credit card and kept there for some time, causing you to pay credit card interest, which is higher than mortgage interest and is not tax deductible. Consider carefully what allocating more funds for the down payment will do to you over the next few months after you purchase a new home, which will almost certainly require some tender loving care, or at least furnishings.