“Home Mortgage Planning Can Save You Money – Part II”
Last week, we started to discuss how difficult it is to choose from the more than 200 varieties of home mortgage options. This week, we’ll continue to help clarify the mortgage decision process.
Is Private Mortgage Insurance (PMI) a bad thing? In this competitive environment, some mortgage bankers will loan 100% of a home’s purchase price. But if your down payment is less than 20% of the purchase price, you will likely be charged private mortgage insurance (PMI) which will increase your effective interest rate by .25% or more. Over a long period of time, PMI will significantly add to the costs of home ownership. One way to avoid PMI is to do a ‘split loan’ whereby you take out a conventional mortgage for 80% of your home’s value and use an Equity Line of Credit (ELOC) for the balance. The interest rate on your ELOC will likely be higher than your underlying conventional loan, so use any extra cash flow towards payoff of your ELOC first.
How big a mortgage is too big? Mortgage companies are adept at calculating how large a mortgage you can maintain without risking having to foreclose on the property. It is true that the amount they are willing to loan you is an amount you can afford but generally, it is more than you should borrow. The typical limits are a mortgage payment (principal, interest, taxes and insurance) equal to 28% of your gross income or all debt payments equal to 36% of your gross income. If you accept this offer, you will have little money left over for other important goals such as retirement funding, college funding, family vacations and the other extras that make life a pleasure. I recommend that you limit all debt payments, including mortgage payment, auto loans, credit cards, etc. to a maximum of 30% of your ‘take-home’ pay. This means less house but a lot more fun in your life.
Should I prepay my mortgage? Virtually every mortgage company promotes its own version of the biweekly mortgage payment plan. These plans have you make mortgage payments every two weeks instead of monthly, resulting in one additional payment a year. This ‘extra’ payment serves to reduce the term of your mortgage and can significantly reduce the interest that you pay over the life of the loan. Sounds like a good idea, right? Maybe. First, if your mortgage interest rate is low, less than 6%, your extra cash may be more productive invested elsewhere—your company’s matching 401(k), an IRA, your child’s 529 college savings plan. If you do decide to make extra payments on your mortgage, avoid the fees associated with the biweekly payment plans and simply send the extra money to the mortgage company as a separate check and write ‘extra principal payment’ on your check.