A mortgage loan is a major long-term financial commitment. And the stakes are high because if you get the wrong mortgage when you buy a home, you could struggle to pay it for years to come or even find yourself getting foreclosed on.
To make sure you don’t make a serious mistake when taking on a huge debt, watch out for these three red flags that could suggest you’re setting yourself up for financial trouble.
1. Your mortgage is too high a percentage of your income
When you apply for a home loan, your mortgage lender looks at your credit score and also your debt-to-income (DTI) ratio. Your DTI is a measure of your total monthly payments relative to your income.
Some lenders will give you a loan if your DTI is as high as 57%. This would mean that more than half of all of your income would be devoted to covering your borrowing costs, including your mortgage and other debts such as credit cards and car payments.
Unfortunately, if you borrow as much as your lender allows and you have a very high debt-to-income ratio, this could leave you constantly struggling and with no money for other important expenses like retirement savings or even fun spending. You do not want to condemn yourself to 30 years of being house poor and constantly struggling to make ends meet.
To make sure you leave yourself plenty of money left over, you should aim to keep your total housing costs to no more than 25% to 30% of your income — regardless of whether a lender is willing to give you a larger loan than that.
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2. Your rate is adjustable
You have a choice of a fixed or adjustable-rate mortgage when you apply for a home loan. With a fixed-rate loan, you know exactly what your payment will be for the life of the loan. With an adjustable-rate loan, your rate and payment are only guaranteed for a period of time, such as five, seven, or 10 years. After that, they can change (often once per year).
When your rate adjusts, it might go up — and this could lead to payments increasing. Depending on how much your rate can rise, your payments could go up by thousands of dollars. Say, for example, you borrowed $500,000 on a 30-year mortgage with a starting interest rate of 7.00% that was guaranteed for 60 months and your rate could adjust upward by 0.25% every 12 months after that.
Your starting payment in this scenario would be $3,326.50. And the table below shows what could happen if your payment actually increased by that 0.25% for each payment thereafter.
| Payment Number | Interest Rate | Monthly Payment |
|---|---|---|
| 1 | 7% | $3,326.51 |
| 60 | 7.25% | $3,401.95 |
| 72 | 7.5% | $3,476.14 |
| 84 | 7.75% | $3,549.01 |
| 96 | 8% | $3,620.43 |
| 108 | 8.25% | $3,690.33 |
| 120 | 8.5% | $3,758.57 |
| 132 | 8.75% | $3,825.06 |
| 144 | 9% | $3,889.67 |
| 156 | 9.25% | $3,952.27 |
| 168 | 9.5% | $4,012.72 |
| 180 | 9.75% | $4,070.90 |
| 192 | 10% | $4,126.63 |
| 204 | 10.25% | $4,179.77 |
| 216 | 10.5% | $4,230.13 |
| 228 | 10.75% | $4,277.55 |
| 240 | 11% | $4,321.83 |
| 252 | 11.25% | $4,362.77 |
| 264 | 11.5% | $4,400.16 |
| 276 | 11.75% | $4,433.79 |
| 288 | 12% | $4,463.41 |
Data source: Author’s calculations
It’s important to understand just how high your payment could go, as you can’t assume you’ll always be able to refinance or move before it begins adjusting. While it may not increase by the maximum allowed every time, and it could even go down, you have to plan as if it will climb and make sure the mortgage would be affordable in a worst-case scenario before you move forward.
3. You have a balloon payment
Finally, some mortgages have a balloon payment. This means you typically make fixed payments for a period of time, such as five or 10 years, at the end of which you owe the entire balance on your home loan.
Typically, people take these types of mortgages to get lower starting payments on the assumption they will move or refinance before the balloon payment comes due. But there’s no guarantee that will happen or that rates will be affordable when they do need to get a new loan, so there’s just too much risk involved.
If you spot any of these three red flags, you should seriously consider whether moving forward with your loan is the right choice. You don’t want to commit to a loan that will leave you facing foreclosure or financial hardships over time.
