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Financing

4 Times It Makes Sense to Pay More (Yes, More) for Your Mortgage

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When shopping for a mortgage, it's all too tempting to go for the rock-bottom option -- in other words, whatever will keep your monthly payment as low as possible. Yet bargain hunters should beware: Extremely low interest rates or monthly payments may look great at first glance, but they aren't always the smartest option for every circumstance.

Here are four instances where you're better off paying a bit more per month for your home loan, and why you'll reap the benefits down the road.

Reason 1: You want your interest rate to stay constant

Probably the biggest reason not to reach for the lowest interest rate on the block is that it's often attached to an adjustable rate mortgage, or ARM. This type of loan offers extremely low rates for the first five or seven years of the loan, which is great for certain circumstances (say, if you're definitely planning on moving before that time is up). However, if you're planning on staying put longer, an ARM is risky since after the initial low-interest period, the interest rate adjusts to reflect market indexes and could shoot up considerably.

The safer bet is to get a fixed-rate mortgage -- which typically has a higher interest rate than an ARM, but its saving grace is that it remains the same over the life of the loan (which may last up to 30 years).

"Borrowers may choose to pay the higher rate on the fixed-rate mortgage because it gives them the peace of mind to know that the rate isn't going to change," says Michelle Bobart, a senior vice president of mortgage lending and branch manager with Guaranteed Rate. This is especially true today, because rates are at near historic lows and expected to move upward.

Reason 2: You're rolling in your closing costs

Buying a house is the most expensive transaction that most people will make in their lives. Plus, on top of that hefty down payment and moving expenses, you'll need to cough up more money at the end of the process for closing costs, which include things such as fees and taxes and can run around 3% of the value of the loan. What if you just don't have enough cash to cover it?

Luckily, some lenders will offer buyers the option of not paying these costs at closing. Instead, they will either add it on to the principal of your loan or to the interest you pay on it. This pay-it-later approach is a smart option if you're worried about the levels of your cash reserves. After all, paying a bit more per month may be worth it if it allows you to eat or maintain a small emergency fund.

Reason 3: You're paying PMI

Immediately after the housing bust, it was difficult to get lenders to offer loans to buyers putting down less than 20% on a home. Credit availability has loosened up since then, with some programs offering mortgages for down payments as low as 3.5%. The catch? Any mortgage for less than a 20% down payment now typically requires private mortgage insurance, an added monthly fee that protects the lender should you default on your loan.

While your knee-jerk reaction might be to avoid PMI no matter what, it does make sense sometimes to take on this added monthly expense. One obvious example is if you just can't afford a 20% down payment. Or perhaps you can, but you'd have to tap investments that would trigger costly taxes or fees if withdrawn.

"It can be a tactical decision to take a loan with mortgage insurance," says Keith Gumbinger, vice president of mortgage research site HSH. Use this calculator to get a sense of how the size of your down payment will affect the cost of your loan.

Reason 4: You're skipping points

Some lenders give buyers the option of paying points at closing to "buy down" the interest rate on their home loan. Which sounds great … but only if you have the cash to afford them and you plan to stay in your home long enough to reap the benefits. Otherwise, they're an added expense that isn't worth the lower rates.

For instance: Let's say you've got a 30-year, $400,000 loan. At an interest rate of 5%, you'd be paying $2,147 per month. Now, let's say you buy 2 points, which will lower your interest rate by a total 0.5 percentage points, to 4.5%. This will drop your monthly payments to $2,027 over the life of your loan. Still, you'll have to pay a total of $8,000 for those points upfront.

Should you buy them? It all comes down to how long you'll live in your home. In the above scenario, you'll have to stay there 5.5 years to recoup the cost of those points. So if you're planning to stick around, see what you can do to pay points. But if you're planning to move, it's a waste to buy points, even if they do win you a lower interest rate.

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Related: A Realistic Look at Budget and Trade-offs