When it comes to buying a house, most people know what they want: a bungalow or a condo, a hot neighborhood, or a sleepy street.
Mortgages, too, come in several styles. Recognizing which type to choose is just slightly more involved than, say, knowing you prefer hardwood floors over carpeting.
To pick the best loan for your situation, think about your situation. Will you be staying in this home for years? Decades? Are you feeling financially comfortable? Are you anxious about changing loan rates? Consider these questions and your answers before you start talking to lenders. (And before you choose a lender, read this.)
Next, understand the types of loans out there. There are lots of options, and it can get a little complicated. But you’ve got this.
Mortgages Are Fixed-Rate or Adjustable, and One Type Is Better for You
Let’s start with the most common type of mortgage, that workhorse of home loans — the fixed-rate mortgage.
A fixed-rate mortgage:
- Lets you lock in an interest rate for 15 or 30 years. (You can get 20-year loans, too.) That means your monthly payment will stay the same for the life of the loan. That said, your property taxes and insurance premiums will likely change over time.
It’s ideal when: You want long-term stability and plan to stay put.
Here’s what else you need to know about fixed-rate mortgages:
- A 30-year fixed-rate mortgage offers a lower monthly payment for the loan amount. For this reason, it’s more popular than the 15-year option.
- A 15-year fixed-rate mortgage typically offers a lower interest rate but a higher monthly payment because you’re paying off the loan faster.
Now let’s get into adjustable-rate, the other type of mortgage you’ll be looking at.
An adjustable-rate mortgage, or ARM:
- Offers a lower interest rate than a fixed-rate mortgage for an initial period of time — say, five or seven years. But the rate can fluctuate after the introductory period ends, depending on changes in interest rate conditions. So, budgeting can be difficult.
- Has caps that limit how high the rate can go.
It’s ideal when: You plan to live in a home for a short time or you expect your income to increase to offset potentially higher future rates.
Here are some other things you need to know about adjustable-rate mortgages:
- Different lenders may offer the same initial interest rate but different rate caps. It’s important to compare rate caps when shopping for an ARM.
- Adjustable-rate mortgages have a reputation for being complicated. The Consumer Financial Protection Bureau advises reading the fine print.
A rule of thumb: When comparing adjustable-rate loans, ask the prospective lender to calculate the highest payment you may ever have to make. You don’t want any surprises.
Conventional Loan or Government Loan? Your Life Answers the Question
Which fixed-rate or adjustable-rate mortgage you qualify for introduces a host of other categories, and they fall under two umbrellas: conventional loans and government loans.
Conventional Loans
- Offer some of the most competitive interest rates, which means you’ll likely pay less interest over the period of the loan.
- Require less paperwork than a government loan, so typically you can get a conventional loan more quickly.
Who qualifies? You usually need a credit score of at least 620 to qualify for a conventional loan. You’ll need to make a down payment of 3% or 5% for for a primary residence. But the tradeoff is you’ll need to pay for private mortgage insurance (see private mortgage insurance below).
If you’re not a first-time home buyer or you earn 80% or less than the median income in your area, the down payment requirement is 5%. If the house you’re buying has more than one unit, you may need to put down 15%. And if you’re buying a second home, you’ll need a down payment of at least 10%. If you’re getting an ARM, the minimum down payment requirement is 5%.
Here are some other things you need to know about conventional loans:
- If you put down less than 20% for a conventional loan, you’ll be required to pay private mortgage insurance, an extra monthly fee to help mitigate the risk to the lender if a borrower defaults on a loan. (PMI ranges from about 0.46% to 1.50% of your home loan, according to Bankrate.) The upshot: The lender has to cancel PMI when you reach 22% equity in your home, and you can ask to have it canceled once you hit 20% equity.
- Most conventional loans also have a maximum 43% debt-to-income ratio, which compares how much money you owe (on student loans, credit cards, car loans, and other debts) to your income — expressed as a percentage.
Fannie Mae and Freddie Mac set limits on how much money you can borrow for a conventional loan. A conforming loan is a home loan that conforms to these limits:
- In most cities, the maximum amount for a conforming loan is $766,550.
- In high-cost areas, such as New York City and San Francisco, the limit is $1,149,825.
- Limits are revisited annually and are subject to change based on each area’s average home price.
A home loan that exceeds these limits is called a jumbo loan:
- Jumbo loans typically require down payment of 10% to 15% and a credit score of at least 700.
- They also tend to have stricter debt-to-income requirements, generally preferring a debt-to-income ratio of no more than 43% and preferably closer to 36%.
In addition, consider practical matters before getting a jumbo loan too. Are you comfortable carrying that much debt? The answer depends on your current financial situation and long-term financial goals.
Government Loans
- Include loans secured by the Federal Housing Administration (FHA), U.S. Department of Veterans Affairs (VA), and the U.S. Department of Agriculture (USDA) Rural Development.
- Are meant to stimulate the housing market and enable potential those who may be unable to qualify for conventional loans to become homeowners.
Who qualifies? That depends on which government loan you’re looking at.
If you’ve had trouble qualifying for a mortgage because of income limitations or credit:
A broad swath of people, including those with lower credit scores and income, use FHA loans.
- You can get an FHA loan with a down payment of 3.5% if you have a minimum credit score of 580. You can still qualify with a credit score below 580 — even with no credit score — but the down payment and other requirements will be much higher.
- FHA loans conform to loan limits set by county; these limits typically range from $420,680 for lower-cost areas to $970,800 in high-cost areas. You can view the FHA mortgage caps for your county at hud.gov.
- If you get an FHA loan, you must pay an upfront mortgage insurance premium and an annual premium. MIP is based on home value but is often around 0.55% of the loan amount. Currently, the upfront MIP is 1.75% of the loan amount — so, $1,750 for a $100,000 loan. This premium can be paid at the mortgage closing or rolled into the monthly mortgage payment.
Also, a heads-up — the date an FHA loan was issued affects the MIP.
- If you received an FHA loan on or before June 3, 2013: You’re eligible for canceling MIP after five years, but you must have 22% equity in your home and have made all payments on time.
- If you received an FHA loan after June 3, 2013: To stop paying MIP, you’d have to refinance into a conventional loan and have a current loan-to-value of at least 80%.
If you’re in the military, a veteran, or a veteran’s spouse:
- VA loans offer active or retired military (or a veteran’s surviving spouse) a mortgage with a 0% down payment.
- VA loans also can have more lenient credit requirements. There is no minimum credit score requirement for a VA loan, but most mortgage lenders want a FICO credit score of at least 620.
- The VA allows lenders to charge only 1% maximum to cover the costs of originating and underwriting the loan, so you save money at closing. There is, however, an additional upfront, one-time funding fee based on the amount of your loan and other factors, according to the U.S. Department of Veterans Affairs.
VA loans also don’t charge borrowers mortgage insurance — potentially helping you save a significant chunk of cash on your monthly payment.
Given the benefits, a VA loan is often the best mortgage option for people who qualify.
If you have a limited income and live in a small or rural town:
USDA loans are for limited-income home buyers in towns with populations of 10,000 or less or that are “rural in character.” Some areas that now have bigger populations are grandfathered in. You can see whether your town is eligible on the USDA’s website.
- USDA loans typically have lower interest rates than non-USDA loans.
- Down payments can be as low as 0%.
- USDA mortgages also have more lenient credit score requirements than conventional loans. A score of 640 or higher is needed to qualify to use the USDA’s automated underwriting system.
- Income limits to qualify depend on location and household size.
- USDA loans charge an upfront mortgage insurance fee of 1% of the loan amount and annual mortgage insurance premium of 0.35%.
- And USDA loan borrowers must buy a “modest home” — a property with a market value deemed reasonable for the area, though the USDA does not set specific price limitations.
Only a select number of lenders offer USDA loans; here’s a list of USDA-approved lenders nationwide.
If your job is to help people:
Niche programs, like the Good Neighbor Next Door from HUD, provides teachers, law enforcement officers, first responders, and government workers with a substantial incentive in the form of a 50% discount off the list price of eligible properties in revitalization districts.
Note: Down payment assistance programs offer qualified buyers such support as grants and interest-free loans. Start with your state’s housing finance agency to find options.
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Now You Know the Basics. It’s Time to Call for Backup
Ultimately, you’ll be working with your loan officer or broker to narrow these choices and find a loan that works for you and your finances. (That’s another reason it’s important to choose a lender you’re comfortable with.)
Your real estate agent should be able to offer some insight, too. And because they don’t earn a paycheck from your loan selection, their advice about mortgages should be impartial.
You know your stuff. And you know who to ask for help. Who’s overwhelmed? Not you.
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