Buying your first home is an exciting opportunity, and for many, it’s fulfilling a lifelong dream. However, you’ll need to get a mortgage first. The key to picking the best mortgage for you is to understand the different types of mortgages, as well as the pros and cons of each.
Conventional Fixed-Rate Mortgages
With a conventional fixed-rate mortgage, the interest rate remains the same throughout the entire life of the loan. It’s no wonder why conventional fixed-rate mortgages are the most popular type of home loans. They usually have terms of 30, 15, or 10 years. A 30-year term is the most popular option, but a 15-year fixed-rate mortgage builds equity much faster.
Down payments with a fixed-rate mortgage can be as low as 3%. The biggest advantage of a fixed-rate mortgage is that you know exactly how much the interest and principal payments are for the entire length of the loan. Knowing exactly what your monthly payments are allows you to budget easily, and you can feel secure in knowing that your interest rate will never change. Plus, if you get a fixed-rate mortgage when market interest rates are high, you’re able to refinance once the market rates go down. If you get a fixed-rate mortgage when market rates are low, you keep that interest rate locked in for the entire life of your loan. However, you do pay a premium, as the interest rates of fixed-rate mortgages are usually higher than those of adjustable rate mortgages.
When applying for a fixed-rate mortgage, lenders typically like to see a credit score of at least 620-640, and there are usually higher rates for lower credit scores.
Adjustable Rate Mortgages
An adjustable rate mortgage (ARM) is a home loan in which the interest rate changes based on a specific schedule after a “fixed period” at the beginning of the loan. ARMs are considered to be riskier because the payments can change significantly, but, as a reward, you get an interest rate lower than that of a 30-year fixed rate mortgage. When you get a one-year adjustable rate mortgage, what you’re basically getting is a 30-year fixed rate mortgage on which the rates change every year on the anniversary of the loan. A one-year ARM allows you to qualify for a higher loan amount, and therefore purchase a more valuable home.
Many homeowners with large mortgages can get a one-year ARM that they can refinance each year. With a low rate, you can buy a more expensive home, and you pay a lower mortgage payment so long as market interest rates do not rise. But, because the rates on an adjustable rate mortgage can significantly change each year, you should try to pay extra on your mortgage payments in order to build up equity in case the market turns south.
Balloon mortgages work a lot like fixed-rate mortgages and last for a much shorter term. A balloon mortgage has an initial period of low or no monthly payments, and at the end of that period, you are required to pay off the full balance in a lump sum – a “balloon” payment. The reason why the monthly payments are lower is because it is primarily interest that’s being paid monthly. Balloon mortgages are great for responsible borrowers who intend to sell the home before the due date of the balloon payment. However, you can get into big trouble if you cannot afford the balloon payment, especially if you are required to refinance the balloon payment through the lender of the original loan.
Insured by the Federal Housing Administration, FHA loans allow down payments as low as 3.5% with a credit score of 580 or higher. FHA loans are best for buyers with little savings or lower credit scores, as they allow lower credit scores for approval than conventional loans. Because these loans are insured by the FHA, lenders are more willing to offer favorable terms to buyers who might not otherwise qualify.
FHA loans can be used to buy or refinance single family houses, two-to four-unit multifamily homes, condominiums, and some manufactured and mobile homes. There are also specific types of FHA loans that can be used for new construction or renovating an existing house. FHA loans are one of the only types of mortgages that allow you to pay 100% of your down payment using a gift from family, friends, an employer, or a charitable group. Also, since the down payment with an FHA loan can be as low as 3.5%, you don’t have to worry about saving as much for your down payment, and you can save your money for things like home repairs or an emergency fund instead.
You also do not have to have a social security number to qualify for an FHA loan, making this a good option for non-resident aliens, or employees of the World Bank or a foreign embassy.
The FHA does require a debt-to-income ratio of less than 50% to qualify for their loans. This means that your total monthly debt payments can’t be more than half of your pretax income. This includes debts that you aren’t actively paying. The FHA also requires a home appraisal (separate from a home inspection) to ensure that the home meets strict health and safety standards. FHA mortgage insurance lasts the full term of the loan when your down payment is less than 10%. Finally, your loan amount cannot exceed the conforming loan limit for the county in which your home is located.
VA loans are guaranteed by the US Department of Veteran Affairs, and help veterans & active duty military members purchase a home without requiring a down payment. VA loans do not require private mortgage insurance, so there are no recurring insurance payments. The credit guidelines are also much easier: there’s no minimum credit score, the interest rates are lower, and a higher debt to income ratio is allowed compared to other loans.
However, VA loans can only be used for primary residences, and a fee is required upfront to fund the loan. With a VA loan, the closing can take an extra 2-5 days, as it’s a much more complex transaction. Also, some sellers are disinterested in accepting VA loans. And, of course, VA loans are only available to active duty military members, reservists, and military veterans.
If you’re willing to live in a rural area, the US Department of Agriculture’s Rural Development Guaranteed Housing Loan Program can offer you a zero-down-payment mortgage. USDA loans are mainly for homebuyers who aren’t wealthy and can’t get a traditional mortgage. Since these loans are insured by the USDA, lenders will give you lower mortgage interest rates without a down payment.
Compared to other loan programs, USDA mortgage rates are some of the lowest available. The interest rates of a USDA loan are only matched by those of a VA loan, which is exclusive to veterans. However, you will have to pay a mortgage insurance premium if you put little or no money down.
USDA loans are mortgages for very low to moderate income applicants, and income limits vary by location and depend on household size. Only owner-occupied primary residences can be funded by a USDA loan.
To qualify for a USDA loan, you have to meet the USDA’s “ability to repay” standards:
- Income eligibility: you must have a steady job and a monthly income, proven by tax returns
- Credit requirement: your credit score must be at least 640
- Debt-to-income ratio: your monthly debt payments cannot exceed 41% of your pretax income
USDA loans have restrictions on where you can purchase a home. Metropolitan areas are excluded, but rural areas are always eligible. There are opportunities to purchase a home in suburban areas with a USDA loan, but they can be difficult to find.
So What’s Next?
- Select Your Loan Type & Compare Top Lenders:
After selecting the right type of mortgage for yourself or for your family, start by comparing the top mortgage lenders for each particular loan type that is right for your situation and financial goals. Make sure to compare quotes from at least three different lenders in order to get the best possible rates for your investment.
- Best Refinance Mortgage Lenders
- Best Fixed Rate Mortgage Lenders
- Best Reverse Mortgage Lenders
- Best Cash Out Mortgage Lenders
- Best Government Mortgage Programs
- Make Sure Your Debt & Credit Score are in Good Shape:
It is very important to improve your credit score before applying for a mortgage loan or even before refinancing your existing mortgage loan. Better credit scores will lead to better interest rates and lower monthly payments to the banks. Check your credit score here to get started!
If you have outstanding debt exceeding $10,000 from student loans, credit cards, medical bills or other personal loans, you qualify to consolidate that debt and reduce your monthly payments and overall amount owed back to the banks – this will allow you to have more money for your mortgage and also save more money moving forward. Check here to get a Free Quote on consolidating your existing debt.
- Get Pre-approved for your Mortgage Loan:
Once you have compared quotes from at least three or more mortgage lenders (from step 1 above) and confirmed that your credit score and debt are in order, get started on buying your home by getting pre-approved for your mortgage here. If you are refinancing, then get in touch with this year’s top refinance lenders like Quicken Loans, loanDepot and many more.
There are many options for homebuyers when it comes to choosing a mortgage. By understanding the different types of mortgages, as well as the benefits and risks of each, you will be able to choose the best home loan for you. Remember to do your research and shop around with different lenders to find the best deal once you decide which type of mortgage you would like.