Selecting the ideal mortgage type can make all the difference in your home-buying experience, but navigating all of the available options can be intimidating.
Before making a decision, take into account how long you plan to live in the home and if you’re comfortable with potential changes in interest rate levels. These considerations will help determine which mortgage option is most suitable for you.
Types of Mortgages
When purchasing a home, there are various mortgage types to consider. Each one has its own advantages and drawbacks, so you must decide which loan works best for your financial circumstances. Your decision should largely depend on factors like debt-to-income ratio (DTI), credit score and down payment amount.
A fixed-rate mortgage, also known as a conventional loan, is the most popular type of home mortgage. This loan has an established interest rate for the entirety of its duration – usually 30 years – which helps you budget and plan your monthly payments with precision. Furthermore, for those planning on living in their house for an extended period, this may be the ideal option.
Conventional mortgages are provided by private lenders such as banks or credit unions and require strict qualification criteria for those with steady income and a documented employment history.
Another type of mortgage is an adjustable-rate mortgage (ARM), which offers a variable interest rate that changes throughout the loan’s term. Some ARMs feature fixed rates for several years before increasing every year up to a cap. These mortgages may be costlier than fixed-rate options and come with stricter application criteria as well.
The Federal Housing Administration (FHA) offers several government-insured home mortgages to promote homeownership in America. FHA loans feature lower down payment requirements and credit score requirements than other types of mortgages, making them particularly appealing to first-time homebuyers.
Some borrowers opt to take out a second mortgage to access the equity in their homes, which can then be used for home improvements, college tuition or medical expenses. These loans are particularly popular among seniors 62 or older who have significant equity in their properties.
Another option for homeowners who need to purchase a new home but lack the time to sell their current property is a bridge loan. These short-term loans enable you to close on your new house before selling the one they currently own.
Adjustable-Rate Mortgages
Interest rates are an important factor when searching for a home. A fixed-rate mortgage offers more security, as your monthly payment remains consistent throughout the loan’s term. Conversely, an adjustable-rate mortgage (ARM) allows your interest rate to fluctuate with market fluctuations.
Arms usually offer lower introductory rates than fixed-rate mortgages, but these loans may not be the best choice for homeowners who plan to remain in their homes long term. Indeed, ARMs are often sold to consumers who will have difficulty repaying them when interest rates increase.
Some ARMs also contain errors that could prove costly for borrowers. These mistakes include an incorrect index date, incorrect margin or lack of interest rate change caps. Not only will these errors increase your loan costs but they may negatively affect your credit rating as well.
Most ARMs also feature initial and periodic caps to regulate how much an interest rate can change. These caps are indexed to the length of the initial fixed period, typically ranging from 2-3% above the Start Rate on three-year or longer ARMs up to 5-6% above that rate for five-year or longer ARMs.
Another popular type of ARM is a hybrid ARM, which combines an ARM with a fixed-rate mortgage. These products are often referred to as 3/1 ARMs due to their two year initial fixed rate period followed by an adjustment period of one year after that.
The rate on an ARM will reset according to a benchmark or index, such as the London Interbank Offered Rate (LIBOR). It could be directly tied to this index or simply be a margin that reflects the lender’s costs in borrowing money.
ARMs offer potential advantages and drawbacks; they allow borrowers to save money by paying down the balance early and reduce the overall amount of interest paid over time. Despite these drawbacks, ARMs remain an appealing choice for many consumers.
Due to this, ARMs are a popular option for first-time home buyers. Although they tend to be more costly than fixed rate mortgages, ARMs can be an advantageous option for borrowers who can afford increased monthly payments and are willing to accept the risk of changing interest rates.
Conventional Mortgages
Conventional mortgages are the most popular loan type available to home buyers. They’re originated, backed and serviced by private mortgage lenders such as banks, credit unions and other financial institutions. Conventional and nonconforming loans differ depending on whether they adhere to guidelines established by Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).
If you’re a first-time homeowner with good credit and low debt, conventional mortgages might be worth looking into. They typically provide lower interest rates than other types of mortgages and require only 3% down payment on the purchase price.
With a conventional loan, however, you must still pay for private mortgage insurance (PMI). PMI safeguards the lender’s investment in your loan; thus, it’s essential that you comprehend how it functions and what responsibilities come with it.
Conventional mortgages typically feature fixed rate terms of 10-30 years, making it simpler to plan your monthly payments and manage debt effectively.
Another great advantage of a conventional loan is that it allows you to cancel PMI once you reach 20% equity in your home. This can be especially advantageous if you plan on selling the house in the future, since FHA loans typically require that PMI remain active throughout the entirety of the loan term.
Conventional loans often have higher loan limits than FHA loans, allowing you to borrow more money for your home without incurring a high mortgage insurance premium. Furthermore, some lenders allow you to make both mortgage insurance and property taxes payments directly instead of placing them in an escrow account.
A conventional mortgage can help you purchase your dream home, second home or vacation property – and may even be suitable for real estate investors looking to finance multiple properties. Furthermore, you may use a conventional mortgage to refinance existing loans.
Conventional mortgages can be used for either your primary residence or secondary home, with tougher eligibility criteria than government-backed loans. Before applying for any mortgage loan, always check your credit score – free with Experian! If it’s 620 or above, there’s a good chance you could qualify for one of these mortgages.
FHA Loans
If you’re in the market for a home but lack the funds or credit score to put down as a down payment, an FHA loan could be your ideal solution. These types of loans are insured by the federal government, so lenders have less of a risk in approving your application.
They may provide leniency on debt-to-income ratios, making them an attractive option for those who struggle to meet conventional criteria. Your DTI ratio is the percentage of your monthly income used to pay off debt obligations such as mortgage, car payments and other costs; the lower this number, the better off financially you will be.
Additionally, FHA loans provide special programs for people looking to make energy-saving improvements in their homes. These initiatives enable homeowners to install solar panels and other equipment and reduce energy costs significantly.
Before applying for an FHA mortgage, it’s essential to have a budget and gather all necessary financial documents. Your lender will review your credit, debt, income and assets to determine your eligibility for the loan.
Borrowers who qualify for an FHA loan tend to be approved for higher amounts than those with conventional loans. That is because the federal government subsidizes mortgage insurance premiums on these loans, protecting lenders in case you default on your payments.
The government sets ceiling and floor limits for FHA loans based on the cost of living in an area. These limits can differ by county, with some areas such as Alaska, Hawaii and Guam having higher ceiling and floor limits than other parts of the US.
Loan limits vary based on a borrower’s credit score and down payment amount. First-time homebuyers or those with limited income may qualify for an FHA loan with as little as 3.5% down payment requirement.
You may be able to include a non-occupant co-borrower on your FHA loan. This person, such as a child or sibling, can assist with purchasing your home provided they meet the standard eligibility requirements.