Choosing the Right Kind of Mortgage
Attractive lower payments could end up costing you thousands more in the long run.
Buying a home and choosing the right mortgage are two of the most important decisions of your life. Making a hasty or foolish choice could leave you thousands of dollars poorer and saddled with a lot of homeowner headaches, too.
Mortgage documents are legally binding and describe your responsibilities and any restrictions. But it doesn't take long after cracking one of open to realize that it can be a bit complicated and confusing. So, to help you make an educated mortgage decision, we've put together a primer on the basics of what's involved and the issues that could affect you later on.
A mortgage is a loan issued to buy a home. While there are many lenders and types of mortgages, they all use a common language to describe the mortgage details.
The amortization period is the total length of time it will take to pay off the loan if you make the regular payments specified in your mortgage documents.
In the U.S., amortization periods are commonly 15 or 30 years, although a few mortgages have a 40-year amortization. Government-insured mortgages are typically no longer than 25 years.
A fixed-rate mortgage has a set interest rate throughout the life the loan. That sounds like an attractive option for the borrower, but there is a catch. Lenders will charge a higher interest rate when they "lock in" the interest to compensate for potential losses in case interest rates rise.
Many homeowners choose a 30-year fixed rate mortgage because of the low payments. But a long amortization period costs you more overall due to the additional interest that accrues on the loan over time. Shorter 15- and 20-year mortgages have higher payments but they will build equity (the difference between what you owe and the value of your home) more quickly and reduce your total interest costs.
Adjustable Rate Mortgage (ARM)
Adjustable rate mortgages have a lower initial interest rate. the rate could, however, increase significantly when it's time to renegotiate your mortgage.
ARMs can work well if interest rates are relatively stable or if you sell your home in a few years before they have a chance to rise. You enjoy lower payments, and can save or invest the extra money instead.
An important factor to look at before you decide on an ARM is how frequently the interest rates are adjusted. Lenders offer various ARMs and amortization periods, such as:
- 3/1 ARM – Interest rate changes every 3 years throughout a 27 year amortization period
- 5/1 ARM – Interest rate changes every 5 years throughout a 25 year amortization period
- 7/1 ARM – Interest rate changes every 7 years throughout a 23 year amortization period
- 10/1 ARM – Interest rate changes every 10 years throughout a 20 year amortization period
Qualifying for a conforming mortgage depends on your financial situation and specific guidelines.
If you qualify for a conforming mortgage, you’ll probably enjoy a lower interest rate, and a simpler, speedier process. Generally, the limit for a conventional loan is $424,100 for a single-family dwelling, but it varies by region.
These mortgages usually require at least a 5 percent down payment and a FICO credit score of 740 or higher (find out How Your Credit Score Affects Your Insurance Rates).
Non-Conforming or “Jumbo” Loans
If you want to borrow more than $424,100, you’ll need a jumbo loan. They typically have higher interest rates, and require a bigger down payment than conforming loans.
You’ll also need excellent credit to qualify, but jumbo loans may not require mortgage insurance, even if your down payment is less than 20 percent.
Many people want to buy a home but don't meet conforming loan requirements. Luckily, the government offers several loan types that may still allow them to obtain a mortgage.
Federal Housing Administration (FHA)
The Federal Housing Administration offers loans to people with a smaller down payment or with less-than-perfect credit. Buyers may qualify with a down payment as low as 3.5 percent, or a 500 FICO score if they can put 10 percent down.
Unfortunately, FHA loans also include hefty fees. If you put less than 10 percent for a down payment, you will pay a mortgage insurance premium upfront and monthly insurance fees until you pay off the mortgage, or refinance with a conforming mortgage. Because of this, a conforming mortgage is always the preferred option if you can qualify for one.
Veterans Administration (VA)
If you’re a veteran or active in the military, definitely look into VA loans. They’re guaranteed for qualified personnel and often waive the down payment and mortgage insurance.
United States Department of Agriculture (USDA)
Low- and moderate-income applicants may qualify for a loan to buy a home in a rural area and some suburban areas, too. They offer below-market interest rates without a down payment.
Your mortgage payments depend on the amount you borrow, how long you take to repay the loan, and the interest rate.
Most (but not all) mortgage payments include principal, interest, taxes, and insurance (collectively referred to as PITI). The amount paid toward the principal (the original loan amount) increases with each payment, while the amount paid toward interest decreases.
Initially, almost your entire mortgage payment goes toward paying the interest. This allows your lender to collect as much money as they can quickly in order to minimize the risk of lending such large sums of money.
Higher interest rates mean higher mortgage payments. And higher payments mean you qualify for a smaller mortgage and a less expensive home. Even a slightly higher interest rate means you’ll pay thousands of additional dollars over the length of the loan.
Government bodies levy taxes annually to pay for public services. Your lender will come up with an estimate of those taxes for the following year and divide it equally across your payments. They will hold on to that money and use it to pay the taxes when they’re due.
Private mortgage insurance (PMI) protects the lender against risk if you should default on your loan. Once you have sufficient equity in your home, lenders may allow you drop this coverage. You will also need a homeowner’s policy to protect your property and contents.
You can estimate your monthly payments using the mortgage payment calculator here.
Your mortgage documents will specify whether you can pay more on your mortgage, when, and how much.
Many lenders allow annual lump sum payments between 10% and 20%. Some also let you double-up or increase your payments, or pay bi-weekly rather than monthly.
All these options can help you pay down your mortgage more quickly, but not all mortgages allow them. Make sure you understand your options before you sign.
If you want to prepay your mortgage before your term ends or prepay an amount greater than your permitted amount, prepayment penalties may apply. This could come into play if you want to refinance, sell your home, or come into some money.
Some lenders allow you to sell penalty-free, but levy a penalty if you refinance. Others penalize you either way. FHA, VA, and USDA loans, however, prohibit prepayment penalties.
Prepayment penalty amounts also vary greatly among lenders. Commonly, lenders charge 80% of six months' interest, which may be a great deal of money, especially if you have a relatively new mortgage where most of the payment goes toward interest.
Understand all of these details before you sign.
Loan Officer vs. Mortgage Broker
Loan officers work for banks, credit unions, and other traditional lenders. Their professional conduct falls under the umbrella license of the institution and they promote their company's offerings.
Mortgage brokers act as middlemen between lenders and buyers. They access many lenders and products, and most states require licensing and regulate their practices. They’re liable for fraud for the life of the loan. And they’re paid a commission if you choose a mortgage through one of the lenders they recommend.
Brokers can often access mortgage products traditional lenders do not offer. That can make them the ideal choice for people with less-than-perfect credit or self-employed or commission workers.
Although they operate a bit differently, both institutional loan officers and mortgage brokers register through the Nationwide Mortgage Licensing System and Registry (NMLS). That means they should have the expertise to answer all your questions regarding potential mortgages.
Whatever kind of mortgage you choose, ask questions and make sure you understand the contract before you sign. No one wants to pay penalties unless they really have to, and everyone wants to pay as little as possible if they can't avoid them. Ask about closing costs, HOA fees (if they apply), and don’t forget about your homeowner’s insurance.
Don’t feel pressured to accept a mortgage just because you’re approved. Actively seek the mortgage that best suits your plans for the future (and consider these Top Reason to Forgo Mortgage Protection Life Insurance).