A home is typically the largest purchase we ever make in our lives. This also means a mortgage is generally the longest-term loan we'll ever have. You'll want to make sure you understand exactly how mortgages work and all of the lingo in the discussion of mortgages, especially if you're a first-time buyer. What types of home financing options are out there? How do you choose a mortgage for your new home?
When you understand the terms, you can find the best mortgage loan to finance a house. That's why we've put together this comprehensive guide on the different types of home loans and their various terms to make the process of financing and home buying easier for you.How Do Mortgages Work?
A mortgage is a loan that you receive from a lender to finance your home purchase. You and the lender agree on an interest rate and a length of time during which you repay this borrowed money. If you cannot pay back the mortgage, the lender can foreclose on your house.
Your monthly mortgage payment is split primarily into principal and interest. However, these amounts are not split evenly in every payment. In the first years of your mortgage term, interest is the majority of your payment, while in the later years of your mortgage term, you'll pay more of the principal than interest. Your lender will provide you with an amortization schedule to show how your balance will decrease over the duration of your loan term, along with how principal and interest will be split in each payment.
So should you get a fixed or adjustable-rate mortgage? Should you secure a short-term loan or a long-term loan? Here are the basics of loan terms:
A fixed-rate mortgage means your interest rate will not change over the term of your loan. One of the main benefits of a fixed rate is stability and consistency. Your mortgage payment will be the same every month throughout the term of your loan, making short-term and long-term budgeting easy for homeowners.
An adjustable-rate mortgage (ARM), on the other hand, can fluctuate throughout the term of your loan. Therefore, your interest rate and monthly payment can increase or decrease depending on a few different factors, such as the rates set by the Federal Reserve and the state of the economy.
The adjustment will occur after a predetermined period. For example, a 5/1 ARM means that during the first five years of your loan, your rate is fixed. After five years, your interest rate will adjust every year.
Many borrowers can secure an ARM with a lower initial interest rate than they can with a fixed-rate mortgage. This can result in lower monthly payments during the first few years of the loan. An ARM does tend to be riskier than a fixed-rate mortgage, however, since interest rates can rise, so you may have difficulty making your future monthly payments if you end up with a higher interest rate.
Along with the fixed or adjustable rate, you'll also want to choose whether you want a short-term or long-term mortgage.
The standard mortgage term is a long-term, 30-year loan. The popularity of this term is due to generally lower monthly payments compared with shorter loans. Interest rates, however, tend to be higher on 30-year mortgages than for 15-year mortgages.
For short-term loans, typically 15 or 10 years, you'll pay much less interest than you would for a long-term loan. Depending on the amount of your loan, you could potentially save hundreds of thousands of dollars in interest by opting for a short-term loan.
To qualify for particular mortgages and terms, you'll need a certain down payment, credit score, income, and debt-to-income ratio.
The general rule of thumb is a down payment of at least 20% so you can avoid paying private mortgage insurance (PMI). A down payment of less than 20% will likely result in you needing to pay PMI on top of your other mortgage costs. For some borrowers, however, putting down less than 20% and paying the PMI may be the preferred financial decision. For certain mortgage loan types, you can qualify with as little as 3% down.
Another factor in whether you qualify for a certain type of mortgage is your credit score. For many conventional loans, you'll want a credit score of at least 620 for a mortgage at a fixed rate or a credit score of at least 640 for a mortgage at an adjustable rate. Government-backed loans tend to accept lower credit scores in the 500 range.
For conventional loans, lenders will also consider the amount of your income, along with whether your income is reliable and stable. To prove your income, you may have to supply your lender with copies of your W2 forms, pay stubs and tax returns. Even if you change jobs frequently, you may still qualify if your income has been predictable and consistent.
Lastly, a lender may also consider your debt-to-income ratio to determine what loan type and terms you qualify for. You can calculate your debt-to-income ratio on your own by taking the sum of your monthly payments for debt and dividing it by your monthly income. Your lender can use your debt-to-income ratio to determine your ability to repay your loan and handle your monthly payments. Typically, a maximum debt-to-income ratio is around 45%, though some lenders may accept a ratio of 50% if you have a high credit score and cash reserves.
Reserves can take the form of:
- Investments in mutual funds, bonds, stocks, CDs or money market funds
- Assets in retirement accounts
- A life insurance policy's cash value
- Cash in savings and checking accounts
- Now that you know how mortgages work, let's cover the various types of home loan options.Types of Home Loan Options
What exactly are the different types of mortgages? What are the key differences between them? The following are eight types of home loan options that you may qualify for.
The most common type of mortgage loan is a conventional loan. This mortgage type is available through private lenders. Fannie Mae and Freddie Mac set the standards for conventional loans. You can secure a conventional loan with either a fixed interest rate or an adjustable-rate.
One of the downsides of this loan type is that the down payment requirement tends to be higher than for other mortgage types, with most lenders looking for a down payment of 20% or more.
The Federal Housing Administration backs FHA loans. Borrowers with low incomes, less-than-excellent credit, and small down payments can secure these loans. Like conventional loans, FHA loans can be secured at a fixed rate for a term of 15 or 30 years.
One of the downsides of an FHA loan is that borrowers must pay both an annual insurance premium and an upfront premium. An annual insurance premium can fall between 0.45% and 1.05% and is paid every month, while the upfront insurance premium is 1.75% of the mortgage loan's total amount and is paid when the borrower secures the loan.
The U.S. Department of Veterans Affairs backs VA loans and offers them to veterans following active duty or spouses of service members who passed away while on active duty. Borrowers aren't limited in the amount they can borrow, but there are limitations on the amount that will be backed by the VA. These mortgage loans generally offer some of the lowest interest rates on the market, and borrowers aren't required to pay for private mortgage insurance.
The U.S. Department of Agriculture designates which areas are eligible for USDA loans. Borrowers must live in the house for which they are acquiring the mortgage. Location is the most important factor for this type of loan, rather than factors like your income or credit. Borrowers with low to moderate-income levels can often secure a USDA loan.
Jumbo mortgages are loans that exceed the limit on conventional loan amounts set by Fannie Mae and Freddie Mac. Jumbo loans are typically used to finance expensive or luxury homes. Homes valued over $424,100 generally fall into this bracket, though the limit varies by location. For example, more expensive markets, like those in some Californian cities, have higher limits.
Because jumbo loans present more risk to lenders due to their large amount, borrowers generally need excellent credit scores above 700, low debt-to-income ratios and large down payments.
Borrowers with interest-only loans only have to pay the interest portion of their monthly payment for the first five or 10 years of their mortgage rather than the full payment. While this does slow your repayment, it can be useful to have lower monthly payments when your finances are tight. After those initial years of interest-only payments, the remainder of your loan will be paid off like a conventional loan.
A combo loan, also known as a piggyback loan, is when a borrower takes out two loans to avoid paying private mortgage insurance after they put less than 20% down on their home.
For example, borrowers looking to secure a construction loan to build a house may take out both a construction loan and a permanent loan. While the home is being built, they'll pay only interest, and after the construction is complete, they'll begin paying both interest and principal.
Balloon loans are unique in that they are paid in a lump sum. Typically, balloon loans are borrowed short term, but they can be secured with terms up to 30 years. Balloon mortgages can also have fixed or variable interest rates. For a certain timeframe, such as five years, you'll pay only interest. Then after that set period, the entire amount of your principal will be due.
Because of the increased risk, they pose to lenders, balloon loans typically offer higher interest rates than other mortgage loan types. Additionally, paying a large amount of money in a lump sum isn't for everyone.How to Finance a New Home
No one loan option is right for every borrower. Now that you know what some of the various loan options are, how do you select the right one for your new home? The key components to choosing a financing option are determining your needs and figuring out what you can comfortably afford.
The best place to start when selecting a financing option is to make an assessment of your financial situation. Look at your credit score and history. Do you tend to have a lot of surplus in your budget? Calculate how much home you think you can comfortably afford.
A borrower's credit score tends to be one of the major factors involved in qualifying for a mortgage. Your credit score can qualify or disqualify you from securing a loan, and it can also determine what interest rate you'll get. The higher your credit score, the more likely you are to get a lower interest rate, meaning you'll pay less for your mortgage overall. Borrowers with lower credit scores tend to get higher interest rates since they are riskier for lenders. The difference can be thousands of dollars, so be sure to check your credit score, dispute any errors and do what you can to boost your credit score if needed.
For higher-risk mortgages, such as jumbo and construction, you'll need an excellent credit score to qualify. But options such as FHA and VA loans accept borrowers with less-than-excellent credit.
A large factor in determining the best financing option for you is the loan amount you can comfortably afford. How much can you put down on your home upfront? Determine whether you can afford the generally recommended 20% down payment or only a smaller percentage.
If you can't afford 20% down, you may want to look into an FHA loan. On the other hand, if you're a high-income earner interested in a jumbo loan, you may need a large down payment to qualify. For a conventional loan, you can still secure a mortgage without a 20% down payment, but you'll likely have to pay private mortgage insurance on top of your monthly mortgage payments.
Budgeting is especially helpful when calculating whether you can afford a certain monthly payment. Take a yearly budget and play with the numbers to see how your budget is affected month to month. Additionally, you may want to check out a mortgage calculator online.
Another key factor in selecting the best financing option for your new home is your location. The limits on conforming loans vary by location. So a $450,000 loan in one part of the country may require a jumbo loan, while in a more expensive real estate market, $450,000 may still count as a conforming loan.
The cost of living in your area may also affect how much home you're able to afford. If your other expenses tend to be low, you may be able to afford a higher monthly payment than you expected. You may also be able to secure a bigger home than someone in a higher cost of living area for the same price.Building a Way of Life With SK Builders
We look forward to helping you through your new home purchase. Our agents will make every effort to ensure that your experience will be as smooth and easy as possible.
To assess your financial situation, it's a good idea to order your credit report and review before you start looking at new homes. Even if your payment history is spotless, sometimes they can contain errors or discrepancies that take time to correct. Once you have decided to purchase a new home, call our preferred lender to determine how much house you can afford with ease and convenience — our preferred lender will make it easy!
We can help you with the following:
- Immediate pre-qualification and pre-approvals
- Low down payment programs
- Special financing programs for our home buyers
- FHA, VA, and Conventional Loans — Adjustable and Fixed Rate
Learn more about us at SK Builders by contacting us today!