Buying a home - especially your first home - can be both an exciting and daunting endeavor. The mortgage process can be confusing, time consuming and costly if entered into haphazardly.
And if you end up with the wrong mortgage, the experience of purchasing your dream home can quickly turn into a nightmare. Especially if you end up with payments that are too high and leave you struggling to make ends meet.
Fortunately, it doesn't have to be that way.
While each situation is unique and the process will vary individually, having a basic understanding of the types of mortgages, interest rates and loan jargon can greatly expedite the process, reduce stress and equip you with knowledge to get a mortgage that’s right for your financial situation.
So let's get started!
A mortgage is a home loan secured through a lending institution for a term of 10, 15, 20 or 30 years-the most common loan terms are 15 and 30 year mortgages.
A mortgage has 3 basic parts:
- Down Payment: This is the initial amount paid to the seller of the home directly by the purchaser. The outstanding amount is paid through a loan. The down payment is typically a percentage of the total purchase price of the home.
Most lenders require a minimum down payment of at least 3% but it could be as high as 20%. This dependents on a number of factors including the particular lender you choose, your credit history, the loan type (government vs conventional) and purpose for buying the home (primary residence vs. rental property). Some loans insured by the federal government do not require a down payment.
Keep in mind that just because you can get a small down payment, doesn’t mean you should, as repayment terms will often be friendlier the bigger the down payment.
- Monthly Payments: This is the amount you pay each month to pay off the loan. This payment includes both principal and interest payments, mortgage insurance (depending on the type of loan), homeowner's insurance and property taxes.
- Closing Costs/Fees: These are all the fees/costs associated with the final purchase of the home and are paid on the day of the final sale or "closing". This is where the initial cost of buying a home can become quite pricey. These fees-which can run in the thousands of dollars-- are negotiable and are typically split between the buyer and the seller. The amount of closing costs the seller will pay is decided when the contract between the buyer and seller is first negotiated.
Most lenders do give buyers the option of rolling some or all of the closing costs into the mortgage to help offset the upfront costs of buying a home. The majority of these fees are paid to third parties for services such as attorney fees, local governments taxes, housing inspection, property appraisal. The list goes on and on.
According to Zillow.com home buyers will typically pay anywhere from 2 to 5 percent of the purchase price of their home in closing fees.
So, if your home cost $150,000, you’d most likely pay between $3,000 and $7,500 in closing costs.
Understanding these fees and preparing for them greatly reduces stress, makes the final closing smooth and can eliminate costly delays in the process.
Now that you have a basic understanding of how a mortgage works in general-let's dive a little deeper.
All of the costs that go into a mortgage vary and can drastically affect your monthly payments.
Some costs-such as a down payment, interest rate and loan type - can affect how high or low your monthly payment will be.
One of the primary factors that will determine how much you will pay up front and over the life of the loan is the type of loan you choose.
There are two types of loans: Conventional and Government insured.
This is a loan that is not insured by the government; the lender takes on the risk of losing money in the event that the borrower defaults on the mortgage.
Conventional loans are very straightforward and the process for applying is usually pretty cut and dry.
There are several variations, terms and interest rates available with a conventional loan but they are all fairly rudimentary. The terms of the loan and the amount you will be allowed to finance depends on 3 primary factors: your debt to income ratio, credit history and a minimum down payment.
These loans are insured or backed by the federal government, meaning if you default on the loan the lender will be able to recoup some money from the government. With these types of loans the lender assumes less risk than with a conventional loan.
Let's look at 2 of the most popular government loans:
FHA Loans - These are loans insured by the Federal Housing Administration. They were created to assist those with low credit scores, high debt to income ratios or otherwise may not be able to afford a large down payment.
With FHA Loans, the mortgage is financed through a traditional FHA approved lender; however the criterion for qualifying for these loans is less stringent. Borrowers typically need a credit score in the neighborhood of 620 (as opposed to 720 for conventional loans) and are allowed to spend up to 57% of their monthly income on housing (as opposed to 43% with conventional loans).
FHA Loans also require a lower down payment-usually around 3.5% which is significantly lower than with conventional loans.
FHA Loans require that the borrower pay mortgage insurance. There is an upfront premium and an annual premium. The borrower must pay 1.75% of the loan amount when the loan is secured and then an annual premium which is broken down into monthly payments and bundled into the monthly mortgage payments.
VA Loans - Very similar to FHA loans, these loans are backed by the Veterans Administration and are designed specifically for US Veterans or their surviving unmarried spouse. The requirements for this type of loan are: "satisfactory" credit(usually in the 620 range) suitable income (must demonstrate the ability to make monthly payments) and a certificate of eligibility (which is obtained from the VA and is based on length and character of service).
VA Loans require no down payment.
VA Loans do require a "funding fee" which is very similar to the "upfront" mortgage insurance payment required by FHA Loans however, VA Loans do not require the annual premiums.
Which one is right for you?
In a nutshell:
Conventional Loans: While the requirements for qualifying are restrictive and stringent and the upfront cost can be pretty hefty with these loans, they do have some clear advantages.
For one, these loans are accepted throughout the property market, have a higher borrowing limit and property purchased with a conventional loan can be used for investment or rental purposes. Mortgage insurance is not required with a down payment of 20% or more. Processing time for these loans is short and the overall process is simple and straightforward as there are a lot fewer hurdles to clear.
All of this means that if you meet the minimum requirements to get such a loan, it’s definitely worth considering.
Government Loans: The requirements to qualify for these loans are extremely flexible and amendable. Upfront costs are relatively low and those with lower credit scores can still receive decent interest rates. However, these loans are not as widely accepted throughout the housing market as conventional loans. There are caps on how much one can borrow and no matter how large a down payment one makes-mortgage insurance (upfront and annual) for FHA Loans and the funding fee for VA Loans are still required.
Properties purchased using a government loan must be used as a primary residence and cannot be used as an investment or rental property. The processing time for these loans can be lengthy because of the additional requirements needed.
And the winner is?
Unfortunately, there’s no single loan type that’s always best, no matter the circumstance.
It depends on:
- Your Credit Score and History
- Down Payment and Closing Costs/fees
- Your Debt-To-Income Ratio
Before you decide, here's a few other factors to consider.
Interest Rates Simplified
The interest rate you qualify for makes a huge difference in the cost of your mortgage. While they may seem hard to understand, they don't have to be.
The first and most important thing to note is that your interest rate is directly tied to your credit score. The lower your credit score the higher your interest rate will be and vice versa.
This is an interest rate remains the same over the life of the loan. This means monthly mortgage payments remain the same and you’ll never have any unwelcome surprises.
Also known as ARM's, the rate adjusts with the market interest after a set period of time (example 5 years). As a result monthly payments can vary from month to month.
The difference between the two is that generally over time, you end up paying less overall interest with an ARM than with a fixed rate mortgage. Generally.
This decision on which type of interest rate you should chose is really a matter of preference. Do you mind having to pay a little more some months do prefer the peace of mind knowing exactly what your monthly payment will be?
3 Steps to Choosing the Right Mortgage:
In mortgages like in life, knowledge is power.
There are so many options when it comes to mortgages and home loans.
Understanding your financial situation and long term goals are key to choosing the best options for you. When purchasing a home - especially your first home - keep it simple.
1. Evaluate Your Financial Situation
What is your credit score? Do you have a high or low debt to income ratio? Do you have money for a down payment and to cover some closing costs?
The answers will help you find the right loan.
You may even want to consider waiting a year or two in order to establish better credit and save for a down payment. Simply choosing to wait and improve your credit could save you thousands of dollars down the road.
2. Choose either a Conventional or Government Loan:
What can you afford to do? What are your intentions long term?
3. Choose either a Fixed or Adjustable Rate Mortgage:
Which one best fits your financial personality?
Mortgage hunting is an active process in which you have to work to become knowledgeable, understand your financial profile and personality and then do what suits you and what makes you most comfortable.
At the end of the day, choosing the right mortgage comes down to the research and planning that you do. A few hours of preparation can literally save you tens of thousands of dollars in payments, so it’s well worth doing.