It isn't very often that you get to choose your home. So once you arrive…
Once you have decided to settle down and find your dream home, there’s one important choice you have to think of next. For most people, that decision is the mortgage option they will be choosing to finance their ideal house.
There are many reasons why it’s better to apply for a mortgage than to pay in cash upfront. Whether you do have enough money to pay for your home purchase or not, it just feels wiser to keep your liquidity in case of a rainy day. With a mortgage, you can slowly build home equity until you can genuinely call your house your own, while you can put your money away in other investments that can even help you pay for your real estate.
Today, we are going to compare mortgage options that are ideal for first-time homeowners. We will be explaining the pros and cons of these types of mortgages to aid you in your determination. After all, we don’t get to make these big decisions often in our lives, so we might as well make our choices count!
Before we start digging into mortgage rates and other points of comparison, let’s get a little background on the common terms you’ll keep reading about as you learn about home loans.
A mortgage loan is a debt that you will owe to a mortgage lender to pay for a residence. Obviously, as part of the application process, mortgage lenders will take a closer look at your financial background, and this is why credit scores are significant. They can really make or break your application for the best mortgage you would want.
Types of Mortgages
There are two main types of mortgage loans. You either have a federal government-backed loan or not. The latter is what you call a conventional loan which you will owe to a private mortgage lender. Conventional mortgage lenders conform to limits defined by the Federal Housing Finance Administration. Their down payment and income qualifications also need to be approved by Fannie Mae and Freddie Mac.
For government-backed loans, you’ll need to have a minimum credit score of 580, although in some cases, you can be approved for a mortgage with a credit score as low as 500. On the other hand, for conventional loans, you’ll have to spruce your financial resume for a credit score of at least 620. That’s the absolute bare minimum if you want to access the best conventional mortgages with the most attractive interest rates.
On the lender’s end, another thing they’ll be looking at aside from your credit score is your debt-to-income ratio (DTI).
As a mortgage applicant, you might be wondering, “How much can I borrow?” The lender, on the other hand, will ask, “How much is this person qualified to get?” To answer these questions, you need to look at how much income you bring every month. Apart from your future mortgage, you make monthly payments for other necessities and commitments such as utilities, credit card bills, and so on. Your DTI ratio will be computed based on how much money will be left after paying off all your monthly debts.
Imagine your income as a pie, wherein the remaining slices will be the only parts you can allocate for your monthly mortgage payment. If the lender sees that you might be asking for a loan amount more than you can pay monthly, it can lower your chances of getting approved.
Here‘s a handy calculator from Bank of America to find out your current DTI ratio.
An important criterion for choosing the best mortgage for you is the down payment required to secure the loan. This will depend on your own financial capacity, and it can later affect the other costs of your loan.
Private Mortgage Insurance
Remember, the lower the down payment required, the higher the monthly payments you will have to make for the length of the loan term. It might also mean that you will have to pay for private mortgage insurance (PMI), which is an additional expense that many borrowers would prefer to skip. This is an assurance for the lender in the worst-case scenario that you default on your loan. Even though the borrower will pay for it, it will actually protect the lender, not the borrower.
Zero Down Payment Options
Through government-insured mortgages, home buyers, even first-time ones, have the opportunity to apply for a mortgage without having to make a down payment. But these require particular qualifications. You either have to be an active duty member (for VA loans) or a buyer of rural real estate (USDA loans). The former is a mortgage that can be secured via the Department of Veterans Affairs as a hard-earned benefit for military service members. The latter is a mortgage insured by the Department of Agriculture. You can check this eligibility map to see if the property you plan to buy might qualify for a USDA loan.
Federal Housing Administration Loan
The next best alternative to zero down payment options is a Federal Housing Administration (FHA) loan, another type of government-insured home loan. Through FHA loans, you can be allowed to make as little as a 3.5% down payment with a credit score starting at 580. Below this score, you’ll have to save up for a lump sum payment of at least 10% of the house’s purchase price to qualify for an FHA loan.
Now, let’s say you have indeed been able to maintain a good credit score as well as build up some savings. Should you go for a conventional mortgage, it will be wise to strive for a 20% down payment. With 20% home equity in the can, you’ll be able to forgo PMI completely, which will mean deep savings in the long run. Below a 20% down payment, you will have no option but to pay for the mortgage insurance required for your conventional loan until such time that you gain a fifth of the home equity.
Finally, another significant aspect of mortgage rates we have to understand is interest rates.
Annual Percentage Rate
Before we discuss fixed-rate and adjustable-rate mortgages, it’s necessary to point out the difference between the mortgage interest rate and the annual percentage rate (APR) that you will often see advertised by mortgage lenders.
Under the Truth in Lending Act of 1968, mortgage lenders are obligated to distinguish the APRs they quote, especially the breakdown and inclusions. Keep in mind that as a borrower, you have a right to know just exactly what you will be paying for, and this is one of the details you must scrutinize before you commit to a quoted mortgage rate.
As you will notice, when you get a mortgage, the APR is always higher than the actual interest rate. While both are expressed as a percentage rate, the interest rate reflects the cost of borrowing the money based on the loan amount. The APR, on the other hand, includes all the other costs that are not taken from the interest rate. As Bank of America puts it, “it includes other charges or fees such as mortgage insurance, most closing costs, discount points, and loan origination fees.” However, not all lenders are the same. It is the prerogative of each exactly which fees go to their APR; that’s why it’s necessary to find this out when applying for a mortgage.
It is often possible to choose the kind of interest rate you will be taking on when you avail of a mortgage. After all, this will determine your mortgage payments, and your decision to sign on the dotted line hinges on this factor. There are very few mortgage options that will not offer you the chance to choose between a fixed or a variable interest rate.
Fixed-rate mortgages give you an easier monthly payment to remember because the interest rate does not change for the life of the loan. (That is until you decide to negotiate with your lender.) Borrowers often choose this loan type for the advantage of protection against rising interest rates. Once you get a fixed-rate mortgage, you’ll be asked to choose a loan term of either 15, 20, or 30 years of monthly mortgage payments. Keep in mind that however attractive a low fixed mortgage rate looks, the total cost of your loan will vary depending on the length of your loan term.
The opposite of a fixed-rate mortgage is an adjustable-rate mortgage (ARM). The mortgage interest rates for ARMs vary depending on the current mortgage rates. However, you initially have a fixed period in the loan term wherein the mortgage rates do not change. For example, when you look up today’s mortgage rates, you’ll often see a fractional label for an ARM. Take a 10/6 ARM, for instance; while it does look like a fraction, the first number (10) represents the initial number of years wherein you will enjoy a fixed rate in the monthly payment. After those 10 years, the second number (6) represents the frequency of adjustment for your mortgage rates in terms of months.
You can check out this link to find out today’s current mortgage rates, whether for 15-year fixed-rate mortgages or 10/1 ARMs.
When it comes to home loans, no one size fits all. You cannot simply be offered a mortgage rate or loan type that you are incapable of paying. Even when it comes to searching for the lowest possible mortgage rate, the one that will fit your profile will depend on several factors: your credit score, DTI, and amount of savings. The cheapest interest rate will depend on your own terms because even if you get a relatively high mortgage rate for a 15-year fixed mortgage, this can still be cheaper overall compared to a low-interest 30-year fixed-rate mortgage. Keep in mind that the longer you are making a monthly payment, the more expensive the loan truly becomes.
The best bank to choose will be the best among the lenders you will speak to. Do not become one of the 47% of people who do not shop around for mortgage options. Talk to as many lenders as you can so you can shop and compare mortgage rates.
There’s a world of options you can choose from in your journey to actualizing your American Dream!