Finding the Best Payment and Loan Options for Your Mortgage
House hunting and purchasing a home can be one of the most exciting times in your life. But before you sign on the dotted line, you need to make sure you have your mortgage—and in some cases, your down payment—lined up and ready to go.
Keep in mind that there are several different types of financing. From fixed-rate, traditional mortgages to adjustable rate mortgages (ARM) to VA or FHA loans, there are many options. We explore the pros and cons of each.
The most common, and usually the best, option for homebuyers a fixed-rate mortgage. This option locks in a set interest rate and payment for the duration of your loan, which means your rate cannot go up. This means your mortgage payments cannot unexpectedly go up. That being said, you can always refinance your home if interest rates go down.
With a fixed-rate mortgage, you can choose the term of your loan, usually 15, 20 or 30-year options. The shorter term usually has a lower interest rate, but higher payments.
Conventional mortgages usually offer better interest rates, which can you save you money in the long run, as well. However, keep in mind that your income, credit score, and debt-to-income ratio also affect your interest rate.
Adjustable Rate Mortgage
Another mortgage option is an adjustable rate mortgage (ARM). This type of mortgage's interest rate is tied to an economic index.
So what does that mean, exactly? Well, while an ARM offers a lower initial interest rate, it's only at first. Your interest rate (and therefore your mortgage payment) can be periodically adjusted within certain periods as laid out in your mortgage as the index changes.
In short, this means your mortgage payment can increase unexpectedly. It's important to keep this in mind that you will need to adjust your budget, plan for larger payments, or make more money to be able to afford your mortgage.
Also keep in mind that many mortgage brokers will push this option, and tell you that you can refinance in three years to avoid the adjustment. But interest rates may be higher at that point, so that's not always a sure thing. Additionally, your house may not increase in value during that time, which can make refinancing so soon difficult.
Interest-only payments are another option when it comes to a mortgage. This option allows a borrower to only pay interest for a set period of time, usually three to five years. After this time, you'll then need to pay a lump sum, refinance your home, or begin making payments on the principal amount of your mortgage loan.
However, as with an ARM, you may find yourself in a difficult situation once the interest-only payment option runs out, as your mortgage payments will significantly increase.
Other Types of Mortgages
There are other mortgage options if you don't qualify for (or don't want) a conventional mortgage, such as a Federal House Association (FHA) loan, a VA loan, a USDA Rural Housing Loan, and a 203(k) Rehab Loan.
- FHA Loan - This type of mortgage is generally easier to qualify for than a conventional mortgage. For example, your credit score can be lower. An FHA loan also offers a down payment of 3.5%, though interest rates are higher.
- VA Loan - This loan is offered to veterans of the U.S. Armed Forces. Benefits include no down payment required, limited or no closing costs, and competitive interest rates.
- USDA Rural Housing Loan - This mortgage is offered to qualified homebuyers in rural and suburban areas. This lesser-known mortgage also offers a zero down payment option.
- 203(k) Rehab Loan - This type of mortgage is aimed at all those Fixer Upper fans out there. Basically, it allows you to roll the purchase and renovation of your home into a single mortgage. Shiplap, anyone?
Private Mortgage Insurance
While not a type of mortgage, private mortgage insurance (PMI) is another important aspect of the mortgage process to consider.
Private mortgage insurance is required if you do not put down a 20% down payment on your home. PMI protects the lender in the event you default on your loan.
While it's usually only a few hundred dollars a month and is tacked onto your mortgage payment, you should try to avoid PMI if possible. If you have a good credit score, your lender might pay PMI on your behalf. Or, you can take out two mortgages to help cover the 20% down you'll need to avoid PMI.
Once the equity on your home reaches 20%, you can ask your lender to have PMI removed. You will not need to pay this for the life of the loan.
Do not confuse PMI with homeowners insurance, which protects you if your home is burned down or damaged. As long as you have a mortgage, the bank will require you to have homeowner's insurance, but you will purchase it separately and pay separately from your mortgage.
What Option is Right For Me?
When it comes to choosing the right mortgage term and payment options, you should assess the risk involved with each, as well as how each option fits into your budget.
It's wise to determine how much you can afford monthly, including the cost of your taxes and insurance. Another great tip: Try to borrow as little as possible, so you do not end up underwater on your mortgage.
Generally speaking, a fixed-rate traditional mortgage is the best option. These options usually offer the best interest rates, as well as a set payment throughout the life of the loan. You'll also likely be able to avoid paying PMI if you choose this option and put 20% down.
Another point to consider: If you cannot the afford mortgage payments on a 30-year mortgage with a fixed rate, you likely are not in a position to buy a home.
But there are some things you can do to work toward your goal of buying a home.
- Work to improve your credit score, so you qualify for better interest rates, which means a lower monthly payment.
- Save up a larger down payment. This will reduce the amount that you need to borrow, which can make your mortgage payments more affordable and your interest rate lower.
- You may also consider buying a fixer-upper or moving to a different city or neighborhood that has more affordable housing options.