Folks looking to purchase a home, whether as a personal residence or an investment property, have myriad financing options available. Each comes with its own advantages and drawbacks, so be sure you fully understand the ramifications of each choice.
Fixed-rate (traditional) mortgage
The most common type of mortgage is a fixed-rate mortgage, also known as a traditional mortgage. With a fixed-rate mortgage, you have a defined interest rate that stays the same over the life of the loan. Especially in a time of unpredictable interest rates, this bears repeating: even if interest rates change, your rate is locked in for the duration of the loan. An amortization schedule will show the portion of each payment that goes towards principal and interest.
Most mortgages are for a thirty-year term. You can typically obtain a lower interest rate if you have a shorter term, such as fifteen years, since paying back the loan over a shorter time period is less risky for the lender. Your monthly payment will be higher, but you will save tens of thousands in the long run because you will only be making payments for half as long.
Consider two options for borrowing $400,000: a 30-year loan at 6% versus a 15-year loan at 5%. Your monthly payment (principal and interest only) on the 30-year loan would be $2,398.20; after 360 payments, you will have paid a total of $863,352.76. Your monthly payment on the 15-year loan would be $3,163.17; after 180 payments, you will have paid a total of $569,371.41. The 15-year loan, with a payment of under $800 more each month, saves you nearly $300,000 in the long run—without even counting what you could gain by investing the amount of your former mortgage payment for the next 15 years after paying off your loan!
If you do not want to lock yourself into a 15-year mortgage, you can still make extra principal payments each month to reduce the number of remaining payments and save interest in the long run.
Of course, there are many varieties of fixed-rate mortgages. The most common ones are highlighted below, in no particular order.
Conventional mortgage
Among fixed-rate mortgages, a conventional mortgage is the most straightforward. There are no special requirements. The amount of down payment required varies by lender but can be as low as zero. Down payments lower than 20% will require the buyer to purchase private mortgage insurance (PMI) until home equity is at least 20% of the total value.
FHA loan
A Federal Housing Administration (FHA) loan works like a conventional mortgage but is insured by the government. (A bank lender still issues the loan.) These are popular with first-time homebuyers because they often require lower down payments. Additionally, because they are insured by the government, banks are more flexible regarding borrower credit scores. On the other hand, interest rates may be higher and mortgage insurance premiums are typically required for the life of the loan. There are various types of FHA loans beyond the traditional mortgage, such as those for renovations or energy-efficient improvements.
VA loan
If you or your spouse have current or prior military experience, you may qualify for a Veterans Affairs (VA) loan that is issued by a bank lender and guaranteed by the U.S. Department of Veterans Affairs. This means servicemembers only, whether full-time active duty, reserve, or National Guard; it does not include civilian employees or contractors.
Work with a lender, not the VA directly, to obtain a VA loan.
Similar to FHA loans, there are various types of VA loans available beyond a typical purchase loan. For instance, there are specific programs for refinancing, Native American borrowers, and adapted housing.
Servicemembers that have exhausted their VA benefit may qualify for a “military” loan, if offered by their lender of choice. These often have more favorable terms or credit requirements than conventional mortgages.
USDA loan
The U.S. Department of Agriculture’s Single Family Housing Guaranteed Loan Program is designed to promote home ownership by low- and middle-income families in rural areas. Eligibility is based on (1) your income relative to the median household income in the United States and (2) location of the home. Ask your lender if a USDA loan is available.
Jumbo loan
A jumbo loan is a loan that exceeds an amount set by the Federal Housing Administration each year for the location of the home. That amount is currently $766,550 for most of the nation. If you will be borrowing more than this, you will need a jumbo loan, which comes with some additional requirements and a slightly higher interest rate than a conventional mortgage.
You can avoid a jumbo loan by making a larger down payment such that the amount you borrow is below the applicable limit.
Construction loans
Some folks choose to build their new home rather than purchase an existing one. This is a lengthier process during which you will need regular access to funds. A construction loan gives you access to money to pay your contractor in stages as various milestones are reached.
Construction loans typically require interest-only payments during the construction period. The construction loan then converts into a conventional loan once the building is complete.
Non-primary residence
If you are purchasing a second home or an investment property, you will not be able to use special programs, and your lender may impose additional requirements or offer only higher interest rates. Be clear about your intentions for using the property at all times. If you let a lender believe you will occupy a home as a primary residence, but you instead use it as an investment property, you may be committing mortgage fraud.
Adjustable-rate mortgages
Besides fixed-rate mortgages, the other major type of mortgages is adjustable-rate mortgages (ARMs). These are also called variable-rate mortgages.
The name is exactly what it sounds like: The interest rate changes over time. Your interest rate with an ARM is typically fixed for an initial period (typically five years), and then will adjust periodically afterwards in response to market conditions. For example, a “3/1” ARM means that the rate is fixed for the first three years and then adjusts every one year afterwards, and a “5/3” ARM means that the rate is fixed for the first five years and then adjusts every three years afterwards.
ARMs are attractive to folks who are unable or unwilling to pay prevailing market rates. With the low “teaser” rate during the initial period, payments can be deceptively low. But the rate can jump significantly at the end of the initial period, leaving the borrower unable to make payments and causing default.
Realtors and lenders often promote ARMs as a way to get more “qualified” buyers, telling them that they can always refinance before the initial period expires. There are two major problems with this approach. First, refinancing always involves extra time, hassle, and costs because you are essentially buying your home from yourself. Second, and more importantly, you can never count on favorable changes in the future. In the early 2000s many people fell into this trap, leading to an avalanche of foreclosures when folks were unable to refinance their ARMs after interest rates jumped. If you get one takeaway from this article, please let it be this: Do not ever get an adjustable-rate mortgage.
Other considerations
There are other important considerations to keep in mind beyond just selecting the right type of mortgage for your situation.
First and foremost, remember that lenders will generally require you to maintain an escrow account for property taxes and insurance, so your payment will be more than just the principal and interest portions shown in online loan calculators. Additionally, property taxes and insurance—which would be necessary even if you paid cash for your home purchase—tend to increase over time, which is particularly burdensome for folks with fixed incomes.
Besides property taxes and insurance, you may need to pay mortgage insurance, homeowners association dues, and other costs. Be sure to have a full picture of your monthly expenses. This includes budgeting for items such as home repairs. Make sure you can really afford it!
Next, all these programs are offered through regular lenders. For example, you do not obtain a VA loan by contacting the VA; you apply through the bank or credit union of your choice.
Finally, keep in mind that you will need funds for a down payment and other one-time transaction costs when purchasing a home. Fortunately, there are many state and local programs available to help, particularly if you are a first-time home buyer, as well as specialized programs for teachers and other public servants.
How do I know what is right for me?
Your best bet to find the loan program that is right for you is to work with a trusted lender early in the home-buying process. They will be best positioned to help you evaluate your options. Start early, be candid, stay diligent, and above all avoid ARMs.
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