How to choose the best mortgage
What Is a Mortgage?
There are two components to your mortgage payment: principal and interest. Principal refers to the loan amount. Interest is an additional amount (calculated as a percentage of the principal) that lenders charge you for the privilege of borrowing money that you repay over time. During your mortgage term, you pay in monthly installments based on an amortization schedule set by your lender.
Another factor involved in pricing a mortgage is the annual percentage rate, or APR, which assesses the total cost of a loan. APR includes the interest rate and other loan fees.
Main Types of Mortgages
Not all mortgage products are created equal. Some have more stringent guidelines than others. Some lenders might require a 20% down payment while others require as little as 3% of the home's purchase price. To qualify for some types of loans, you need pristine credit. Others are geared toward borrowers with less-than-stellar credit.
Here's a rundown of the main types of mortgage loans:
A conventional loan is a loan that is not backed by the federal government. Borrowers with good credit, stable employment and income histories, and the ability to make a 3% down payment can usually qualify for a conventional loan from Fannie Mae or Freddie Mac, two government-sponsored enterprises that buy and sell most conventional mortgages in the United States. Also, some lenders offer conventional loans with low down payment requirements and no private mortgage insurance (PMI).
There are two types of conventional loans: conforming and non-conforming.
Conforming loans are bound by maximum loan limits set by the federal government. These limits vary by geographic area. For 2018, the Federal Housing Finance Agency set the baseline conforming loan limit at $453,100 for one-unit properties. However, FHFA sets a higher maximum loan limit of $679,650 in certain parts of the country (think New York City or San Francisco, for example). That's because home prices in these high-cost areas exceed the baseline loan limit by at least 115% or more.
Non-conforming loans generally can't be sold or bought by Fannie Mae and Freddie Mac due to the loan amount or underwriting guidelines. Jumbo loans are the most common type of non-conforming loans. They're called "jumbo" because the loan amounts typically exceed conforming loan limits. These types of loans are riskier to a lender so borrowers typically must show larger cash reserves, make a down payment of 10% to 20% (or more), and have strong credit.
The U.S. government isn't a lender, but it does guarantee certain loans that meet stringent eligibility requirements for income, loan limits and geographic areas. Here's a rundown:
Low- to moderate-income buyers, typically purchasing a house for the first time, turn to loans insured by the Federal Housing Administration when they can't qualify for a conventional loan. Borrowers can put down as little as 3.5% of the home's purchase price. FHA loans have more relaxed credit score requirements than conventional loans. However, the FHA doesn't directly lend money; it insures loans by FHA-approved lenders. One drawback of FHA loans: All borrowers pay an upfront and annual mortgage insurance premium, or MIP – a type of mortgage insurance that protects the lender from borrower default – for the loan's lifetime.
Who it's best for: Low- to moderate-income borrowers who can't qualify for a conventional loan product or anyone who cannot afford a significant down payment. FHA loans allow a FICO score as low as 500 to qualify for a 10% down payment – and as low as 580 to qualify for a 3.5% down payment.
The U.S. Department of Veterans Affairs guarantees homebuyer loans for qualified military service members, veterans and their spouses. Borrowers can finance 100% of the loan amount with no required down payment. Other benefits include a cap on closing costs (which may be paid by the seller), no broker fees and no MIP. VA loans do require a "funding fee," a percentage of the loan amount that helps offset the cost to taxpayers. The funding fee varies depending on your military service category and loan amount. The following service members do not have to pay the funding fee:
- veterans receiving VA benefits for a service-related disability
- veterans who would be entitled to VA compensation for a service-related disability if they didn't receive retirement or active duty pay
- surviving spouses of veterans who died in service or from a service-related disability
Who it's best for: Eligible active military personnel or veterans, and their spouses, who want highly competitive terms and a mortgage product tailored to their financial needs.
The U.S. Department of Agriculture guarantees loans to help make homeownership possible for low-income buyers in rural areas nationwide. These loans require little to no money down for qualified borrowers – as long as properties meet the USDA's eligibility rules.
Who it's best for: Homebuyers in eligible rural areas who have lower incomes, little money saved for a down payment and can't otherwise qualify for a conventional loan product.
Loan Terms: Rates
Mortgage terms, including length of repayment, are a key factor in how a lender prices your loan and your interest rate. Fixed-rate loans are what they sound like: a set interest rate for the life of the loan, usually from 10 to 30 years. If you want to pay off your home faster and can afford a higher monthly payment, a shorter-term fixed-rate loan (say 15 or 20 years) helps you shave off time and interest payments. You'll also build equity in your home much faster.
Opting for a shorter fixed-term mortgage means monthly payments will be higher than with a longer-term loan. Crunch the numbers to ensure your budget can handle the higher payments. You may also wish to factor in other goals, such as saving for retirement or an emergency fund.
Who it's best for: Fixed-rate loans are ideal for buyers who plan to stay put for many years. A 30-year fixed loan might give you wiggle room to meet other financial needs. However, if you have the appetite for a little risk and have the resources and discipline to pay your mortgage off faster, a 15-year fixed loan can save you considerably on interest and cut your repayment period in half.
Adjustable-rate mortgages (ARMs) have a fixed rate for an initial period of three to 10 years, but after that period expires, the rate fluctuates with market conditions. These loans can be risky if you're unable to pay a higher monthly mortgage payment once the rate resets. Some ARM products have a rate cap in which your monthly mortgage payment cannot exceed a certain amount. If so, crunch the numbers to ensure you can potentially handle any payment increases up to that point. Don't count on being able to sell your home or refinance your mortgage before your ARM resets because market conditions – and your finances – could change.
Who it's best for: ARMs are a solid option if you don't plan to stay in a home beyond the initial fixed-rate period, or know that you intend to refinance before the loan resets. Why? Interest rates for ARMs tend to be lower than fixed-rates in the early years of repayment so you could potentially save thousands of dollars on interest payments in the initial years of homeownership.
First-Time Assistance Programs
Special programs in your state or local housing authority offer help specifically to first-time buyers. Many of these programs are available based on buyers' income or financial need. These programs, which usually offer assistance in the form of down payment grants, can also save first-time borrowers significant money on closing costs.
Mortgages for First-Time Buyers
All of these loan programs (with the exception of first-time homebuyer assistance programs) are available to all homebuyers, whether it's your first or fourth time purchasing a home. Many people falsely think FHA loans are available only to first-time buyers, but repeat borrowers can qualify, as long as the buyer has not owned a primary residence at least three years leading up to the purchase.
Choosing the loan that's best for your situation relies primarily on your financial health: your income, credit history and score, employment and financial goals. Mortgage lenders can help analyze your finances to help determine the best loan products. They can also help you better understand the qualification requirements, which tend to be complex. A supportive lender or mortgage broker may also give you homework—targeted areas of your finances to improve—to put you in the strongest position possible to get a mortgage and buy a home.
The Bottom Line
No matter which loan type you choose, check your credit report beforehand to see where you stand. You're entitled to one free credit report from each of the three main reporting bureaus each year through annualcreditreport.com. From there, you can spot and fix errors, work on paying down debt, and improve any history of late payments before you approach a mortgage lender.
It can be advantageous to pursue financing before you get serious about looking at homes and making offers. Why? You'll be able to act more quickly and may be taken more seriously by sellers if you have a pre-approval letter in hand.