Whether it’s a fixer-upper, a remodeled ranch or a downtown townhouse, finding your perfect home can feel like a dream come true. But before you make your move a reality, you have another essential choice to make: What type of mortgage will you get?
You’ve probably thought about your mortgage rate, but there’s a lot more to consider before you find the right fit for you and your future home. How long will you live there? What kind of down payment can you afford? What about lender fees? We’re breaking down all of the details (beyond rate) that you should keep in mind when you’re ready to buy a new home.
Budget basics
It may not be glamorous, but you can’t start your home search without some budgeting to figure out how much house you can afford. Knowing your debt-to-income ratio (DTI) is a great place to start.
DTI is calculated by taking the amount of your monthly debt payments (credit card debt, student loans, etc.) and dividing it by your gross monthly income. Ideally, your DTI should be below 43%. While it’s possible to get a mortgage with a higher DTI, a lower one is better for both you and your lender.
Look out for hidden mortgage costs
If you’re on the hunt for a mortgage, there are some additional expenses buyers often overlook when budgeting. You’ll need to account for all the expenses of getting a mortgage, including the down payment and closing costs (which typically fall between 2% and 5% of the home’s price and include expenses like title charges, real estate taxes and homeowners’ insurance).
In addition to standard closing costs, many large banks and lenders charge additional fees, including application, origination, process and underwriting costs. These fees can add up to 1% to 2% of the total loan amount. On average, homebuyers pay $1,387 when purchasing lender fees.
Mind these down payment best practices
Traditional thinking says that you need 20% of the home’s cost for your down payment. But don’t panic if you don’t have that much saved up. Some lenders may accept as low as 3.5%.
Take note: The smaller the down payment you start with, the more risk there is for your lender. So, if you make a down payment that’s less than 20%, it’s likely you’ll have to pay for private mortgage insurance (PMI).
If you can afford to put down 20% (or more), your benefits may include:
Increased home equity
Decreased monthly payments
Potentially thousands saved in interest charges
Check your credit
You should also review your credit history before beginning your home-buying journey. Your credit score can have a major impact on your ability to get pre-approved for different types of home loans, as well as the interest rate (which is determined by several factors) you qualify for. While loans are available for those with not-so-great credit, taking steps to initially improve your score will benefit you (and your wallet) in the long run.
The loan application process
No matter the type of mortgage you choose, you will have to apply for a loan. You may choose prequalification, standard mortgage pre-approval or a verified pre-approval letter (VPAL) to help expedite the process. Your lender will require financial documentation, and depending on the type of pre-approval, you will also undergo a soft or hard credit check.
While the interest rate is important, it’s not the only factor to think about when looking for your new home and mortgage.
Get to know your mortgage options
As a home buyer (or a homeowner who is refinancing), you have plenty of options to choose from when it comes to your mortgage. When exploring the different types of mortgages out there, keep in mind your home cost, down payment, what you can afford to pay month-to-month and how long you’ll live in your home.
Conventional loans
These are the most common types of mortgages and are either conforming or non-conforming.
Conforming loans
While these are not insured by the federal government, they do meet the guidelines set by government-sponsored companies Freddie Mac (the Federal Home Loan Mortgage Corporation) or Fannie Mae (the Federal National Mortgage Association). If you have strong credit, a steady income, and can make a down payment of about 5% or more, applying for a conventional, conforming loan is likely a good option.
Non-conforming loans
These mortgage options do not meet borrowing criteria set by lenders, whether that’s because the amount is higher than the conforming loan limit or the borrower doesn’t have the standard amount of credit or collateral. They may be a good option if you need to forgo a down payment.
Jumbo loans
Jumbo mortgages are the most common type of non-conforming loans. They exceed the loan limits set by Fannie Mae and Freddie Mac and are most common in affluent areas where homes are pricier. To qualify for a jumbo loan, you’ll typically need a top - notch credit score (above 700), a low debt-to-income ratio (below 45%) and must be able to afford a higher down payment.
Non-conventional loans
Depending upon your personal situation, you might be eligible for a government-backed loan or non-conventional mortgage.
Federal Housing Administration (FHA)
FHA loans are for people who don’t have the best credit or can’t afford a large down payment — only 3.5% is required — making them a good option for first-time homebuyers.
FHA mortgages require you to commit to a mortgage insurance premium (MIP) that you’ll pay for the life of the loan. (Unless you can put 10% down, in which case you’ll pay an annual premium for 11 years.)
United States Department of Agriculture (USDA)
Managed by the Rural Housing Service, these mortgages are provided to qualifying borrowers in rural areas with low-to-moderate incomes. Some USDA loans don’t require a down payment and may offer below-market interest rates.
Veterans Affairs (VA)
Whether Army, Navy, Air Force, Marine Corps or Coast Guard (active duty or a veteran), if you’ve served our country, you are eligible for a Veterans Affairs loan. These mortgages are flexible, require little-to-no down payment and have low-interest rates.
Rate type
Regardless of what loan you choose, the interest rate can be either fixed or adjustable.
Fixed-rate mortgages
If you’re planning on living in your home for a significant number of years, or you simply prefer the stability of knowing your interest is not going to change, a fixed-rate mortgage may be the loan you’ve been looking for. The interest rate is locked in for the life of the loan, meaning your monthly payment will stay the same and you can plan your budget for months and years ahead. Fixed-rate mortgages typically come in 15-, 20- and 30-year terms. Keep in mind, longer mortgage terms may mean lower monthly payments, but you’ll likely end up paying more overall in interest. Fixed-rate mortgages are steady and dependable.
Adjustable-rate mortgages
Your other option is an adjustable-rate mortgage (ARM), which typically offers a lower interest rate than a fixed mortgage would for the first few years (usually between three and seven), which can make them attractive. ARMs are also less predictable and carry more potential for risk. After the initial period, your interest rate could adjust repeatedly throughout the duration of your loan.
If interest rates rise, the cost of your monthly payments will increase with an ARM. (An interest rate hike may not seem like a big deal now, but it could cause your mortgage payments to become unmanageable in the future.) Likewise, if interest rates fall, your payments could decrease.
If you only plan to live in your home for a couple years, an adjustable-rate loan may make sense. You can enjoy the lower initial interest rate and move on to a new home (and mortgage) before your rate is subject to change.
Refinancing
As a homeowner, you may come across several reasons for choosing to refinance (aka updating the terms of your mortgage). That might mean converting from an ARM to a fixed-rate mortgage. Or you could pay off your loan faster with a lower interest rate. Maybe you want to pull out cash from your home’s equity — and the list goes on. If you choose to refinance, you’ll likely pick between one of three common types: Rate-and-term, cash-in, and cash-out.
Rate-and-term
Just like the name implies, this option allows you to adjust your interest rate, the length of your loan term or both. You’d likely choose this if you want to convert from a 5-year ARM to a 20-year fixed-rate mortgage or shorten your fixed-rate loan from 30 years to 20.
Cash-out
If you want to pull out cash from your home’s equity — this is often done to finance a major home project — you may opt for this option. In this instance, you would replace your existing mortgage with a larger loan. For example, if you owe $100,000 and refinance with a cash-out loan of $120,000, you are giving up $20,000 worth of equity in your house, but you walk away from the deal with that amount in cash. With cash-out, lenders generally require you to maintain at least 20% equity in your house.
Cash-in
This refinancing option can help you lower your mortgage by increasing the equity on your home (and reducing the amount of your loan balance). Think of a cash-in refinance as making another down payment on your home. Doing so can make your mortgage more manageable every month or allow you to qualify for a lower interest rate.
Beyond the rate
While the interest rate is important, it’s not the only factor to think about when looking for your new home and mortgage. Make sure you consider all the components before making this monumental decision. Once you’ve determined your budget and figured out which type of loan fits your lifestyle, you can start living happily ever after.
