Although many people dream of buying their home in cash and owning it free and clear from the get-go, the reality is that most prospective homeowners will need a mortgage to make their homeowning dreams come true. The process can be daunting, but it’s the smart way to go, as long as you choose the home and mortgage that is right for your needs.
Choosing a mortgage isn’t like buying a loaf of bread; there are many types of mortgages out there, all comprised of a variety of elements that will dictate your experience during the life of your loan. For example, your mortgage will determine everything form the lifetime of the loan, to the interest rate.
To help you make the right decision, we’ve compiled a list of some of the pros and cons of the different mortgages you might encounter when you begin your search.
Fixed and adjustable interest rate mortgages
Usually, the first step in choosing a mortgage is determining how your interest rate is treated. You can lock in your interest rate, make it adjustable, or some combination of both.
For example, on a 30-year mortgage with a 5/1 adjustable interest rate, your interest rate will be locked for five years, then will annually adjust for the remaining 25 years.
Pro of a fixed-rate mortgage
The interest rate is stable for the lifetime of the loan, so your monthly payment will be the same until you’ve paid off your balance, simplifying your budget for many years.
Con of a fixed-rate mortgage
When compared to an adjustable-rate mortgage, the interest on a fixed rate might be higher, at least at first.
Adjustable-Rate Mortgages (ARMs)
- Pro: ARMs offer a lower interest rate and monthly payment for the first few years of the life of the mortgage. In many cases, this allows people to buy a home that would otherwise be out of reach financially.
- Con: Once the period of low interest and reasonable monthly payments is over you risk higher interest rates. In times of economic downturn or unemployment, increased interest rates can quickly make the monthly payment too expensive and put homeowners at risk of foreclosure.
Bottom line: ARMs are indeed appealing but try for a fixed-rate mortgage. Your real estate agent can help you find one that works for you.
Types of Mortgage Terms
Your mortgage term refers to the lifetime of your loan in years. It’s an agreement with your lender on the maximum amount of time it’ll take you to pay off the loan. Common terms are 15, 30, and even 50 years.
- Pro: A 15-year term is a fast track to paying off your loan; it usually features a lower than average interest rate and costs less overall compared to mortgages with longer terms, because more of your money goes to paying off your principal.
- Con: A 15-year mortgage comes with a high monthly payment, especially compared to mortgages with longer terms.
- Pro: Low, reasonable monthly payments compared to a 15-year mortgage.
- Con: A 30-year mortgage means that you will have a higher interest rate, which means that you will not only pay more in interests compared to a 15-year loan, but you will be in debt for much longer.
- Pros: Monthly payments are dramatically lower, compared to shorter-term mortgages.
- Con: The interest rate on a 50-year mortgage is the highest out of all the terms listed, meaning that you will pay the most in total interest with a loan of this term.
Bottom line: Opt for the shortest-term loan you can afford; even if your monthly payment is higher than it would be with a longer-term loan, you will get out of debt and own your home faster and pay less interest.
Conventional vs. Unconventional Mortgages
A conventional loan is a deal between you and a lender that meets Fannie Mae’s underwriting guidelines. An unconventional loan, such as subprime loans, breaks those guidelines and offers loans to people who do not qualify for conventional loans. However, unconventional loans also include government-insured programs, like the FHA, VA, and USDA, that set their own underwriting guidelines. In these cases, the agency agrees to buy the house if the lender forecloses on the home, so the lender won’t lose money if the borrower defaults.
- Pro: The total cost of these loans is generally lower than unconventional loans.
- Con: Conventional loans aren’t backed by the government, which means that lenders may charge a higher interest rate or require a higher down payment (typically at least 5%) compared to unconventional loans. This type of loan also requires that you to pay private mortgage insurance (PMI) if your down payment is less than 20% of the home’s value. PMI protects the lender if you default on your loan, but does not go toward paying off your home.
- Pro: Subprime mortgages can help people who have experienced financial setbacks, like divorce, unemployment, bankruptcy, etc., buy a home and get back on their feet. They can also help people who, for one reason or another, do not qualify for a conventional mortgage.
- Con: The terms on subprime loans are generally unfavorable to the borrower, with a high-interest rate and dangerous penalties.
- Pro: A Federal Housing Administration (FHA) loan can help you buy a home with a little as a 3.5% down payment.
- Con: Unless you can pay more than 10% of the value of the home as your down payment, you will need to pay a mortgage insurance premium (MIP). A MIP can tack on hundreds of extra dollars per month to your mortgage payment.
- Pro: Military veterans can buy a home with no down payment or mortgage insurance.
- Con: A homeowner with this type of loan can quickly find themselves underwater in the event of a downturn in the housing market.
- Pro: The United States Department of Agriculture (USDA) offers a loan program, managed by the Rural Housing Service (RHS), to people who live in rural areas and show a financial need based on a low or modest income. These types of loans allow people to buy a house with no down payment and below-market interest rates.
- Con: USDA/RHS loans cannot be refinanced, which makes it impossible to improve the interest rate, and often come with dangerous penalties.
Bottom line: Avoid the high fees and hidden restrictions of unconventional loans and go with a conventional loan to pay a lower total cost and stability.
Conforming vs. Non-Conforming Mortgages
Your mortgage will either be considered a conforming or non-conforming loan, depending on how much money your lender grants you.
A conforming loan is a loan that meets the standard underwriting guidelines, also known as the approval process, of your specific mortgage program. For example, guidelines for unconventional loans are determined by the FHA or VA, while government-sponsored companies like Fannie Mae or Freddie Mac provide the guidelines for conventional loans.
These companies buy loans from your lender so the lender can fund more mortgages. However, they will only buy loans that are within limits established by their guidelines. If your loan exceeds those limits, it does not conform to their guidelines and is considered a non-conforming loan.
- Pro: You’ll pay a lower interest rate compared to non-conforming loans.
- Con: As we learned earlier, non-conventional loans, like those through the FHA and VA, already feature high-interest rates.
Jumbo Loans (Non-Conforming)
- Pro: Jumbo loans give homebuyers increased buying power.
- Con: Jumbo loans are exclusive; they require excellent credit and significant down payments. They also usually have higher interest rates than conforming loans.
Bottom line: A conforming Fannie Mae loan will be your cheapest option, provided that you are able to put down at least 20% of the home’s value to avoid PMI.
In the case of most mortgages, you slowly own more of your house as you make timely payments. However, there’s a popular mortgage out there that does the opposite: the reverse mortgage.
- Pro: Reverse mortgages allow senior homeowners to supplement their income by borrowing against their home equity in the form of tax-free monthly payments, or a lump sum from their lender.
- Con: Reverse mortgages put a paid-for home at risk because homeowners are selling off their equity for cash and inviting the possibility of debt, thanks to fees.
Choosing the right type of mortgage loan doesn’t have to be confusing or difficult. At Scott Jones Real Estate, we are well-equipped to help you find the perfect home and the loan that will put you on the path toward homeownership. Contact us today to benefit from our experience and know-how.