Choosing a mortgage is an involved process, and we are here to help you understand each factor in depth. Whether you’re a first time home buyer or an experienced buyer, knowing each factor well is the first step to ensuring you get the right mortgage that fits your needs.
The factors to consider when choosing a mortgage are:
- Interest rate: fixed or adjustable
- Loan length: usually a choice between 15 or 30 years
- Loan type: Conventional, government, etc
In the next few paragraphs, you’ll learn how mortgages work, as well as important information on their length, types, and most bet options in terms of lenders.
Adjustable-rate mortgages vs. fixed-rate mortgages
When choosing a mortgage, most homebuyers start by determining if they want a fixed-rate or adjustable-rate mortgage. The difference between these two is straightforward: fixed-rate mortgages have a fixed interest rate, and adjustable-rate mortgages have variable interest rates. There are pros and cons for each—and rewards and risks of each—so continue reading to learn what these are.
Before diving into the pros and cons, here are two general rules of thumb:
- The shorter the mortgage, the more seriously you should consider a variable-rate mortgage. This is because ARMs usually start out at a lower rate and increase over time so by only staying with the mortgage for so short, you get to take advantage of that low intro rate.
- In a world of lowering interest rates, consider an adjustable rate. And in a world of increasing rates, consider a fixed rate. Why? Because if the rate drops, your ARM drops with it and with increasing rates, your fixed rate will always stay the same.
Pros and Cons of Fixed-rate Mortgages
A fixed-rate mortgage has a fixed interest rate. That is it—the interest won’t change during the time of the mortgage. Fluctuations in interest rates on the financial market will have no bearing on the amount you pay each month.
There are a handful of advantages and disadvantages with fixed-rate mortgages. Here are just a few of them.
Pros of a fixed-rate mortgage
- Lock in lower payments. With lower interest rates (like right now), you get to lock in a historically-low interest rate.
- Reduced anxiety around interest rate fluctuations. You can sleep better at night, knowing that your mortgage payment will not increase.
- Easier to budget for the future. When you know that you’ll pay the same amount for your mortgage all the time, you can much more easily predict what your future annual budget will be.
Cons of a fixed-rate mortgage
- Higher-income required. Banks don’t generally offer fixed-rate mortgages to low-profile mortgage seekers so you’ll need to have a substantial income and some savings to be eligible to qualify for a fixed-rate mortgage.
- Possibility of refinancing. If interest rates drop, you’ll have to rearrange your mortgage to get those more favorable rates (called “refinancing” your mortgage); every such refinance plan incurs additional costs.
So, it’s necessary to calculate how much money you can pay per month in line with your income. This will help you avoid defaulting on a hard-money loan and pay your installments on time.
Pros and cons of adjustable-rate mortgages (ARMs)
An adjustable-rate mortgage (ARM) is one that’s interest rate fluctuates with market conditions. It goes up or down depending on what the market lender rates are set at.
Pros of an ARM
- Lower initial interest rate. The interest rate at the beginning of the loan is usually lower than a fixed-rate mortgage. This will save the average homebuyer thousands of dollars a year.
- Affordable for clients with lower salaries. Another benefit of ARMs is that you don’t need an exceptionally high income to qualify for such a mortgage, so people with different socio-economic backgrounds can be eligible.
- Savings in case of lowered interest rates. The most significant benefit is that if interest rates on the market decrease, your monthly installment will drop without you having to refinance your mortgage (and pay those high fees!).
Cons of an ARM
- Higher interest rates, higher installments. As interest rates grow, your monthly payment will be higher, taking a larger part of your income. This could be too costly if rates increase a lot. Imagine qualifying for a 3% ARM this year, then in 8 years from now, your interest rate is 12%. This is scary, and the main reason why buyers are applying for fixed-rate mortgages when they qualify.
Term length and total paid amounts
One of the most valuable mortgage hints is negotiating the shortest mortgage length for which you may qualify. You can save a substantial amount of money on interest rates if you opt for a more straightforward mortgage.
If you can afford a 15-year mortgage (instead of 30 years), do it. By paying off your mortgage faster, you build your equity faster. However, monthly installments for a short-term mortgage are much higher. It’s much harder for people with lower salaries to endure such a payment pace.
On the other hand, a mortgage arranged over a 30-year period will have significantly lower monthly installments. This makes it suitable for people with lower salaries and people with higher wages who don’t want to pay a high monthly installment. But in this case, you’ll be paying interest rates for 30 years, i.e., 360 months. In other words, you’ll end up paying a much higher total sum in the end due to paying interest rates for 30 years.
Loan types and options
There are numerous mortgage types available for mortgage seekers that banks offer. For most home buyers or refinancers, the following four options are the most important and common ones.
A conventional mortgage is the one offered and concluded with a commercial bank, in line with the market conditions. Traditional loans can be arranged via private companies, such as Freddie Mac. They are private entities, but they’re under the supervision of the government.
Credit unions are a good option for people with lower or middle-class incomes. These are non-profit organizations funded by their members to enable a larger number of people to buy their own homes.
Jumbo loans for higher loans
The loans higher than $510,400 belong to the category of jumbo loans. If you’re aiming at such a mortgage, you need to talk to private lenders and investors. There are different investment funds and real estate brokerages that give such mortgages.
Federal Housing Administration (FHA)
As a section of the Department of Housing and Urban Development (HUD), the FHA insures real estate loans to people with lower incomes and those who are buying their first property. These loans include certain limits that are not the same in all the US states. It’s easier to qualify for mortgages insured by the FHA than for those offered by banks. That said, it will also increase your monthly payments because the FHA doesn’t fund the mortgage; it merely insures it against default. This additional insurance is what increases your monthly income.
Loans without documentation
No-document loans are a viable option for people who don’t want to bother with detailed documentation or don’t have a credit history. For such loans, you don’t have to submit any information about your employment type or salary. The application process for such mortgages is usually more straightforward than for traditional loans.
On the downside, no-doc mortgages come with higher interest rates, and the number of lenders here is limited. If you can avoid this option, you should do your best to go another route.
During the process of negotiations with your potential lenders, you’ll learn that most of them will ask you to pay the “mortgage points” related to the loan before the conclusion of the deal. This is usually 1% of the total amount of the mortgage in question. So, take that amount of money into account when negotiating the terms of the loan.
A well-maintained credit score is a factor to consider before taking a loan to buy a house or apartment. If you have some unsettled debts, you’re less likely that you’ll get a mortgage under acceptable conditions. So, take some time to polish your credit history before you apply for a loan.
Last but not least: no matter what mortgage type you opt for, do your best to pay at least one additional installment per year. This will reduce the total savings amount paid to the lender and keep a few thousand dollars more in your pocket.
Mortgages can be tricky so it’s important to do your research so you understand what you’re working with. For those of you new to home-buying, make sure to read our Millennial Mortgage Guide so you can have more in-depth knowledge of how mortgages work, the different types, and all other important need-to-know mortgage information.