This is part two of the Buying a House series. If you haven’t read the first part, “How Much House Can I Afford?” you click over and read that one first. It’s important to know how much house you can afford before worrying about mortgages.
What is a mortgage?
Most people these days cannot afford to pay cash for their home, and I’m guessing that if you’re reading this, you are not completely established yet and/or this is your first home purchase. Luckily, for those of us that do not have the cash to purchase a home, we have the option of getting a mortgage to cover the (usually large) portion that we can’t. A mortgage is a loan that either a bank or mortgage lender gives you to help finance the purchase of a house.1
A mortgage is made up of four things: principal, interest, taxes, and mortgage insurance. Principal is the amount of money you are borrowing to purchase the house. The interest is a percentage of the principal that you pay to borrow money from the lender. Taxes are the property taxes that you pay based on the value of the house. Mortgage insurance protects the lender if you default on your loan, and for conventional loans, you typically only have to pay this if your down payment is less than 20%.
A conventional mortgage is a mortgage that is not insured or guaranteed by the federal government. A conventional mortgage meets the funding criteria of Fannie Mae and Freddie Mac, and the interest rate can be either fixed or adjustable. Most conventional mortgages require at least a 20% down payment, although this is not always the case.
A fixed-rate loan is pretty straight forward. It is a loan where the interest rate remains the same throughout the life of the loan. This means that if you get a 15 year conventional mortgage with a fixed-rate of 5%, you would pay 5% interest this year, the 15th year, and every year in between. If the market changes and mortgage rates drop to 3%, you’re still locked into your 5% rate unless you refinance. The same goes if mortgage rates increase to 8%, you’re still paying your 5%.
An adjustable-rate mortgage is a loan where the interest rate fluctuates with the market. Most adjustable-rate mortgage loans have an initial fixed-rate period, followed by a longer period where the rate is adjustable. This means that initially your monthly payments will be the same, but after the fixed-rate period ends, your payments could increase or decrease. The benefits of adjustable-rate mortgages is that the initial rate is generally lower than that of a comparable fixed-rate mortgage, and after the fixed-rate period ends, the interest rate could drop along with the monthly payments. The down-side to adjustable-rate loans is that after the fixed-rate period ends, the interest rate could increase along with the monthly payments, and since interest rates are unpredictable, you can’t predict what your payments will be in the future.
A FHA loan is a mortgage insured by the Federal Housing Administration. The FHA is an agency within the US Department of Housing and Urban Development. FHA loans offer attractive interest rates and have more flexible requirements, such as lower down payments, because they require mortgage insurance to protect the lender from a loss if the borrower defaults on the loan. FHA loans can be ideal for people with low credit scores and not much money available for down payments. A couple of other benefits are that your closing costs may be covered and the FHA offers a 203(k) loan to borrowers who need extra money to make repairs, which is a loan based on the projected value after repairs are completed.
A VA mortgage is a loan that is backed by the Department of Veterans Affairs for veterans, active military personnel, and military spouses. The VA backs these loans, but they do not actually lend the money. These mortgages come with benefits such as no PMI (private mortgage insurance) and zero down payment. Unless you or your spouse is or has been in the military, you will not qualify for a VA loan.
USDA loans are mortgages that are backed by the USDA Rural Development Guaranteed Housing Loan program of the US Department of Agriculture. These loans are available to home buyers with incomes that are determined to be below average. USDA loans offer 100% financing, feature below-market mortgage rates, and offer ruduced mortgage insurance premiums.2 Check out the USDA’s website to determine if you and/or your house are eligible for a USDA mortgage.
Which Is Best For Me?
Let me start by making sure you understand that I am not a licensed financial advisor, I’m just telling you what I would tell a friend. Please check with a licensed financial advisor or Realtor before you decide on a mortgage. Anyways, the right mortgage for you is going to depend on a few different factors. First, let’s get the VA loan out of the way. If you or your spouse are not veterans or currently in the military, you will not qualify for a VA loan.
If you do not have a great credit score or much money to put towards a down payment, a FHA or USDA loan might be right for you. If you have a very low or low income and no money for a down payment, the USDA loan would be best for you if you can find a house that qualifies. The FHA loan has slightly higher income and credit qualifications than the USDA loans, with a minimum down payment of at least 3.5% (though this can be a gift from parents), but there is no geographic restrictions for the homes.
If you have decent credit and money for a down payment, a conventional mortgage is the way to go. For the down payment, 20% is ideal, but I was able to get my first conventional mortgage with only 3% down. Your minimum down payment is going to depend on your credit score. As far as whether you should go with a fixed-rate or adjustable-rate mortgage, I would never tell someone to go with the adjustable-rate. These loans are for anywhere from 15 to 30 years, and there’s no way you can say today that the interest rates aren’t going to climb during that time, so just lock in a low interest rate from the beginning.
“Save a down payment of at least 10% on a 15-year (or less) fixed-rate mortgage, and limit your monthly payment to 25% or less of your monthly take-home pay.”3
- What is a Mortgage? by Zillow
- USDA Loans – USDA Loan Rates & Requirements by The Mortgage Reports
- The Truth About Mortgages by Dave Ramsey
- Featured image by NY Photographic