There are so many different financing options for purchasing a home. Your real estate agent may advise you to invest in an adjustable rate mortgage, while a loan officer might tell you that a fixed rate mortgage is better for you. Selecting the right mortgage can be a difficult decision. Homebuyers have lots of questions such as: What is a mortgage? What are the different mortgage options available to me? What do I need to apply for a mortgage? Rather than getting confused and pulling your hair out, it is best to understand the different types of mortgage so you are properly informed. Let’s take a look at the basic information needed before buying a home

What Is A Mortgage?

A mortgage is a loan given by a financial institution to finance the purchase of a home. Banks, credit unions, and home loan companies serve as mortgage lenders for potential homebuyers. They offer a variety of loans to homebuyers based on their qualifications including income, credit score, employment history. The three most types of loans available to home shoppers are 

• Fixed Rate Mortgages 

• Adjustable Rate Mortgages 

• FHA Mortgages

Fixed Rate Conventional Mortgages

The most popular type of home loan is a fixed rate mortgage with ninety percent of homebuyers opting for a fixed rate mortgage. A fixed rate mortgage has a static interest rate throughout the loan meaning your payment is the same for the entire life of the loan. There is no variance in the principal and interest payment from month to month. The average fixed rate mortgage borrower has a 30-year term. Some individuals opt for a 15-year term to pay off their mortgage sooner.

Advantages

• The consistent monthly payment makes it easier to manage your finances and proactively plan your budget.
• It gives you the ability to lock in a low interest rate for a 30 year time period protecting you from higher rates during inflationary periods. You can lock in a 3 to 4 percent rate for 30 years.
• Fixed rate mortgages have terms that are easier to understand and are similar regardless of the lender.

Disadvantages                                   

• If interest rates decline, buyers are stuck with higher fixed rates unless they refinance.
• There is no incredibly low introductory period for a few years.
• Fixed rate mortgages require better credit from the borrower and a higher down payment up to 20 percent. 

Adjustable Rate Mortgages (ARM)

Adjustable rate mortgages have flexible interest rates that rise and fall based on the interest rate policy set by the Federal Reserve. The interest rate is fixed for the first few years then becomes variable after the expiration of the fixed term. Adjustable rate mortgages offer 3, 5, 7, and 10 year fixed time periods before rates adjust.  Interest rate only loans are ARM’s that allow the borrower to pays only interest the first few years before having to deal with the principal at a future date. The principal amount remains untouched during the years that only interest is being paid. Balloon mortgages offer lower monthly payments for a number of years with a massive balloon payment due at the end of the loan term. Interest only and balloon payment loans can leave a homeowner upside down with more debt than home equity.

Adjustable rate mortgages are dangerous because they are so unpredictable. Hostile interest rates caused many homeowners to lose their homes during the financial crisis of 2008-2009. ARM homebuyers start with very low payments that quickly escalate after a few years.

Advantages

• Your monthly payments are lower when interest rates are lower which saves you money.
• You can qualify for a larger loan amounts during low interest periods.
• Interest rate caps restrict the maximum interest payment that is allowed for the loan.
• You can get an ARM with a lower credit score.
• ARM’s offer incredibly low introductory payments.

Disadvantages

• Your monthly payments are volatile. Your mortgage payment could double or triple as interest rates rise.
• The potential for drastically higher payments increases the risk of defaulting on the loan costing you your home.
• You can easily find yourself upside down after a few years owing more on the home than it’s worth.

I always advocate for homebuyers to lock in a fixed rate mortgage due to the stable interest rate and stable monthly payments. Adjustable rate mortgages are best for deep-pocketed investors who are looking to sell homes quickly and possess the cash to ride our interest rate turbulence. Primary residence homeowners should never buy a home without the expectation of living in it for a minimum of five years.

FHA Loans

FHA loans are issued by financial institutions and are guaranteed by the Federal Housing Administration. FHA loans allow for lower down payments with 3.5% being the minimum down payment percentage. They grant loans to individuals with low to moderate-income levels. FHA loans grant loans to individuals with credit scores as low as 500 as long as they meet other loan criteria. The mortgage cannot exceed greater than 31% of gross monthly income and the total debt burden cannot exceed 43% of gross monthly income. The borrower must also possess a minimum of two established lines of credit. The home must be the borrower’s primary residence. FHA loans are fixed term loans issued for either 15 or 30-year time periods. 

Advantages

• Smaller down payment – Down payment ranges from 3.5% – 10% based on credit worthiness
• Lower closing costs
• More lenient income requirements
• Approval with lower credit scores
• Easier approval process 
• FHA loan rates are fixed regardless of credit score.

Disadvantages

• Mortgage insurance premium is required. You will have to pay MIP until you have paid off 20% of your home’s value. This insurance protects the lender in the event of default.
• Your ability to purchase the home you want can be limited since homes in some areas do not qualify for FHA financing.
• Lower loan ceiling may not allow you to purchase the home you want since there are caps on borrowing amounts.

Other Loan Types

United States Department of Agriculture (USDA) loans offer low-income buyers the opportunity to purchase homes in rural areas with no down payment. Buyers who served in the military can apply for VA loans, which help service members, veterans, and surviving spouses purchase homes with a low interest loan insured by the Department of Veterans Affairs. Since private lenders make VA loans, rates do vary based upon credit scores.

Applying For A Mortgage

Applying for a mortgage can be overwhelming because there are so many things that you have to place on your mortgage checklist. You need to first make sure that you have your ducks in a row. Here are some factors that first time homebuyers should consider during the application process:

Get Copies Of Your Credit Report

As a borrower, it is important to obtain credit reports from each of the three major credit bureaus (Equifax, Experian, Transunion), and examine them carefully. If the information isn’t correct, your interest rate can go up, and you might not be approved for mortgage altogether! Ensure that the credit report is error-free. Rectify all discrepancies and credit reporting errors quickly. Carry extremely low credit card balances, and pay them off along with all other outstanding bills before applying for the mortgage. 

Ensure You Have A Good Credit Score

Don’t apply for a home loan until your credit score reaches the 660 level. There are programs for borrowers with credit scores in the 500’s but the loan terms are not as favorable. A high credit score makes you a less risky borrower. This gives you access to lower interest rates, less fees, and lower down payment requirements. The loan approval process is much easier with a good credit score as there are fewer creditors to pay off and fewer debts to settle.

Make No New Purchases

Once you have been approved for a home loan, avoid making any new major purchases that could affect your loan approval amount. Wait to buy new furniture, new appliances, and that new car until after you have closed on your house. New purchases can ding your credit and increase your debt levels. The credit utilization of the borrower is considered when applying for a mortgage so steer clear of closing current accounts or applying for new ones. They can cause the bank to yank away the loan approval that you previously qualified for.

Get Your Down Payment Ready

The more money you can afford to pay up front, the better your chances are of getting approved. The loan amount is also lower. Paying at least 20% of the home’s purchase price up front greatly minimizes the overall figure. Buyers who can make a larger down payment are able to purchase more expensive houses, and 20% or more can help buyers avoid mortgage insurance altogether. Of course, borrowers with an excellent credit history are likely to be approved regardless of how much money they can afford to put down. For those with less than perfect credit, the amount of the down payment could make the difference between approval and rejection. 

Get Your Documents Together For Income Verification 

Lenders and banks take a look at your W-2’s, 1099’s, and 1040’s. Lenders use your tax returns and bank statements to verify your income and employment history. This is why it is not advisable to change jobs or quit before submitting a mortgage application. Banks also typically require two months of bank statements and statements of other assets, which must match the information you previously provided. Abnormal banking activity can make banks suspicious of financial manipulation, money laundering, or criminal activity.

Set Some Spare Cash Aside

Most home loan borrowers need cash for the home down payment, to cover closing costs, and pay for points if necessary. Most loans require some cash from you. Banks like to know that you are as equally invested in your home purchase as they are. Keep some extra cash in a money market or savings account so you are not scrambling at the last minute trying to raise some.

Calculate Your Debt To Income Ratio (DTI)

Figure out your debt-to-income ratio so you can determine how much of a home you can afford on a monthly basis. Lenders are unlikely to approve the mortgage for a borrower with high debt levels. Your debts should be less than 31% of your monthly gross income before applying for a home loan. Your debt to income ration should not exceed 43% with your home loan included. The lower your debt levels, the greater your chance for loan approval.

Remember that buying a home should be an exciting time! You can make it an easy time as well by having your financial house in order before applying.