Obtaining a mortgage doesn’t always mean you’ll be coughing up 20% down and forking over the same payment for 30 years. Take a look at today’s most common types of mortgage so you understand what’s the best for you — and obtain the best mortgage rate in the process.
A fixed-rate mortgage is by far the most common type of home loan. It’s also the easiest to understand. Though the proportion of principal versus interest on your bill will change over the course of the loan, you still pay the same amount every month. Your interest rate is locked in when you close on the loan, so you aren’t vulnerable to sudden increases in interest rates.
Of course, while you aren’t vulnerable to interest-rate increases, you’ll lose out if rates decline — you’ll be stuck paying that higher rate. It can also be harder to qualify for a fixed-rate mortgage if your credit score is less than stellar, particularly if interest rates are high. Down payments are typically high, too, with most lenders requiring 20% of the loan to avoid pricey mortgage insurance.
Fixed rate mortgages are most often offered for 10-, 15- or 30-year terms, with the latter being the most popular choice. Longer terms generally mean lower payments, but they also mean it will take longer to build equity in your home. You’ll also pay more interest over the life of the loan.
We opted for a 30-year fixed rate mortgage when we bought our most recent home. Because we closed at the beginning of 2013, when rates were at historic lows, we were reasonably confident about locking in our rate. Though we still have to pay mortgage insurance because we didn’t quite have a 20% down payment, we’re able to afford it, and we don’t mind taking a while to build equity since we believe we’ll be staying put for a long time. It’s also easy to budget for the same payment every month.
Adjustable-rate mortgages (ARMs)
ARMs make home-buying more accessible for more people. Typically, they offer lower down payments, lower initial interest rates, and lower initial payments, making it easier for a wider range of people to qualify for better homes. The interest rate remains constant for a certain period of time — generally, the shorter the period, the better the rate — then rises and falls periodically according to a financial index.
The main downside is obvious: If your ARM begins to adjust when interest rates are climbing, your escalating payments could start to squeeze your budget. It can also make annual budgeting tricky, and if you want to refinance with a fixed-rate loan, the cost can be quite steep. Ultimately, with an ARM, you’re accepting some of the risk that your mortgage lender would absorb with a fixed rate loan.
There are several kinds of ARMs. One-year ARMs typically offer the best mortgage rates, but they’re also the riskiest because your interest rate adjusts every year. At slightly higher rates, hybrid ARMs offer a longer initial fixed-rate period. Common hybrid loans include 5/1 mortgages, which offer a fixed rate for five years and then and an annually adjustable rate for the next 25 years.
FHA and VA loans
FHA and VA loans are government-backed mortgages. FHA loans require much smaller down payments than their conventional counterparts. In fact, you may qualify for an FHA loan with as little as 3.5% down. They may also be available to those with less-than-perfect credit. However, you’ll likely be on the hook for mortgage insurance each month in order to help the lender blunt some of the risk. That makes FHA loans a good option for those with a steady, healthy income without enough savings for a huge down payment. My husband and I purchased our first home using an FHA loan and roughly 10% down. Though we did have to pay mortgage insurance, we received a good interest rate and could easily handle the payments with our income — and of course, we were happy to start building equity instead of paying rent month after month.
VA loans are also available with low (or even no) down-payment options, minus the mortgage insurance required on FHA loans. However, the VA typically charges a one-time funding fee that varies according to down payment. You must have a military affiliation to get a loan — active-duty members, veterans, guard members, reservists, and certain spouses may qualify.
Technically, interest-only mortgages are a type of ARM. These mortgages are compelling because they allow home buyers to pay only interest for a certain period at the beginning of the loan, keeping payments as low as possible. They can be a good choice for someone who expects a significant increase in income down the pike.
If this sounds like a sweet deal, it’s because interest-only mortgages come with tremendous risk. They can goad buyers to purchase much more home than they would otherwise be able to afford. Your payment is lower initially, because you are only paying interest, and not principal. Once the interest-only payment period is up, your payment will jump significantly when you begin to pay the principal of the loan, plus you can experience a rate increase. With these risks, you’ll probably want to steer clear of interest-only mortgages as your primary option.
Balloon mortgages offer low, fixed interest rates for a short term — typically five to 10 years. In fact, you may only pay the interest on the loan for that term. The catch? The remainder of the loan, likely a very significant sum, is due when the term is up. While most people intend to refinance with a more traditional mortgage to avoid making the lump-sum payment, depending on doing this is a big risk. If your home has declined in value or you’re deemed uncreditworthy, you might be out of luck — and at risk of foreclosure. For this reason, balloon mortgages are best avoided except in very special cases.