Finding the perfect home loan is a crucial step on your journey to homeownership. With a variety of mortgage options available, it can be overwhelming to navigate the choices.
Whether you’re looking to purchase your first home in Austin or refinance your property in Miami, understanding the different mortgage types and key factors is essential. This guide from Redfin aims to simplify your options and help you find a mortgage that suits your needs and budget, making your path to owning a home smooth and well-informed.
What is a mortgage? Understanding mortgage basics
A mortgage is a loan taken out to purchase a home, where the property itself serves as collateral. As a borrower, you enter into a legal agreement to repay the loan, along with interest, over a specified period. Your monthly mortgage payment typically consists of four components:
- Principal: The amount borrowed to buy the home.
- Interest: The cost of borrowing the money, calculated as a percentage of the principal.
- Taxes: Property taxes imposed by the local government.
- Insurance: Homeowner’s insurance and, if applicable, private mortgage insurance (PMI).
When comparing mortgage loans, pay attention to the annual percentage rate (APR), which represents the total cost of the loan, including the interest rate and other fees. Understanding these components can help you make informed decisions about your mortgage options and manage your finances effectively.
6 main types of mortgages
Understanding the different types of mortgages can help you determine the one that best suits your needs and financial situation. Here’s an overview of the main mortgage types:
1. Conventional mortgages
Conventional mortgages are not backed by the federal government. To qualify, borrowers generally need good credit, stable employment, and a down payment. These loans often come with lower interest rates and do not require private mortgage insurance (PMI) if a down payment of at least 20% is provided. Conventional mortgages are versatile and suitable for primary residences, second homes, and investment properties.
2. Conforming mortgage loans
Conforming mortgage loans adhere to the guidelines set by Fannie Mae and Freddie Mac. These loans are subject to maximum loan limits that vary by geographic area but are generally lower than non-conforming loans. Because they meet federal guidelines, conforming loans typically offer lower interest rates due to reduced lender risk and are easier to qualify for compared to non-conforming loans.
3. Jumbo loans / non-conforming loans
Non-conforming mortgage loans, also known as jumbo loans, exceed the loan limits set for conforming mortgages. These loans are designed for higher-value properties and come with stricter requirements, including strong credit, larger cash reserves, and higher down payments. While they allow for higher loan amounts, jumbo loans typically have higher interest rates due to increased risk for lenders.
4. FHA-insured loans
FHA-insured loans are backed by the Federal Housing Administration and aim to assist low- to moderate-income borrowers who may not qualify for conventional loans. These loans have more lenient credit score requirements and lower down payment options, with down payments as low as 3.5% for borrowers with credit scores of 580 or higher. However, FHA loans require both an upfront mortgage insurance premium (MIP) and monthly MIP payments, which can increase the overall loan cost.
5. VA-insured loans
VA-insured loans are backed by the U.S. Department of Veterans Affairs and are available to eligible veterans, active-duty service members, and their spouses. These loans offer significant benefits, including no down payment, no PMI, and competitive interest rates. Additionally, VA loans have minimal closing costs and no prepayment penalties. A funding fee may apply, but it can be waived for eligible veterans, such as those with service-related disabilities.
6. USDA-insured loans
USDA-insured loans are guaranteed by the U.S. Department of Agriculture and are intended to promote homeownership in rural areas. These loans require no down payment and offer low mortgage insurance premiums, making them an attractive option for low- to moderate-income buyers. To qualify, the property must be located in a designated rural area, and borrowers must meet income limits that vary by region and household size.
Key considerations when choosing a mortgage
Your financial health
- Credit score: Your credit score significantly affects your ability to qualify for a mortgage and the interest rate you’ll receive. Higher credit scores typically secure lower interest rates, resulting in lower monthly payments and less paid over the life of the loan.
- Income stability: Lenders prefer borrowers with a stable income and employment history. Documenting at least two years of consistent income can be crucial.
- Debt-to-income ratio (DTI): This ratio compares your monthly debt payments to your monthly gross income. A lower DTI indicates better financial health and increases your chances of loan approval. Generally, a DTI below 36% is considered favorable.
Down payment
The size of your down payment impacts your mortgage terms in various ways. A larger down payment reduces your monthly payment by decreasing the amount you need to borrow. It can also eliminate the need for private mortgage insurance (PMI), typically required for down payments less than 20%.
A substantial down payment showcases financial stability to mortgage lenders, potentially resulting in more favorable loan terms like lower interest rates. However, if a larger down payment is not feasible, many loan programs offer lower down payment options to make homeownership more accessible. While a down payment of less than 20% may require PMI, these options enable you to become a homeowner sooner without the need to save a significant amount upfront. This can be especially beneficial for first-time homebuyers or those wanting to keep more cash available for other expenses.
Loan term
The loan term determines the length of time for repaying the loan, influencing your monthly payments and total loan cost. Common terms include 15, 20, and 30 years, with some lenders offering other options like 10, 25, or even 40-year terms.
- 15-year term: A 15-year mortgage comes with higher monthly payments but significantly lower interest costs over the loan’s life. This is because you pay off the loan faster, reducing total interest paid. Ideal for borrowers seeking to build equity quickly and able to afford higher payments.
- 20-year term: A 20-year mortgage offers a balance between manageable monthly payments and reduced total interest costs compared to a 30-year loan. A good compromise for those desiring a shorter payoff period without the higher payments of a 15-year loan.
- 30-year term: The most popular choice due to lower monthly payments, making homeownership more affordable. However, higher total interest costs over the loan’s life. Suitable for borrowers preferring lower monthly payments and planning to stay in their home long-term.
- Other terms: Some lenders offer unconventional terms like 10, 25, or even 40 years. A 10-year loan has the highest monthly payments but the least interest paid. A 25-year term offers slightly lower payments than a 20-year term, while a 40-year term has the lowest monthly payments but the highest total interest cost.
Interest rates
Interest rates significantly impact your mortgage payments and total loan costs. They play a crucial role in the affordability of your loan and the amount paid over the loan term. Consider two primary types of mortgage interest rates:
- Fixed-rate mortgages (FRMs): The interest rate remains constant for the loan’s life, offering predictable monthly payments.
- Adjustable-rate mortgages (ARMs): The interest rate is fixed for an initial period (e.g., 5, 7, or 10 years) then adjusts periodically based on market conditions. ARMs start with lower rates but can rise significantly after the initial period.
When choosing between fixed-rate and adjustable-rate mortgages, consider your long-term plans, financial stability, and risk tolerance. FRMs offer predictability and peace of mind, while ARMs provide lower initial payments but come with the risk of future rate increases. Evaluate your situation carefully to determine the interest rate type aligning best with your financial goals.
What to do once you’ve decided on the right mortgage
After selecting the ideal mortgage type for your needs, it’s time to take the final steps towards securing your home loan. Firstly, get pre-approved to establish your budget and enhance your position as a buyer. Work closely with your lender to gather required documentation and complete the application process. Review the terms thoroughly and address any queries before finalizing your loan. With the right mortgage in place, you’ll be on track to turning your homeownership dream into reality.
What mortgage is right for me FAQs
What is the difference between a fixed-rate and an adjustable-rate mortgage?
A fixed-rate mortgage maintains a constant interest rate throughout the loan term, delivering steady and predictable monthly payments. An adjustable-rate mortgage (ARM) features an initial fixed-rate period followed by periodic rate adjustments based on market conditions, leading to fluctuating monthly payments.
How much should I save for a down payment?
The amount to save for a down payment depends on factors like the mortgage type, home price, and financial situation. While the traditional guideline is 20% of the home’s price, many loan programs allow lower down payments ranging from 3% to 10%. Saving more can reduce monthly payments and potentially eliminate the need for private mortgage insurance (PMI). If saving 20% is challenging, explore options aligning with your budget and financial objectives.
Can I qualify for a mortgage with bad credit?
Yes, certain loan programs, like FHA loans, cater to borrowers with lower or poor credit scores. However, a higher credit score can secure better interest rates and loan terms.
What is PMI, and do I need to pay it?
Private mortgage insurance (PMI) safeguards the lender if you default on the loan. It’s typically required for down payments below 20%. Some loan programs, like VA loans, waive the need for PMI.
What are the benefits of getting pre-approved for a mortgage?
Getting pre-approved helps determine your affordability, enhances your appeal to sellers, and enables swift action when finding a home. It also provides clarity on the loan terms and interest rates you qualify for.
What should I consider when choosing a mortgage lender?
When selecting a mortgage lender, evaluate factors like interest rates, loan terms, fees, customer service, and the lender’s reputation. Comparing offers from multiple lenders can help find the best deal for your financial situation.
What are closing costs, and how much should I expect to pay?
Closing costs encompass fees related to finalizing your mortgage, such as appraisal fees, title insurance, and attorney fees. These costs typically range from 2% to 5% of the loan amount. Some loan programs may provide assistance with closing costs for first-time buyers.
How can I avoid mortgage lending discrimination?
Mortgage lending discrimination is illegal. If you suspect discrimination, you can file a complaint with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD). Ensure you’re aware of your rights and seek legal advice if needed.