Choosing a mortgage is a major decision and many factors determine which is best for you. Here are the main factors you’ll have to consider:
- Your Income And Financial Status
- How Long You Plan To Keep The Home
- Your Risk Tolerance
- Your Lifestyle
Mortgages come in many variations and sorting through the choices can be complicated. Loan selection is broad and differs by:
- Who Guarantees The Loan
- Interest Rate
- Loan Structure
- Documentation Requirements
What Is Your Situation?
- I’m a first-time buyer
- I’m a veteran
- I can put more than 20% down
- I want the lowest possible payment
- No Documentation (“No Doc”) Mortgage
- I want a consistent monthly payment
- I’m willing to have my payment fluctuate
- I looking at a 30-year term on my mortgage
- I am looking at a 15-year term on my mortgage
- I am looking at a biweekly mortgage
- I am looking at a ballon mortgage
- Interesting Only Mortgage
- I need to get a loan based on my home equity
- Home Equity Line of Credit
WHO GUARANTEES THE LOAN
Government-Backed Mortgages – Do You Qualify?
Some mortgages are guaranteed (“backed”) by government agencies. If you qualify for an FHA or a VA mortgage, they can offer easy qualification requirements and low (or no) down payments. If you don’t qualify, then you can apply for a conventional loan.
The down payment for an FHA Mortgage (Federal Housing Administration) Mortgage is low but the amount that can be borrowed is also low. For 2005, the maximum loan amount is $221,160 or less (for Hennepin, Ramsey and Dakota Counties). The minimum down payment is only 3%. Closing costs can be included in the loan amount, too. Customary costs above and beyond the sale price of the property that must be paid to cover the transfer of ownership at closing. These costs can vary and are spelled out to the borrower after submitting a loan application. You can get a fixed rate (A mortgage with payments that remain the same throughout the life of the loan. Interest rate and other terms are fixed.) or adjustable rate FHA mortgage. Mortgage insurance premiums are required, and you’ll be charged both an up-front premium and an annual premium.
- Best When – You can only afford a small down payment. Good for first-time buyers
- Advantages – Down payment is low and interest rates are competitive
- Disadvantages – The maximum loan amount is $221,160 in Hennepin, Ramsey or Dakota County (for 2005)
A VA Mortgage is available only to active or former servicemen and women. No down payment is required, but you will be charged an up-front mortgage insurance premium at the time of closing. You can get a fixed or adjustable VA loan.
- Requirement – You must meet qualifications regarding military service
- Advantages – No down payment required, and interest rate is competitive
- Disadvantages – The maximum loan amount with no down payment is $359,650 (2005)
If you have at least 20% to put down on a home, you might consider a Conventional Mortgage. With 20% down, mortgage insurance is not required.
- Best When – You can put 20% or more down
- Advantages – You save money by eliminating mortgage insurance
- Disadvantages – Your loan may be sold from one lender to another
Another option is the Insured Conventional Mortgage. If you cannot put 20% down but still want to avoid paying mortgage insurance, some lenders will offer a higher interest rate on the loan in exchange for paying the mortgage insurance. So you need to weigh the ultimate cost of the higher interest rate against the savings gained by avoiding mortgage insurance premiums.
- Advantages – Interest payments are tax-deductible, whereas insurance premiums are not
- Disadvantages – You pay more interest for the life of the loan, whereas mortgage insurance will end when equity reaches 80%
If your loan amount exceeds the FHA or VA limits (mandated by law), then your mortgage is called a Jumbo Mortgage. This term is also used generally to mean mortgage loans for more than $500,000. Jumbo mortgages can also be called “non-conforming mortgages,” although this term is also used to describe mortgages where credit is poor or documentation is inadequate. A jumbo mortgage has a loan amount above conventional loan limits. Currently, FNMA and FHLMC will set a limit on the loan amount that they will purchase from an individual lender. This amount in 2005 is $359,650. Borrowers seeking loans of $500,000 an up, must turn to other lending sources such as banks and insurance companies. Jumbo loans can go up to $10 million but standard is $359,000-$650,000.
- Advantages – You obtain the large loan amount that you need
- Disadvantages – The interest rate is higher because jumbo mortgages are less common
Various levels of documentation are required when applying for a mortgage, and these vary by lending institution. If you can supply full documentation, you’ll be viewed as a solid borrower, which will help you get the best interest rate.
Full Documentation Mortgages
With full documentation mortgages, income and assets are disclosed by you and verified by the lender.
- Advantages – Your chances for a low interest rates and low down payment are optimized (because this is the safest type of documentation for the lender)
Low Documentation (“Low Doc”) Mortgages
With low documentation mortgages, the documentation requirements are loosened, but you still have to provide information about income and assets.
- Stated Income / Stated Assets: When your source of income is verified, but the actual amount is not, and you state your assets, but they are not verified
- Stated Income / Verified Assets: When your source of income is verified, but the actual amount is not. Assets are verified and must meet certain verification standards
If you are unable to provide full documentation, check into the “No Doc” mortgage. These loans waive one or more of the requirements, and are typically adjustable rate mortgages. For No Doc loans, you’ll need a credit score above 680 (although some programs permit scores as low as 660). If you are not a US citizen, a No Doc loan can allow you to obtain a mortgage, provided you meet the credit score threshold.
- No Ratio: When income is disclosed and verified, it the data is not used in qualifying for the mortgage
- No Income: When income is not disclosed but assets must meet verification standards
- No Asset: When your assets are not disclosed but your income is used for qualification
- No Income / No Asset (NINA): When neither your income nor your assets are disclosed. Approval for this type of loan is based on down payment, credit history and the value of the property and requires documentation of employment of the last two years
- Advantages (of Low Doc and No Doc): If you can’t meet full documentations requirements, you can still get a mortgage
- Disadvantages (of Low Doc and No Doc):Because more risk is assumed by the lender, interest rates may be higher and a greater down payment may be required
The term of a Fixed-Rate Mortgage is traditionally 15 or 30 years. Interest rates are fixed, and so is the monthly payment.
- Best When – Your risk tolerance is low
- Advantages – Predictable payment schedule
- Disadvantages – Rates not as low as with ARMs
Usually, an Adjustable Rate Mortgage (or “ARM”) has a limit (cap) on how much the rate may increase. The cap protects you from drastic market changes, but ARMs don’t offer the stability of a fixed rate loan.
ARMs are a good choice for people who predict a rise in their income to keep pace with the loan rate’s periodic fluctuations. If you plan to move in a few years and are not concerned about the possibility of a higher rate, an ARM also could be a good choice.
An ARM’s rate is based on a money market index. A very common index is the one-year U.S. Treasury bill (called a T-Bill). To come up with the ARM interest rate, the lender will add a “margin,” usually two to four percent, to the index.
The first number in the ARM is the number of years that the annual percentage rate is fixed. The second number is the number of times the annual percentage rate can change during a one-year period. For example a “3 to 1 ARM” or “3/1 ARM” has a fixed rate for the initial term of 3 years, but thereafter, the annual percentage rate may change only once per year.
Another index is the London InterBank Offered Rate (LIBOR) This interest rate is offered for U.S. dollar deposits by a group of London banks. LIBOR mortgages differ depending on the length of maturity of the deposit made to the London banks.
- Best When – You are tolerant of fluctuations in your monthly payment in order to get a lower interest rate at the outset. Also good if you plan to sell the home in a few years
- Advantages – Low interest rates
- Disadvantages – Interest rate fluctuates, making planning harder
You can sometimes pay points to get a lower interest rate. A point is one percent of the amount of the mortgage loan. On FHA and FA loans, buyers are prohibited from paying points, although a seller can. On a conventional mortgage, points may be paid by either buyer or seller or split between them.
The term is the length of the mortgage. Payments are due according to an amortization schedule, which incorporates (1) the term, (2) the interest rate, and (3) the frequency of payment. By manipulating any one of these three factors, the dollar amount of the payment will change.
With a 30-year term, monthly payments are lower than on a 15-year mortgage because the payments are spread over a longer period. However, interest rates are higher than on a 15-year loan, and equity is built at a slower pace because payments during the early years go largely toward interest, not principal.
- Best When – You plan to keep your home a long time
- Advantages – If interest rates are low, you lock in a low rate for 30 years
- Disadvantages – You build equity very slowly in the early years
With a 15-year term, monthly payments can be significantly higher than on a 30-year loan. As you can see from the chart below, the total interest paid is less than half that paid on a 30-year loan, but the monthly payment is only about 35% higher. Interest rates are usually lower than on a 30-year loan, they are the same in the chart so you can compare.
- Best When – You can afford a higher monthly payment (than on a 30-year term)
- Advantages – Lower interest rates, less total interest paid, and you build equity faster (than a 30-year term)
- Disadvantages – Locked into higher monthly payment for 15 years
|Loan Amount||Interest Rate||Term||Monthly Payment||Total Int. Paid||Interest Saved|
A good choice if you are willing to make more frequent payments is a Biweekly Mortgage. You pay off your loan sooner, just by paying on a more frequent schedule. For example, a biweekly mortgage payment can pay off a $200,000, 30-year fixed loan at 7% in approximately 24 years (75 months sooner than a standard payment plan), with a total of $68,925 in interest savings.
- Best When – You can afford to make two payments per month
- Advantages – A small change in frequency provides huge savings long-term
- Disadvantages – Less flexibility in payment timing
A Balloon Mortgage is a good choice if you know you won’t be keeping the home long-term. Payments are relatively low, and if the correct term is chosen, the balloon will never come due while you own the home. On a 7-year balloon for example, the payment is relatively low because it’s amortized over a 30-year period. But after 7 years, the balance becomes due, so the loan must either be paid off or refinanced. You do, however, run the risk of higher interest rates at the end of the balloon period.
- Best When – You plan to move before the balloon payment comes due
- Advantages – Regular monthly payments that are relatively low
- Disadvantages – If you decide to keep the home, you must pay off the loan or refinance at end of term, when rates may be higher
If you need the lowest possible payment, you can opt for an Interest-Only Mortgage. No part of the payment goes toward principal, so the loan balance remains unchanged over time. The term of the loan is usually short (up to 10 years). You have the flexibility to make payments toward the principal, if you wish.
- Best When – You want a low monthly payment
- Advantages – With the money you save, you can invest in something else instead
- Disadvantages – You aren’t paying down the principle (that’s optional)
CASHING EQUITY OUT OF YOUR HOME
Home Equity Loans are usually made for the purpose of making home improvements or debt consolidation, but the money can be used for anything. A home equity loan is another mortgage in addition to any existing mortgage. Interest paid on a home equity loan is tax deductible.
- Best When – You have home equity, but are paying a high interest rate on other debt
- Advantages – You can consolidate debt at a lower interest rate, and the interest is tax-deductible
- Disadvantages – If you default on the loan, your property can be foreclosed on
A Home Equity Line of Credit doesn’t provide funds in a lump sum. Instead, it’s a mortgage set up as a line of credit, from which a borrower can draw, up to a maximum amount. Money can be drawn by writing a check or using a credit card.
- Best When – You have equity and will need cash in increments, as when remodeling
- Advantages – You only pay interest on what you’ve borrowed (not on a large lump sum)
- Disadvantages – If not careful, you may run up large debt more quickly than anticipated
If you want to learn more about loan types and terminology, please browse through our Glossary.