So you’ve finally found the home you like. After months of searching, comparing prices and features, and negotiating, it is finally time to buy. If you are like most Americans, you will be financing the purchase of your home with a residential mortgage.
But with different loan products out there, which one is right for you? The decisions you must make include fixed rate vs adjustable rate, 15 year vs 30 year, conventional vs government backed, conforming vs nonconforming, subprime, etc. An overview of these topics may help you make the right decision.
Fixed Rate Mortgage (FRM)
With a fixed rate mortgage, the interest rate is fixed throughout the life of the loan. As such, the monthly payments will also be the same for the entire loan term. An advantage of this type of loan is that it makes it easier to budget for your mortgage payment. There will be no surprises depending on what transpires with the economy and interest rates.
FRM’s can be especially beneficial at times such as the present, when interest rates are very low on a historical basis. With an FRM, you can lock in a low interest rate for as long as 30 years. If you happen to be in an FRM and rates drop significantly, you may wish to consider refinancing the loan. However, if there are only a few years left on the loan or if you will be selling the home soon, it may not pay to refinance.
Adjustable Rate Mortgage (ARM)
Unlike FRM’s, adjustable rate mortgages have an interest rate and monthly payment which will vary over the term of the loan. However, changes do not occur real-time as the market fluctuates. Instead, interest rates “reset” during specified intervals.
A 3/1 ARM for example means that the interest rate will remain fixed for the first three years. Then it will reset or adjust annually after that based on an index. ARM terms are typically 30 years. The initial rate is typically lower than a comparative fixed rate mortgage. This lower rate is in exchange for the borrower taking on interest rate risk.
Most ARMs, however, have caps and floors which limit the amount the interest rate and therefore your payment can increase or decrease. There are annual caps, as well as caps over the lifetime of the loan. For example, the 3/1 ARM above may have a 2/5 cap. This means that the annual cap is 2%, and the lifetime cap may be 5%.
ARM loans may be a good option if you plan to own a home for a shorter period of time. They may also be an option when rates are historically high, and may be expected to decline in the future. However, no one can really predict with accuracy and consistency the direction of interest rates.
ARM loans can also make sense if you are young and it is the only thing you can afford now (due to the lower initial interest rates). However, you should also ideally expect that your income will be higher in the future.
But such strategies may be risky if your expectations don’t pan out. If you can’t afford the maximum cap increases and are not able to refinance, you may ultimately face default and foreclosure.
Term of the Residential Mortgage
The most common mortgage loan terms are 15 and 30 years. With a 15 year loan, you will typically get a relatively lower interest rate due to the shorter term. However, your monthly payment of principal and interest (P&I) will also be higher for the same reason.
If you can comfortably afford the shorter term, it pays to do so. You can save thousands of dollars in interest over the life of the loan, and your home can be paid off in as little as 15 years. Your equity in the home also builds at a more rapid rate. This is so because the lower interest rate allows more of each monthly payment to be allocated towards principal.
On the other hand, if you are looking for a lower monthly payment, you may be better off with a 30 year loan. The interest rate will be relatively higher compared to a similar 15 year loan. But the monthly P&I payment will be lower since you are spreading the payments over a longer time period. Another way of looking at this is that you may be able to buy a more expensive home with a 30 year loan due to the relatively lower monthly payments.
Making Extra Principal Payments is An Option
Keep in mind that regardless of the term of the loan, you can usually make extra principal payments. The purpose of such payments is to pay off your mortgage sooner. As such, a 30 year mortgage may provide you with more flexibility than a 15 year term. It has a smaller mandatory monthly payment for when times are though. But you can also make extra payments for when times are good.
Due to their flexibility, stability, and lower monthly payments, thirty year fixed rate mortgages account for the vast majority of loans issued to home buyers in the United States.
Your Required Monthly Payment May Not Be Reduced
Another thing to consider with extra principal payments is that they may or may not reduce your monthly payment. This is especially true with fixed rate loans where the monthly payments are the same until the loan principal is completely paid-off.
So in such a situation, you may wish to accumulate the extra payments in a separate bank account. Then you can pay off the loan in one shot once you accumulate enough to equal the outstanding balance.
The advantage of this strategy is that the money can be used as an emergency fund if necessary. It can also be used to take advantage of any potential investment opportunities which may come along that have a greater yield than the interest rate paid on your mortgage. However, the downside is that a lack of discipline may cause you to spend the money, or maybe not even put it away in the first place.
With an adjustable rate mortgage, each time the interest rate resets, the minimum required payments will be based on the updated principal balance. So any extra principal payments before this reset will be reflected in a lower monthly payment, assuming the interest rate remains stable.
Conforming Residential Mortgage Loans
The loan you get will at some point generally be sold to another entity by your original lender. However, your bank will probably still “service” the loan. This means that they will still collect payments from you, but someone else will be the owner of the loan.
A key reason for the selling of loans is for the bank to free up capital in order to make more loans. The two largest purchasers of residential mortgage loans are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
But these entities don’t just buy any loans. The loans must meet specific criteria in order to qualify for purchase. When a loan meets these this criteria, it is called a conforming loan. Typical rules consist of the size of the loan and its riskiness.
For example, in 2017, a conforming loan cannot exceed $424,100 for a one-unit property. The highest cost areas in the country can have conforming loan limits up to $636,150. Loans beyond these limits may be referred to as “jumbo” mortgages. The lender also must generally have a credit score of at least 620 for fixed rate and government backed loans and 640 for ARMs.
You must also meet certain ratios. For example, the PITI payment (principal, interest, taxes, and insurance) to income ratio cannot be greater than 28%. Further, the total of all recurring debt payments of the borrower cannot exceed 36%. Recurring debt for this purpose includes car payments, credit cards, and other such loans with ten or more payments remaining. The down payment these loans can be as low as 3%.
Nonconforming loans are loans which do not meet these rules. Conforming loans have the better terms as compared to non-conforming loans since they are less risky.
Conventional Residential Mortgage Loans
Loans which are not insured or guaranteed by a government agency such as the FHA or VA are called conventional loans. These loans can, however, be secured by government-sponsored enterprises such as Freddie Mac and Fannie Mae.
Typical down payment requirements for conventional loans are 20%. This would imply an 80% loan to (home) value ratio (LTV). The LTV can go up to 90 or 95%, but private mortgage insurance (PMI) will be required on the amount over 80%. The down payment and PMI requirements are necessary to protect the lender since the government does not back these loans.
Government Backed Residential Mortgage Loans
Loans backed by the Federal Housing Administration (FHA) require a minimum down payment of 3.5%. The debt to income ratios and credit score requirements are also less strict as compared to conventional conforming loans. For example, the (PITI) debt to income ratio limit is 31%, and the total debt to income ratio limit is 43%.
However, these types of loans require you to pay a mortgage insurance premium (MIP) regardless of the amount of your down payment. The MIP is different than PMI for conventional loans. It requires an up front charge of 1.75% of the loan amount. Borrowers must also pay annual premiums, which can amount to as much as 1.25% of the loan balance.
Keep in mind that private lenders make both conventional loans and government backed loans. The government agencies do not make any loans, they just insure or guarantee them.
Subprime Residential Mortgage Loans
Technically conventional loans since they the government does not back them, these are loans lenders make to higher risk borrowers with bad credit profiles. Credit scores are typically below 600. In order to compensate for this higher risk, lenders charge significantly higher interest rates. Lenders may also require higher down payments.
Predatory lending is something to watch out for when it comes to subprime loans. Predatory lending involves a lender taking advantage of a borrower through excessive fees, misrepresentation of loan terms, and other illegal acts.
Having some basic knowledge should give you some more confidence and clarity in dealing with lenders and mortgage brokers in determining the best residential mortgage product for your situation. Shop around for a good rate. But pay attention to the points (interest paid up front) and other closing costs the lender will be charging. This way you can compare apples to apples.
Some negotiating and bargaining can go a long way in saving you money. Your credit score and income will also play a major part in whether or not you are able to obtain a residential mortgage, and at what terms.
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