Making one of the biggest purchases in your life requires an equally large loan: A mortgage is one of the largest debt instruments available to consumers designed for home buying in mind. However, taking on a new financial burden shouldn't be a source of anxiety. Armed with the right knowledge, you'll be able to demystify mortgages and their unique requirements well before you speak with a lender.
Mortgages are a type of secured loan: Unlike credit cards or personal loans which are unsecured, the borrower pledges the real property to the lender as security in case the debt cannot be repaid. (In the case of credit cards, there is no collateral pledged and lenders will send the borrower to collections to settle any outstanding debts.) The lender holds onto the title of the home until the borrower completes their payments or until the home is sold or transferred.
A mortgage is made of two pieces: The principal and interest. The principal represents the original amount borrowed used to pay the seller, and the interest is calculated following market rates at the time of the rate lock. In a fixed-rate mortgage, the borrower pays the same predictable monthly payment for the life of the loan. With adjustable-rate mortgages, the interest rate is locked in for a predetermined amount of time but afterward, follows the market rate for the life of the loan. Mortgages can be paid off early, refinanced, or assumed by another party, so although a borrower may take out a 30 year fixed mortgage, that borrower isn't stuck in the same home for 30 years!
Defining the types of mortgages.
There are many types of mortgages, each with their own unique strengths and weaknesses depending on your own needs. Your mortgage advisor will go into more details, but we'll give you a top-level view of the most common types of mortgages. Keep in mind a few questions as you begin the mortgage process: How long do you see yourself living in the home? Are you planning on adding more to the family? Or do you foresee downsizing?
In addition, your unique mortgage needs will also depend on the type of property you wish to purchase. For example, most condos will have higher interest rates on top of the 20% down requirement, whereas loan options for single-family residencies will be more flexible.
Fixed vs. Adjustable Loans:
Fixed rate mortgages are exactly as they sound: The interest rate remains fixed for the duration of the loan. The most common fixed rate mortgage lengths are 15 and 30 years. Fixed rate mortgages offer unique benefits to borrowers. First, the rate is locked in, which means the borrower is protected from monthly payment increases if market interest rates change. Second, fixed-rate mortgages have predictable monthly payments, which means budgeting is much easier for the borrower. Lastly, fixed-rate mortgages are simple and easy to understand: Fixed monthly payments on a fixed schedule with a fixed interest rate.
On the contrary, fixed-rate mortgages have one unique disadvantage: When interest rates go below the borrower's fixed rate, the borrower cannot take advantage of the lower rate. It is possible to refinance, but there are no guarantees.
Just like fixed rate mortgages, adjustable rate mortgages are exactly as they sound: Monthly payments for adjustable rate mortgages change throughout the duration of the loan. Adjustable mortgages begin with an initial fixed rate term, generally 5 to 10 years. Because adjustable rate mortgages have lower initial fixed interest rates than fixed rate mortgages, borrowers can take advantage of lower monthly payments over a fixed rate mortgage. In addition, it's easier for borrowers to qualify for adjustable-rate mortgages as the monthly payments are more affordable. However, monthly payments for adjustable rate mortgages make it hard for borrowers to create precise budgets. Market rates vary based on market conditions, which no one can predict.
Often used interchangeably with conforming loans, conventional loans are not backed nor insured by Fannie Mae and Freddie Mac, which adhere to the guidelines set by the Office of Federal Housing Enterprise Oversight (OFHEO). A conventional loan can be either conforming or non-conforming.
Conventional loans are ideal for borrowers with excellent credit and can meet the right benchmarks. Down payments for conventional loans vary between 5-20%, however, private mortgage insurance is often required for down payments less than 20%.
Conforming Loans vs. Non-Conforming Loans:
Although conforming loans are not backed by the government, they do meet certain guidelines established by the Federal Housing Finance Agency. The amount a borrower can take out is limited ($417,000 in 2016), however, flexibility is built into conforming loans to help borrowers in high-cost markets.
Non-conforming loans are loans which exceed conventional loan limits. There are many types of non-conforming loans, and the most common are the jumbo loan. Due to the size of jumbo loans, the requirements are much more strict, and in addition, interest rates on jumbo loans are higher.
Federal Housing Administration loans are not originated by the government, but instead, lenders issue loans which are promised by the FHA. These types of loans are perfect for borrowers who require more flexible lending standards, as qualifying for a FHA-backed loan is considerably easier than a conventional loan. However, borrowers are often required to take out mortgage insurance with higher premiums.
VA mortgages are reserved for active-, retired-, and those in the reserve armed forces. Much like FHA-backed mortgages, VA mortgages are promised by the government. These types of loans require no down payment. However, they also have lower loan limits, so borrowers may have difficulty finding a home in an expensive or competitive housing market.
Interest-only loans are a unique type of mortgage where the borrower only pays off the interest accrued from the principal. Although the principal will need to be paid off eventually, interest-only loans are perfect for younger, first-time home buyers who will have the higher income in the future required to tackle the larger principal payments.