The Basics of Mortgage Loans
As you learn about mortgages, the language can be intimidating. Here are some key terms to get familiar with:
- Principal: The amount of money borrowed to buy a home that needs to be repaid.
- Interest rate: The cost of borrowing the money, expressed as a percentage.
- Loan term: How long it will take to repay the loan, usually 15 or 30 years.
- Amortization: A way of repaying a loan in equal, scheduled installments.
According to the Consumer Financial Protection Bureau, 70% to 75% of homebuyers choose a fixed-rate mortgage. If you have a fixed-rate mortgage, your interest rate is locked in from the first payment to the last. You know what you’ll pay in principal and interest each month, and that number never changes, even if market interest rates increase. Fixed-rate mortgages are popular due to this stability.
Keep in mind that property taxes and homeowners insurance premiums can vary, which affects your total monthly payment if you pay those expenses alongside your mortgage.
30-year vs. 15-year fixed-rate mortgages
A 30-year mortgage generally has lower monthly payments because it’s paid off over a longer term. This usually means you’re charged a higher interest rate, and by the time you pay off the mortgage, you’ll have paid more interest than with a 15-year loan.
A 15-year term typically requires a higher monthly payment because you’re paying back the mortgage more quickly. The benefit, though, is that you generally pay a lower interest rate and save a lot of money on interest over the loan term.
While 30-year and 15-year terms are the most common, lenders can offer custom terms that run as long as you like.
Pros and cons of fixed-rate mortgages
|Advantages of Fixed-Rate Mortgages||Disadvantages of Fixed-Rate Mortgages|
|• Interest rate stays the same.||• Market interest rates can fall, leaving you stuck with a higher rate unless you refinance.|
|• Predictable monthly payments.||• Higher interest rate to start compared with adjustable-rate mortgages.|
|• Lower risk.|
Unlike a fixed-rate mortgage, an adjustable-rate mortgage has an interest rate that can change periodically during the loan term.
Most ARMs lock in an initial rate that’s lower compared with the interest rate on a fixed-rate mortgage. The most common fixed-period terms are three, five, seven, and 10 years. After the fixed period, most ARMs adjust the interest rate once per year. When the interest rate adjusts, the monthly payments change as well.
Using an example, a 5/1 ARM is a common loan in which the interest rate is fixed for five years and then adjusts once per year after that.
Pros and cons of ARMs
|Advantages of ARMs||Disadvantages of ARMs|
|• Lower interest rate to start compared with fixed-rate mortgages.||• Your interest rate can increase.|
|• Saves money in the short term, especially if you’re moving before the fixed period ends.||• Your monthly payment can increase.|
|• More difficult to plan accurately for the future.|
A conventional mortgage is financed by a private lender and not guaranteed or insured by the federal government. This means that the borrower is solely responsible for repaying the loan. The terms of your mortgage will reflect the lender’s assessment of how much risk you pose as a borrower, and how likely you are to pay off the loan according to its terms.
Conventional mortgages come in two main varieties: conforming and nonconforming.
Conforming mortgages are the most common type of home loan. They conform to limits set by the federal government. Lenders can sell mortgages that follow those limits to Fannie Mae or Freddie Mac, which are government-sponsored enterprises that then package loans into investments sold on the secondary mortgage market. With Fannie and Freddie reducing the risk from borrowers, lenders are encouraged to offer more-affordable mortgages to more people.
Only mortgages that follow the government’s maximum conforming loan limits can be sold to Fannie Mae or Freddie Mac. These limits are $548,250 in most counties and $822,375 in high-cost areas through the end of 2021. Fannie and Freddie also set other eligibility requirements, including a minimum credit score of 620.
Nonconforming mortgages do not meet Fannie Mae and Freddie Mac’s conditions, typically because they exceed the maximum conforming loan limits. Nonconforming loans can be tailored to any situation, for any type of purchase. With no government rules to follow, the specifics of such loans are up to the lender and borrower, and can vary widely.
Pros and cons of conventional mortgages
|Advantages of Conventional Mortgages||Disadvantages of Conventional Mortgages|
|• Lower total cost.||• Requires higher credit scores|
|• More flexible terms.||• Requires a down payment.|
|• Widely available.|
The most common type of nonconforming mortgage is a jumbo loan, which simply is a mortgage that exceeds the maximum conforming loan limits set by the federal government.
Because these mortgages are too large to be sold to Fannie Mae and Freddie Mac, they can be expensive. The higher value of the home typically translates into higher closing costs. Interest rates for jumbo loans, however, are comparable to those for conforming loans.
Jumbo loans also require a more stringent underwriting process, as the lender is taking on more risk. Lenders may require more documentation to confirm that you have enough income to afford the monthly payment.
Pros and cons of jumbo mortgages
|Advantages of Jumbo Mortgages||Disadvantages of Jumbo Mortgages|
|• You can buy a more expensive home.||• Stricter underwriting requirements, like a higher credit score and lower debt-to-income ratio.|
|• Similar interest rate compared with conforming loans.||• A larger down payment is often required.|
A government-backed mortgage is insured by the federal government to protect the lender if the borrower is unable to make payments. These mortgage types are easier to get for borrowers who have lower credit scores or can’t afford a large down payment. They may come with a lower interest rate, because there is less risk involved for the lender.
Government-backed loans can have upfront fees and specific requirements, depending on the government agency, that may make them difficult to qualify for.
An FHA mortgage is a home loan that is issued by a private lender and insured by the Federal Housing Administration. FHA loans are typically easier to get than conventional loans but often more expensive.
FHA loans can be a good option for buyers who can’t afford a big down payment. They allow you to put down as little as 3.5% of the purchase price. FHA mortgages also can be a cheaper option if you have a lower credit score. However, if you have good credit and can afford a down payment of 10% to 15%, then a conventional mortgage likely will cost less.
If you get an FHA mortgage, then you’ll have to purchase mortgage insurance. This type of mortgage is also subject to loan limits that vary depending on your county. To find FHA mortgage limits by location, go to the Department of Housing and Urban Development’s website.
USDA mortgages are backed by the U.S. Department of Agriculture and offered to low- or moderate-income homebuyers in rural areas. Sometimes known as rural development loans, USDA mortgages are typically cheaper than FHA mortgages and require no down payment. However, borrowers must pay an upfront fee and buy mortgage insurance through the USDA.
The rules for USDA loans are very specific. To see if you meet income and location eligibility requirements, check with the USDA’s website.
VA mortgages are backed by the Department of Veterans Affairs for military service members, veterans, and their surviving spouses. VA mortgages allow eligible homebuyers to get a mortgage with either a low down payment or no down payment. If you have difficulty paying your mortgage at some point, the VA also can help you refinance to lower your payments.
Unlike FHA mortgages, VA mortgages do not require mortgage insurance, but you’ll pay a funding fee upfront. If you have good credit and enough savings for a decent down payment, a VA mortgage may wind up being more expensive than a conventional loan.
To learn more about eligibility requirements for VA loans, consult the VA’s website.
Pros and cons of government-backed mortgages
|Advantages of Government-Backed Mortgages||Disadvantages of Government-Backed Mortgages|
|• You can get a mortgage with a low down payment or no down payment.||• You must meet eligibility requirements.|
|• You can get a better interest rate despite having a low credit score.||• Mortgage insurance may be required.|
|• If you qualify, you can get a more affordable mortgage compared with a conventional loan.||• Upfront fees may be required.|
|• Can be more expensive than a conventional loan if you have good credit and a larger down payment.|
Refinancing is for borrowers who already have a home loan. When you refinance your mortgage, you pay off your existing mortgage with the money from a new one that typically has better terms for your financial situation. There are many reasons to refinance, but people generally choose this route when it helps them save money.
If interest rates have dropped since you first took out your mortgage, refinancing could lower your interest rate and monthly payment. But if your mortgage refinance has a longer term, you’ll end up paying more in interest overall.
You also can refinance to shorten your loan term and pay off your mortgage more quickly. This could save you a lot of money in interest over the life of the loan, but your monthly payment will be higher, so make sure you can still afford it.
If you have an ARM and are looking for more stability, you can refinance to a fixed-rate mortgage. Even if you end up with a higher monthly payment for now, you’ll have more certainty and be protected from future increases in market interest rates.
Refinancing to tap into the equity in your home is another option. Your equity is the current value of your home minus how much you still owe on your mortgage. You can refinance for more than what you currently owe on the house, and then take out the difference in cash. Homeowners may use a cash-out refinance for projects that further increase the value of their house or improve their financial security. Examples including paying off high-interest debts or renovating the home.
Pros and cons of refinancing
|Advantages of Refinancing||Disadvantages of Refinancing|
|• You could reduce your interest rate and monthly payment.||• By restarting your loan term, you’ll make payments over a longer period and pay more in interest.|
|• You could shorten your loan term and pay off your mortgage sooner.||• Your current lender could charge a prepayment penalty.|
|• You could switch from an ARM to a fixed-rate mortgage to protect yourself from interest rate increases.||• You might be replacing your original loan with a larger one, so you’ll wind up paying more overall.|
|• You could use the equity in your home to fund home improvement projects or pay off debt.|
Other Types of Mortgages
Lenders offer mortgage types with unusual structures to suit the specific needs of certain borrowers. These are complicated financial products, so borrowers should fully understand the risks and drawbacks before committing to one.
A second mortgage, also known as a junior lien, is an additional home loan that you take out against your property alongside your original mortgage. With a second mortgage, you use your home as collateral to gain access to additional funds.
Second mortgages often come in the form of a home equity loan — where you receive the money in a lump sum at a fixed interest rate — or as a home equity line of credit, where you’re able to withdraw cash up to a maximum amount, subject to an adjustable interest rate. Second mortgages typically come with higher interest rates because covering your primary mortgage takes priority if you can’t make your payments, which poses more risk to the secondary lender.
With a balloon mortgage, your home loan won’t be completely paid off when you reach the end of the term. Instead, you’ll have to make a large payment to cover the remaining principal. While this could reduce your monthly payments at the beginning of your loan term, balloon mortgages can be financially overwhelming if you can’t afford the large final payment when it’s due.
Interest-only mortgages are a type of balloon mortgage, where the borrower pays only the interest each month for a set amount of time — usually five or 10 years. After that, you start repaying the principal as well as the interest, and the monthly payment increases accordingly. If you continue to pay only interest throughout the loan term, then the entire principal must be repaid at the end of the term.
This type of mortgage is much less common because it’s extremely risky for both borrowers and lenders, which are betting that borrowers will be able to make the balloon payment when it’s due.
Construction mortgages are for prospective homeowners who are looking to build a home instead of buying one. This type of mortgage only covers the cost of building the home. After that, the borrower needs to apply for a new mortgage to pay for the finished home.
Like second mortgages, reverse mortgages allow you to borrow against the equity in your home. The borrowed money in a reverse mortgage isn’t due until you no longer live in that home as your primary residence. Often, borrowers pay off the reverse mortgage by selling their home after they move out.
If you have an adjustable-rate mortgage, then a reverse mortgage will provide monthly payments. If you have a fixed-rate mortgage, then you’ll receive a lump sum. Interest and fees on the borrowed equity are added to the principal over time, which increases the total amount you owe. As that debt grows, it will reduce the equity you have in your home.
The most common type of reverse mortgage is called a home equity conversion mortgage, and it’s only offered to homeowners age 62 and older. It allows older homeowners to use their house’s equity to stay in place in their later years. The downside is giving up equity — once the reverse mortgage is paid off, the homeowner will have less money to use or pass on to any loved ones.
Tips for Choosing a Mortgage
Now that you know the key differences between these mortgage types, you may still be asking yourself, “What type of mortgage should I get?” Here are some tips to help you decide:
- Assess your financial situation. If your financial situation is stable and you can comfortably afford your monthly payments — even if they increase — then you may be able to take on a mortgage with a shorter term or an adjustable interest rate. But if your income is subject to change or you’re concerned about costs, then you might want to go the safer route with a fixed interest rate and longer loan term.
- Shop around. Before you commit to a lender, make sure to compare several quotes. “Homebuyers should speak with multiple lenders before ever getting their credit pulled to ask about the options available to them,” says Rashalon Hayes, assistant vice president of Field Mortgage at Navy Federal Credit Union in Vienna, Virginia. “Doing so will help borrowers find not only their ideal mortgage product, but also a lender they can trust.”
- Consider how long you plan on owning the home. If you are buying a starter home and don’t plan on living there for long, then you could consider a 15-year mortgage to build equity faster, or an ARM to pay less interest before the rate adjusts. But if you plan on staying in the home for a long time, then you can lighten the monthly financial pressure with a fixed rate and longer term. “Homebuyers should consider their short- and long-term plans when deciding between a fixed-rate and adjustable-rate loan,” Hayes says.
- See what programs you qualify for. If your credit score is low, or you can’t afford a 20% down payment, then an FHA mortgage can help you buy a home sooner. Veterans or prospective homebuyers in rural areas can look into a VA loan or USDA mortgage, respectively.
- Don’t overestimate what you can afford. Your mortgage is a long-term commitment, which means you need to make sure you can afford it over time. Carefully review the terms of your mortgage to see if your monthly payments will be subject to change. You also don’t want to run the risk of becoming “house poor,” which is when too much of your income is going toward the costs of homeownership.