The Basics of Mortgage Loans
These are some important terms to get familiar with as you learn about mortgages:
- Principal: The amount of money borrowed to buy a home.
- Interest rate: The annual cost of borrowing the money, expressed as a percentage rate.
- Annual percentage rate: APR includes your interest rate as well as other costs associated with your loan.
- Property taxes: Taxes paid to your local government, usually as part of your monthly payment.
- Homeowners insurance: Coverage that pays for losses or damage to your home in the event of a disaster or theft.
- Loan term: How long it will take to repay the loan, usually 15 or 30 years.
- Amortization: A way of scheduling repayment of the loan in equal installments.
- Private mortgage insurance: PMI protects the lender against losses if you default on your mortgage.
- Closing costs: All the fees that must be paid to create your loan and finalize the home purchase.
A fixed-rate mortgage locks in your interest rate from the first payment to the last, even as market interest rates increase or decrease.
For example, if you have a 30-year fixed-rate mortgage for $300,000 at a 4% interest rate, your monthly payment will be $1,432 from year one to year 30.
Keep in mind that many homeowners pay their property taxes and homeowners insurance premiums with an escrow or impound account that adds those costs to their mortgage payment. Changes to those costs will affect the total paid to the lender each month.
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.|
An ARM has an interest rate that changes during the loan term.
Most ARMs lock in an interest rate for an initial term of three, five, seven, or 10 years. After that, the interest rate will adjust according to market rates, typically once a year. A 5/1 ARM is a common loan where the interest rate is fixed for five years and then adjusts once per year after that.
The initial interest rate on an ARM usually is lower than the rate for a fixed-rate mortgage. But you risk interest rates rising and your monthly payment increasing at some point during your loan term.
For example, if you have a 30-year 5/1 ARM for $300,000 at a 3.5% interest rate, your payment for the initial term will be $1,347 a month. After five years, if your interest rate increases to 4%, your payments for the next year would go up to $1,420. If your rate adjusts down to 3%, your next 12 payments would be $1,276 each.
Keep in mind that most ARMs cap how much your interest rate can adjust:
- Initial adjustment cap: How much your rate can change on the first adjustment after the fixed period. Expect this cap to be between 2% and 5%.
- Subsequent adjustment cap: How much your interest rate can change on each following adjustment. It’s typically set at 2%.
- Lifetime adjustment cap: How much your interest rate can increase overall from the initial rate. It’s typically set at 5%.
As you compare different lenders, pay attention to these caps and ask each lender to calculate your monthly payment at the highest possible rate.
Pros and Cons of Adjustable-Rate Mortgages
|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.|
|You build equity faster.||More difficult to plan accurately for the future.|
A conventional mortgage is financed by a private lender without a guarantee or backing from the federal government. 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 follow limits set by the federal government that allow lenders to sell them to Fannie Mae or Freddie Mac. These government-sponsored enterprises package the loans they buy into investments sold on the secondary mortgage market, allowing lenders to use the funds from the sale to make additional home loans.
The most important requirement for selling a loan to Fannie Mae or Freddie Mac is that it must be within the limits established by the federal government. In 2022, these limits are $647,200 in most parts of the country, and $970,800 in specific high-cost areas.
Conforming loans also have minimum requirements for borrowers, such as a credit score of at least 620.
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.|
Nonconforming and jumbo mortgages
Nonconforming mortgages are loans that do not meet the standards to be sold to Fannie Mae and Freddie Mac. With no federal conditions to meet, the specifics of such loans are up to the lender and borrower, and can be tailored to any situation, for any type of purchase.
The most common type of nonconforming mortgage is a jumbo loan, which is a mortgage that exceeds the federal government’s conforming loan limits. Because these mortgages are too large to be sold to Fannie Mae or Freddie Mac, they can be expensive for borrowers. The higher value of the home typically translates into higher closing costs, but interest rates for jumbo loans usually are comparable with those for conforming loans.
Jumbo loans are a greater risk for lenders, which usually require a more stringent underwriting process. Expect lenders to require more documentation to confirm that you have enough income to afford the monthly payment.
Pros and Cons of Jumbo Loans
|Advantages of jumbo loans||Disadvantages of jumbo loans|
|You can buy a more expensive home.||Stricter underwriting requirements.|
|A 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 defaults. These mortgage types are easier to get for borrowers who have lower credit scores or are unable to 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 typically are intended for certain types of borrowers, and usually have very specific requirements and upfront fees.
The Federal Housing Administration insures mortgages that are issued by private lenders and meet its requirements. FHA loans typically are easier to get than conventional loans, but they are often more expensive.
FHA loans can be a good option for buyers unable to afford a large down payment because they let you put down as little as 3.5% of the purchase price. FHA mortgages also can be cheaper if you have a lower credit score. However, if you have good credit and can afford a larger down payment of at least 3%, then a conventional mortgage likely will cost you less.
FHA loans require all borrowers to buy mortgage insurance. They also are subject to loan limits that vary by county. To find online FHA mortgage limits by location, check with the Department of Housing and Urban Development.
The Department of Agriculture backs mortgages for 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 and annual guarantee fee.
Because USDA loans are intended to help borrowers who lack access to other loan options, the rules for getting one are very specific. The home must be 2,000 square feet or less, and located in a rural area with a population of fewer than 35,000 people. Borrowers also have to meet additional criteria regarding income, citizenship, and property value.
To see if you meet income and location requirements, check with the USDA’s website.
The Department of Veterans Affairs backs mortgages 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.
VA mortgages do not require mortgage insurance, but you need to pay a funding fee upfront. And if you have good credit and enough savings for a decent down payment, a VA mortgage may be more expensive than a conventional loan.
If you think you might qualify for a VA loan, the first step is to request a certificate of eligibility. To learn more about the process, consult the VA’s website.
Pros and Cons of Government-Backed Mortgages
|Advantages of government-backed mortgages||Disadvantages of government-backed mortgages|
|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.|
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:
- Lower your mortgage rate and monthly payment. If interest rates have dropped since you first took out your mortgage, refinancing can help you reduce the amount you owe each month. But if your mortgage refinance has a longer term, you’ll end up paying more in interest overall.
- Shorten your loan term and pay off your mortgage sooner. 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 afford it.
- Switch from an ARM to a fixed-rate mortgage. 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 interest rates.
- Tap into the equity in your home. 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 Mortgage 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.|
To see how refinancing could help you save money, check out our mortgage refinance calculator.
Other Types of Mortgages
Lenders offer mortgages with different structures to suit the specific needs of borrowers. These usually are complicated financial products, so borrowers should fully understand the risks and drawbacks before committing to one.
A second mortgage 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 compared to the primary mortgage.
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 final 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 last 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.
Construction mortgages are for prospective homeowners 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 buy the finished home.
Renovation and rehabilitation loans
If you’re buying a fixer-upper, then you may want to take out a loan that finances both the purchase and the renovations.
The FHA offers 203(k) rehab loans to help borrowers save time and money if they are buying a home that needs repairs. Instead of two separate loans, 203(k) loans are a single mortgage with either a fixed or adjustable rate, and can be used to cover renovation materials and labor. Because 203(k) loans are insured by the FHA, they can also come with more-flexible qualification requirements compared with conventional loans.
Mobile and manufactured home loans
If you’re looking into purchasing a mobile or manufactured home, you’ll find that lenders typically do not offer conventional loans for this type of home. Because these homes are prefabricated — where its components are made at a factory and then assembled on location — many lenders don’t consider them real property.
Mobile and manufactured home loans are available from Fannie Mae, Freddie Mac, the FHA, and the VA. To qualify, the home typically needs to meet certain criteria regarding size and other property details.
Like second mortgages, reverse mortgages allow older homeowners to borrow against the equity in their home. The borrowed money in a reverse mortgage isn’t due until they no longer live in that home as their primary residence. Often, borrowers pay off the reverse mortgage by selling their home after they move out.
Interest and fees on the borrowed equity are added to the principal over time, which increases the total amount owed. As that debt grows, it will reduce the borrower’s equity in their home.
The most common type of reverse mortgage is called a home equity conversion mortgage, and it’s only offered to homeowners ages 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:
- Determine what you can afford. 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.
- Examine the rest of your budget. Simply making your mortgage payments is one thing, but you also need to make sure you’re leaving enough money left over to cover the rest of your expenses. Be sure to also factor in home maintenance costs, which can include surprise — and sometimes expensive — repairs. You 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.
- See what mortgage programs you qualify for. If your credit score is low, or you can’t afford a 20% down payment, then an FHA mortgage could help you buy a home sooner. Qualified veterans or homebuyers in rural areas can look into a VA loan or USDA mortgage, respectively.
- 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 a longer term. “Homebuyers should consider their short- and long-term plans when deciding between a fixed-rate and adjustable-rate loan,” says Rashalon Hayes, assistant vice president of field mortgage at Navy Federal Credit Union in Vienna, Virginia.
- 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,” Hayes says. “Doing so will help borrowers find not only their ideal mortgage product, but also a lender they can trust.”
- Freddie Mac