Picture your dream home. What does it look like? Is it on the water, in the mountains, a fancy mansion in the suburbs, a cool urban penthouse? Is there a pool, tennis court, big driveway? There are so many options and choices to make whether it’s your dream home or starter home.
Much like customizing the house you want, you also have to choose a mortgage loan that is right for you. I’m sure you’re now a bit deflated having envisioned an awesome house – and now you’re left considering what boring mortgage that will come with it. Sorry to take you through that, but the loan is a big deal of course.
Selecting the right mortgage type is important because of the big dollar figures associated with it. A good or a bad decision can result in a difference of thousands of dollars over the course of its term. So what are the types of loans?
The standard options are the traditional 30-year fixed-rate mortgage (FRM) and the 15-year FRM. Just about everyone can qualify for these. With the 30 or 15-year FRM, you have a set monthly payment that will only vary due to changes in your real estate taxes and property insurance – assuming those are tied-in with your mortgage. Each week Freddie Mac publishes the latest average rates across the country since these loans are so common. So you always have a good idea of where the market stands. A less common fixed-rate mortgage is the 20-year, but there are some of those out there.
- What is ideal about the fixed-rate mortgage is that you know your rate. It’s locked in. But you always have the option, at a cost, to refinance if rates decline. And if interest rates go up, you look like a hero borrowing at a low-interest rate while everyone else is now paying more.
- Also, keep in mind that normally a 15-year FRM will feature a lower interest rate than a 30-year. It is just the nature of the interest rate environment – the longer the term, the higher the rate – usually. Sometimes that pattern reverses, but not often according to history.
The next set of loan options are the adjustable-rate mortgages (ARMs). ARMs got a bad rap during 2006-2009 because they were a significant driver of the Great Financial Crisis. Many people took out ARMs in the early 2000s when rates were very low, only to see the interest rate ‘adjust’ upward when the Fed raised rates in the mid-2000s. By 2007, what had been a 3-4% loan turned into a 6-8% rate, and home-owners just couldn’t afford it when the economy began to deteriorate.
- ARMs are not all bad though. In fact, throughout history, they have usually offered a lower rate than FRMs. The risk is if short-term rates spike due to inflation or the Fed’s interest rate policy then you’re left paying a much higher interest rate. The 5/1 ARM and 7/1 ARM are two common loan types. A “5/1 ARM” is actually rather straightforward; the rate is fixed for the first 5 years, then ‘floats’ with market rates for the remaining 25-years. The 7/1 ARM works the same way only with a 7-year fixed term and during the remaining 23-years, it adjusts with the market.
- Are you a veteran or in the military? You will likely qualify for a VA loan. What’s great about a VA loan is that they usually come with better rates and a lower required down payment versus a traditional FRM. VA loans often avoid pesky Private Mortgage Insurance (PMI). PMI is needed when borrowing more than 80% of the home’s value, so it’s just an extra cost. The Department of Veterans Affairs backs these loans, so they can offer great terms for qualifying borrowers.
Federal Housing Administration (FHA) loans offer mortgages to borrowers who may need a leg-up. These loans usually feature low down payments for those with lower credit scores.
Balloon & jumbo mortgages are options too. Balloon mortgages are less common and feature a big chunk of the mortgage due at the end of the loan period. A jumbo mortgage is the designated terminology for a huge loan – about $500,000 or more. Jumbo loans, not surprisingly, require extra due diligence by the lender to ensure the borrower can make the payments. Higher credit scores and bigger down payments are needed to get a Jumbo loan.
The dangerous mortgage type is the interest-only loan. This is risky because you are in essence using exclusively debt for a period before you begin to actually pay down the principal. So you are just ‘throwing money’ away by only covering the interest amounts. Be careful!
That is a lot of borrowing options, right!? And we did not even get into refinancing options. We’ll save that for another day.
Here’s the point
- Like customizing your dream home, there are many options for your mortgage
- Researching what is best for your circumstance and financial plan can mean thousands of dollars of savings over the life of the loan
- Keep your goals in mind – do you like to travel & move around? Well, then that could make some loan options unattractive. Always make financial choices in the context of your overall financial plan. TFC is here to help you through that important process.
Action items
- Talk with us at TFC to help you decide what mortgage is best for you
- Dig deep into the types of loans and the associated interest rates
- Shore up your credit score by paying off existing debt and avoid applying for new credit before taking out a loan – get your score as high as possible!
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