Applying for and getting a mortgage is one of the most daunting obstacles to overcome when shopping for a home. The process can be especially scary and confusing for first timers who may be unfamiliar with the various programs out there, or the advantages and disadvantages of each. Here is a quick rundown of the types of mortgages available, to help decide which may be the best option for your own situation.
Fixed-rate traditional
This is the most common type of mortgage these days, and although it comes in a variety of lengths, they typically run either 15 or 30 years. Generally, banks want a sizable down payment and a good credit score, both of which can make them difficult to get for a first-time buyer. The typical down payment is 20% on one of these loans, but now that lending markets are beginning to loosen a bit, I have seen mortgages advertised with as little as 5% down.
With a traditional mortgage, the lower your down payment is, the higher credit score the bank will typically want. Every bank is different, but if a FICO score of 680 is required if you put 20% down, a 740 might be expected with just 5% upfront.
Another decision to make is the time frame. A 15-year mortgage carries with it a higher monthly payment, but you'll pay a lot less in interest over the life of the loan. For example, a $200,000 loan at 4.5% would have monthly payments of $1,410 and $1,013 for 15- and 30-year terms, respectively. However, over the life of the loan, the 15-year option would save you more than $110,000 in interest.
Adjustable rate
Similar to fixed rate in terms of qualifications, adjustable-rate loans can be a good choice in certain economic climates. Basically, it means that your interest rate will change over time, and will be tied to an index that reflects how much it costs the lender to borrow money. This can be beneficial when rates are at cyclical highs, but that is certainly not the case now. If you can lock in a low rate for the life of the loan, why take the chance with an uncertain interest rate?
Even though rates shot up in the latter half of 2013, they are still relatively low on a historical basis. Consider the highs and lows in the following chart for a better idea of when an adjustable-rate mortgage might be a good idea. I would say that once the average 30-year rate moves close to 6% (maybe a few years down the road), adjustable-rate mortgages may be worth a look.
U.S. 30 Year Mortgage Rate data by YCharts
FHA
The Federal Housing Administration's lending standards are designed to allow buyers who either don't have a lot of cash to put down, or don't have a high enough credit score to be able to buy a home. This makes FHA loans very popular among first-time buyers. As of this writing, the FHA requires just 3.5% down and a FICO score of 580, or even lower if the down payment is higher (although specific lenders may have slightly higher requirements). This flexibility does not come cheap, and there are several costs to be aware of before applying for an FHA mortgage.
The FHA charges a 1.75% upfront fee when issuing a loan, in addition to requiring borrowers to pay FHA mortgage insurance as long as they have the loan. This is charged at an annual rate of 1.35% of the average loan balance.
So, on our $200,000 example, this means an upfront fee of $3,500 plus a mortgage insurance payment of $225. This adds more than 20% to the monthly principal and interest payment, a significant expense.
USDA
The U.S. Department of Agriculture guarantees mortgages offered to buyers of homes in rural areas. Just like FHA loans, they have relatively easy qualifications when compared with traditional loans, and offer up to 100% financing. However, you must purchase in a rural area as defined by the USDA, and be under the maximum income requirement for the particular county you're interested in.
VA
If you or your spouse ever served in the armed forces, a VA loan could be a very attractive option for you. VA loans are available with no down payment whatsoever, and have similar credit requirements as FHA loans. Unlike FHA loans, they require no mortgage insurance, making them a very attractive option to those who qualify.
Foolish final thoughts
If you can afford the down payment and have the credit necessary to obtain a good interest rate, it almost always makes more sense to get a traditional mortgage.
However, the FHA has been increasing its fees and lending standards for a few years now, and we are already seeing 5% down payment traditional mortgages designed to compete with the FHA. As the economy improves and credit loosens a bit more, we'll begin to see a shift away from FHA loans, which seems to be the government's goal. In the meantime, if it's all you can qualify for, an FHA loan still may be cheaper than paying rent.
