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Which Mortgage Type Is Right For You?

By Matthew Frankel, CFP® - Dec 14, 2014 at 8:03PM

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The mortgage process can be pretty intimidating, especially for first-timers. Here's a quick guide to the types of loans you have to choose from.

According to a recent J.D. Power study, the majority (54%) of first-time home buyers don't fully understand the different loan options available to them.

Source: 401kcalculator.org via flickr

While the mortgage process can be quite intimidating at first, the loan choices available to you are actually rather straightforward. Here are the main categories of loans available, and a few hints for determining which is right for you.

Fixed-rate loans
As the name implies, these loans have an interest rate that doesn't change and a set amount of time until the loan is paid off. The most common are 15-year and 30-year terms; however, it's not too hard to find other lengths, such as 20 years.

The interest rate you receive can vary slightly between lenders, but mainly depends on your credit and other qualifications. The shorter the term, the lower the interest rate should be. As a general rule of thumb, the interest rate you are offered on a 15-year mortgage should be about one percentage point less than the rate you can get on a 30-year loan.

Lenders also offer the opportunity to pay "points" in order to obtain a lower interest rate. One "point" means 1% of the loan amount, so $1,000 on a $100,000 loan. Generally, if you aren't planning to stay in your home for more than a few years, this isn't worth it. On a "forever" house, however, it may be worth considering.

Adjustable-rate loans
These are more popular among homebuyers when interest rates are high, but they still exist now.

Basically, an adjustable-rate loan will start with a low "teaser" rate for a few years, and then will adjust depending on market rates as time goes on. There are a variety of initial rate periods to choose from, as well as rate adjustment rules (such as a maximum of 2% at a time), but the general idea is the same.

FHA loans
An FHA loan refers to a mortgage that is guaranteed by the Federal Housing Authority. These loans can be fixed-rate or adjustable, and allow for lower credit scores and down payments (as low as 3.5%) from borrowers than conventional loans.

In exchange for the more flexible qualifications, you might (depending on your particular situation) have to pay FHA mortgage insurance initially and over the life of the loan. FHA loans can be quite expensive when compared to their conventional counterparts, so be aware of how much you'll actually end up paying before you agree to one of these.

VA loans
Available to veterans and their families, VA loans can provide up to 100% financing, and generally have relatively loose lending standards when compared to conventional loans. To be eligible, you either need to be an active-duty member of the military or have served during any one of many qualifying wartime periods. A detailed list of eligibility requirements is available on the VA's website.

While these loans come with a "funding fee," which varies depending on your down payment if you have one, VA loans don't have the costly mortgage insurance requirement that FHA and other low down payment loans have.

So, if you are a veteran, a VA home loan may be a pretty good option to look into.

Don't be afraid to shop around
Whichever type of loan you decide on, it's important to shop around. Don't just accept the first loan offered to you, as rates, fees, and terms can vary quite a bit from lender to lender.

Don't worry about all of those loan applications hurting your credit. Sure, credit inquiries play a role in your credit report and too many inquiries can lower your score significantly.

However, with mortgage applications, as long as the inquiries take place within a certain time period (usually 30 days, but may vary depending on the version of the FICO formula your lender uses), they will only count as one single inquiry, whether you apply for one loan or 100. One inquiry won't lower your credit score by more than a few points, so feel free to rate-shop with as many lenders as you'd like.

Which is right for you?
The exact loan that is right for you depends on a variety of factors, but there are some that you should rule out immediately.

For one thing, it is very hard to make a solid case in favor of an adjustable-rate mortgage right now, unless you are planning to sell the house before the initial teaser rate expires. Fixed mortgage rates are extremely low on a historical basis, so it simply doesn't make sense to take the long-term risk.

I always try to talk people out of FHA loans. The cost of FHA mortgage insurance has risen to the point where these loans are often significantly more expensive than renting. Plus, with a low down payment, the loan amount itself will be much higher than a conventional loan. Usually it's a better idea to work on your credit and save a larger down payment with the goal of eventually qualifying for a conventional mortgage.

Having said all of that, the conventional fixed-rate mortgage is cheap and predictable, and is the way to go for pretty much all homebuyers.

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