Buying a home for the first time can be daunting, especially when you begin researching all the different loan options available to make that home a reality. To help simplify this critical step in the homebuying process, here's a breakdown of the three most common loan options available from banks and credit unions.
But before we dive into the specific mortgage loan types, let's quickly define a couple of key concepts that apply to all the various types.
Loan term: The term of the loan is the amount of total time it will take to pay off the loan in full. This includes both principal -- the amount you borrow -- and interest -- the bank's cut. For most loans in the U.S., the bank will offer a 30-year period of time to pay back the loan. That means you'll have 360 monthly payments that, altogether, will repay all of the money you borrow, and all the interest you owe the bank -- assuming, of course, you don't sell the home before then, and pay back the loan at that time.
Interest rate: The interest rate is the price of the loan. As the borrower, the lower the rate the better. Interest rates are required by law to be presented to you as an APR -- annual percentage rate -- which includes all the small fees and charges the bank requires in addition to the interest. That means that if you multiply the APR by the amount you own on the loan, you'll be able to see exactly how much money you'll be paying the bank in a given year.
With those two concepts out of the way, let's dive into the most common types of financing for first time home buyers.
1. The fixed-rate mortgage
The fixed-rate mortgage is the most simple of your financing options. At the beginning of the loan, the bank will offer you a specific interest rate and monthly payment. That interest rate and payment will never change. It's fixed.
The benefits of this mortgage type are its simplicity and its predictability. If you have a monthly budget, then it's comforting to know that your continuing monthly expense for your home won't change.
In today's world, interest rates are very low by historical standards. Another major advantage today is that a fixed-rate loan will allow you to continue enjoying that low interest rate far, far into the future. Even after interest rates rise, your loan will still be cheap!
2. The adjustable-rate mortgage
As you may have guessed, the difference between a fixed-rate loan and an adjustable-rate loan is that the interest rate on an adjustable-rate loan can adjust, or change, over time. You'll typically see adjustable-rate loans that change every two, three, five, or seven years.
Banks will sometimes use a shorthand system to describe these loans. For example, an adjustable rate loan that changes once every three years could be written as a "3/1 ARM." This stands for a three year adjustable-rate mortgage.
For the first three years you have the loan, you will pay the same monthly payment every month based on your original interest rate. Then, when that three year period ends, your monthly payment will change to another amount for the next three years to reflect the adjusted interest rate.
In the same way, a "5/1 ARM" would be a five-year adjustable-rate mortgage where the rate changes once every five years. Your payment would also change once every five years with that change in interest rate.
If interest rates were high, as they were in the 1980s, an adjustable-rate mortgage would give the borrower the benefit of automatically receiving a lower rate if interest rates declined. In today's world, though, it's far more likely that rates will rise.
Because banks know that, over the long term, interest rates will move closer to historical averages, you can often get lower payments in the first few years of an ARM. On the other hand though, that means your payments will almost certainly go up in the future.
3. FHA or VA loans
Both the standard fixed-rate loan and variable rate loan are considered conventional mortgages. That means they typically require a down payment of 10%-20%, and your financial situation must meet certain criteria to qualify for the loan.
For first-time homebuyers, paying a hefty 20% down payment may not be feasible, or, as a young professional, you may not have had enough time to build up a large enough net worth to qualify for a conventional loan. In these cases, mortgage programs exist that don't require the larger down payments, or include more lenient financial standards, so that you can still obtain the loan you need.
The two most common types of these programs are called FHA loans and VA loans. FHA stands for the Federal Housing Administration, and VA stands for the Department of Veterans Affairs. In both of these loan programs, lower down payments and relaxed credit standards make it easier for first-time homebuyers, veterans, or lower-income households to purchase a home.
Qualifying and closing an FHA or VA loan can be more complex than a conventional mortgage. Make sure to consult with a respected banker in your area to assist you with your own specific situation.
Whether you decide to pursue a fixed, variable, or FHA/VA loan, owning your own home can be a highly rewarding experience. It provides stability to your family, improves your credit, and can be the beginning of building a sizable nest egg for your future. Good luck, and Fool on!