First Choice: Fixed or
Adjustable-Rate Home Loans
The different types
of mortgages available today can be placed in one of two categories. They
either have a fixed rate of interest, or an interest rate that adjusts over
time. Technically, there's a third category of "hybrid" loans. But
I'll get to that later. As a home buyer, this is one of the first decisions
you'll have to make about the loan you want to use.
So how do you choose
between these mortgage types? First, you need to understand how they work.
Next, you need to consider the pros and cons of each type. And lastly, you
should choose the loan that best supports your long-term housing plans.
Let's start with the
basics...
• Fixed-rate mortgage: This
type of home loan carries the same interest rate for the entire term (length)
of the loan. The interest rate makes up part of your monthly payment. It's also
the only component that has the potential to change over time. So if you get a
mortgage with a guaranteed fixed rate, your monthly payment is guaranteed to
stay the same -- for the entire life of the loan.
• Adjustable-rate mortgage: These
are also referred to as ARM loans for short. Unlike the previous option, this
type of mortgage has an interest rate that changes over time. This also means
that the size of your monthly payment will change over time. It might adjust up
or down, depending on market conditions at the time of adjustment. But they usually
adjust upward, resulting in a larger monthly payment.
• Hybrid ARM loan: Most of
the adjustable-rate mortgages offered today are considered "hybrid"
loans. They get this name because they start off with a fixed rate for a
certain period of time. After that period, the rate will begin to adjust. The most popular example is the 5/1 ARM loan,
which carries a fixed rate of interest for the first five years. The rate will
change every year after that. Some lenders offer 1-year, 3-year and 7-year
ARMs, as well.
• With an ARM, you can probably save
money during the first few years by securing a lower rate (when compared to a
15- or 30-year FRM). But after the initial fixed-rate period, your loan's
interest rate will begin to adjust to keep pace with market conditions. They usually
adjust upward, which means you'll have a larger monthly payment.
• With the fixed-rate option, you'll have
the same interest rate for the entire life of the loan. This is true even if
you keep the loan for 30 years. You'll pay a higher rate than the initial rate
on an ARM loan, but you won't have any of the uncertainty that comes in the
later years of an adjustable loan you're
basically paying a premium for long-term predictability.
Second Choice: Conventional
or Government Loan
A conventional
mortgage is one that is not insured by the government in any way. This
home loan is made in the private sector with no form of government backing.
A government-backed
loan is insured by some type of federal agency, such as the Department of
Veteran Affairs (VA) of the Department of Housing and Urban Development (HUD).
The loan may still be made in the private sector, but the lender receives
insurance from the federal government.
There are several
types of government mortgages:
• FHA loan
-- This mortgage is made by lenders in the private sector (known as
FHA-approved lenders) and is insured through the Federal Housing
Administration. If the borrower defaults on the loan, the lender gets paid by
the FHA.
• VA loan
-- This program is reserved for military service members and their families. It
can be used to finance 100 percent of a home purchase, which eliminates the
need for a down payment. This program is managed by the Department of Veteran
Affairs. If you're a military member, you should have a VA specialist somewhere
within your command. They can provide you with details about the program.
• USDA loans -- These used to be called RHA loans, for the Rural Housing
Administration. The program is overseen by the United States Department of
Agriculture, or USDA. This type of mortgage loan is reserved for people who
live in certain parts of the country. There are income restrictions as well.
They are sometimes referred to as "farmer loans," due to the geographical
and demographic nature of the program. But you certainly don't have to be a
farmer to qualify. The program is designed for low-income residents of rural
areas.
Choosing
the Right Type of Mortgage for You
We've covered a lot
of different mortgage types up to this point. But how do you choose the best
one for your situation? Here are some questions that will help you
decide.
1. How much do
you have for a down payment?
If you can afford a
20-percent down payment on a house, you're probably better off using a
conventional loan. You'll avoid mortgage insurance if you go that route (it's
only required on loans that make up more than 80 percent of the purchase
price).
If you can't afford
to put that much money down, you might want to consider the FHA program. You'll
pay extra insurance on the loan, but your down payment could be as low as 3.5
percent if you meet the requirements.
2. What's your
credit score?
To qualify for a conventional
mortgage, you will probably need a FICO credit score of 640 or higher. But the
government programs are a bit more flexible. Many home buyers with credit
scores below 640 have to rely on the FHA loan. Find out where you stand. It
will help you decide which type of mortgage to use. It will also help you
negotiate with the lender (by better understanding your qualifications).
3. How long
will you be in the house?
You'll have an easier
time choosing between the fixed-rate and adjustable loan by thinking about your
long-term plans. The longer you plan to stay in the home, the more you should
lean toward the fixed-rate mortgage. But there are certain scenarios where it
makes sense to use an ARM.
Here's an example
from my own experience. When I was in the military, my wife and I bought a home
in Maryland. We knew were would only be there for three to four years, at the
most. We purchased the house because home prices were appreciating in the area,
so it was a good investment (and better than living in an apartment).
We used an ARM loan
to get a lower interest rate. We sold the home at the end of the tour, before
the mortgage started to adjust. So we saved money during our stay, and we got
out of the loan before the rate went up. This is an example of using the right
type of mortgage for your situation.
Some people use an
adjustable loan even when they plan to stay in the home for a long time. The
logic is that they can enjoy having a lower rate for the first few years, and
then refinance the loan before the first adjustment period. This makes sense on
paper. But what if you can't refinance? A lot of things can prevent you from
refinancing -- not enough equity, bad credit score, etc. So there's no
guarantee you'll be able to refinance down the road.
