What Are My Loan Options?

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.