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What Type of Mortgage is Right For You?

Posted by Andy Brikho on May 14, 2018
Andy Brikho
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Buying a home is a huge investment that typically requires a mortgage to finance. But with so many different mortgage options available, how do first-time home buyers pick just one? How do you know which mortgage loan options are best for you?

It's essential that you choose a mortgage that is best suited for your specific financial situation, which is why you should take the time to get familiar with the type of loan products out there.

To make it easier to decide which different mortgage types are right for you, let's go through your options.

Fixed-Rate Mortgages

A traditional mortgage type is a fixed-rate mortgage, which is a loan product that comes with a fixed interest rate, hence its name. Fixed-rate mortgages involve payments that are attached to rates that remain fixed throughout the life of the loan, which means they never change until your mortgage is renewed.

Many homebuyers like the idea of having mortgage payments that do not fluctuate, which is what fixed-rate mortgages promise. They offer more stability and predictability, making budgeting a lot easier and stress-free. The ability to make predictable monthly payments makes fixed-rate mortgages an attractive option for borrowers.

These types of mortgages make more sense if you plan to live in your home for many years. You also have the option to make extra payments every so often in an effort to shorten the mortgage term and pay the loan off faster without being slapped with any prepayment penalties.

Depending on your budget, one might make more sense than the other. For instance, short-term loans would make the overall loan less expensive, but the monthly mortgage payments would be higher. On the other hand, longer terms will make the mortgage more expensive overall because of more interest incurred, though the monthly mortgage payments would be cheaper.

The one caveat with fixed-rate mortgages is that they typically come with a higher interest rate than adjustable-rate mortgages, which we'll discuss shortly. In addition, you wouldn't be able to take advantage of a lower interest rate if they happen to fall at some point in the near future. However, if interest rates are expected to increase in the near future, locking in at today's rate might be a good idea.

Fixed-rate mortgages are best if you appreciate a steady bill payment and are planning to stay put for a long time.

Adjustable-Rate Mortgages

As the name suggests, adjustable-rate mortgages are home loans that have interest rates that fluctuate throughout the term of the loan. These types of mortgages are attractive to borrowers because they typically come with a low introductory rate compared to that of fixed-rate mortgages. As such, adjustable-rate mortgages may make it easier for borrowers to qualify for a bigger loan amount because of the lower initial monthly payments.

However, once that introductory period ends, the adjustable rate is tailored according to market conditions and could increase or decrease accordingly.

Typical introductory rates are usually around one to five years, depending on the exact loan product. When specific economic indexes changed, the interest rate on an adjustable-rate mortgage will also change. If they go up, the rate goes up too, and vice versa.

For this reason, an adjustable-rate mortgage is typically viewed as a bit of a risk because the rate can easily go up if the indexes rise. However, homebuyers who don't plan to stay in their home for long might find this option attractive because they may actually sell their home before the low-interest introductory period ends. If that's the case for you, then an adjustable-rate mortgage might make sense and can save you a lot of money.

The potential drawback to these types of mortgages is that when the interest rate increases, your mortgage payment will increase as well. These sudden jumps in monthly mortgage payments can be tough to manage if you're on a tight budget and are not financially prepared.

Generally speaking, adjustable-rate mortgages are best for those who are not planning to stay in their home for very long and have a bigger appetite for financial risk.

Conventional Mortgages

If you are able to come up with a sizable down payment and have a good credit score, then a conventional mortgage may be appropriate for you. A conventional mortgage requires at least a five percent down payment in relation to the purchase price of the home, though conventional lenders typically expect up to 20 percent for a down payment. That said, the down payment amount required may vary from one lender to another and may also be based on your credit history.

Conventional loans are not guaranteed by the government, so they are considered more of a risk to lenders as a result if borrowers default. Buyers must be financially secure and have good credit to qualify. While credit requirements vary among lenders, 620 is generally considered the minimum score required to be eligible for a conventional loan, and 740 is typically needed to get a lower interest rate.

There are a couple of notable benefits to a conventional mortgage, the first of which is the fact that your loan amount would be smaller. That means you would have less to pay back to your lender, making the overall mortgage more affordable and easier to qualify for.

Another benefit of a conventional mortgage is the fact that you would not be responsible to pay for Private Mortgage Insurance (PMI) (if your down payment is at least 20 percent), which is required on mortgages that are more than 80 percent of the current market value of the property. Since the loan amount is smaller, you would be considered less of a risk to your lender.

FHA Loans

Borrowers who require a home loan that is more than 80 percent of the property's value may want to consider an FHA loan. FHA loans are backed by the Federal Housing Administration (FHA) and are suitable for borrowers who may not be able to come up with a five percent down payment that is required of conventional mortgages, or who have a sub-par credit score.

If your finances are not up to snuff and your credit score is less than 620, an FHA loan might be your best bet. These mortgage products were created specifically for low- to moderate-income borrowers who would not be able to qualify for a conventional loan. Credit scores required to qualify for an FHA loan typically start at 580 and require a minimum down payment of 3.5 percent.

Since these mortgages are insured by the government, a FHA-approved lender isn't at much of a risk if the borrower defaults.

Final Thoughts For First-Time Buyers

Having a solid understanding of your financial situation and the different mortgage types available will help you make the right decision of which mortgage loan is right for you. Be sure to take the time to do your homework on mortgage loan opportunities and crunch the numbers before choosing a specific mortgage for your next home purchase.

Topics: Mortgage Process, Mortgage Types