Reader question: “My husband and I are hoping to buy a house later this year. We are ‘newbies’ when it comes to mortgage loans. How should we go about choosing the best mortgage product or program for us? We make pretty good money between the two of us, if that makes a difference. We were hoping to keep our out-of-pocket expenses as low as possible. Any advice?”
You’re not alone. This is one of the most common questions among first-time home buyers. I know this, because we receive their emails on a regular basis. So let’s dig deep into this question. Here’s a three-step strategy for choosing the best mortgage for you.
Choosing the Best Mortgage: 3 Questions to Ask
First-time home buyers have several important choices when it comes to the different types of mortgage loans. When choosing a mortgage product or program, you should consider three primary factors:
- How much of a down payment can you afford?
- How long do you think you’ll stay in the home?
- Are you comfortable with an unpredictable interest rate?
If you answer these three questions, you’ll have an easier time choosing the right mortgage. Read on to find out why.
1. How much of a down payment can you afford?
If you have limited funds for a down payment, you should consider using the federal government’s FHA loan program. This is a popular option among first-time home buyers, and for several reasons.
In an article for American Banker, David Stevens, president of the Mortgage Bankers Association, said the following: “Today, the FHA is the dominant source of mortgage financing for borrowers with low down payments. Many of these are first-time home buyers.”
As of summer 2014, the FHA program allows borrowers to make a down payment as low as 3.5%. That’s about the smallest down payment you’ll find these days, aside from VA loans for military members. This makes it one of the most popular mortgages for first-time home buyers. First-timers typically don’t have a lot of money for a down payment, compared to a person who currently owns a home and plans to sell it. So the down payment is a major consideration.
This is why so many first-time home buyers choose FHA mortgage loans as their financing tool. The down payment for an FHA-insured home loan is generally lower than the down payment for a conventional or “regular” mortgage that is not insured by the government.
Most lenders today require a down payment of at least 5% for a conventional loan, and some set the bar as high as 10%. But with an FHA mortgage, a first-time home buyer could pay as little as 3.5% down. The maximum loan-to-value (LTV) ratio for these loans is 96.5%.
How much can you afford to pay out of pocket? This is an important question when choosing the best type of mortgage for your situation.
2. How long do you plan to stay in the home?
We’ve talked about the differences between FHA and conventional home loans. But that’s not the only choice you’ll have to make, when choosing a financing option. You must also decide whether you want to use a fixed-rate (FRM) or an adjustable-rate mortgage (ARM).
This article covers the key differences between fixed and adjustable loans. A fixed-rate product has the same interest rate for the entire term, even if the term is 30 years. So the monthly payments never change. An ARM loan, on the other hand, has an interest rate that adjusts on a regular basis, typically every year.
Some ARMs start off with a fixed interest rate for a certain period of time, such as 3, 5 or 7 years. After that, the rate changes annually. These ‘hybird’ loans typically start off with a lower mortgage rate than their fixed counterparts, but only during the initial phase. After that, the rate adjusts every year.
When choosing the best mortgage product for you, think about your long-term plans. If you’re only planning to stay in the house for a few years, you might prefer the long-term stability of the fixed-rate loan. If you’ll only be in the home for a few years, you might benefit from using an ARM to secure a lower interest rates.
3. Are you comfortable with an unpredictable interest rate?
Many first-time home buyers avoid adjustable mortgages for one simple reason. They’re not comfortable with the idea of a changing, unpredictable interest rate.
Jack Guttentag, a finance professor at the University of Pennsylvania, says the following:
“Whether the adjustable rate mortgage (ARM) or fixed rate mortgage (FRM) turns out better depends on what happens to interest rates in the future, which no one knows. Shoppers faced with this decision should ask themselves ‘Is this a risk worth taking,’ and ‘can I afford to take it?'”
You know the interest rate will change on an annual basis. You just don’t know how it will change. So there is an uncertainty factor with ARMs you don’t have with fixed mortgages. That doesn’t mean adjustable loans are a “bad” choice for home buyers. In some cases, they make sense. You just have to know what you’re getting yourself into.
Conclusion: Choosing the best mortgage for you requires some soul-searching. You have to think about your long-term plans. You have to think about your appetite for risk, and the amount of money you have for such upfront costs as the down payment. If you answer the three questions above, you’ll have an easier time choosing the right type of loan.