First-time home buyers typically have a lot of questions about mortgage loans. So I thought it might be helpful to compile some of the most frequently asked questions about mortgages. Without further ado, here are the seven most common questions about first-time home buyer mortgages:
- Is FHA the best option for a first-time home buyer?
- Should I use a fixed-rate or adjustable-rate mortgage?
- How much of a down payment will I need?
- What credit score is needed to get a mortgage?
- What percent of my income should go toward the loan?
- How much of a house payment can I afford to take on?
- How do lenders decide what interest rate I get?
1. Is FHA the Best Option for a First-Time Home Buyer?
The FHA program is a popular financing tool for first-time home buyer mortgages. This program is managed by the Federal Housing Administration, which is part of the Department of Housing and Urban Development, or HUD.
What makes these loans unique is that the government, through the FHA, insures the lender against any financial losses that might result from a mortgage default.
As a result of this government backing, lenders are generally more flexible with their guidelines for FHA loans, compared to conventional mortgages (that are not insured by the government).
FHA mortgages are not limited to first-time home buyers, but they are well-suited for such borrowers. First-time buyers typically lack the funds needed to make a large down payment. So the FHA’s minimum down-payment requirement of 3.5% can be very appealing to these borrowers. A conventional loan will require at least 5% down, and sometimes as much as 20% depending on the borrower.
It is generally easier to qualify for an FHA mortgage than a conventional loan, in terms of credit scores and debt ratios. But it’s the down payment factor that makes them such a popular mortgage for first-time home buyers.
Of course, there are some disadvantages to using this program. For one thing, you will have to pay a mortgage insurance premium on top of the loan itself. If you use a conventional mortgage with at least 20% down, you would not have to pay for any mortgage insurance. But for most first-time buyers, the benefits of a low down payment and easier qualification outweigh the mortgage insurance premium.
First-time home buyers should explore all of their mortgage options before coming to a final decision. This means weighing the pros and cons of both FHA loans and conventional financing.
2. Should I Use a Fixed or Adjustable Rate Mortgage Loan?
This is another common question regarding first-time home buyer mortgages. Should you use a loan with a fixed interest rate, or one with an adjustable rate that changes over time? There are pros and cons to both of these financing options.
Here are the pros and cons in a nutshell:
An adjustable-rate mortgage (ARM) typically starts off with a lower interest rate than a fixed rate loan. By extension, this will lower the borrower’s monthly payments during the initial phase of the mortgage (typically the first one to five years).
For example, if you take a look at the average mortgage rates reported by Freddie Mac each week, you will see that the 5-year adjustable-rate mortgage has a lower interest rate than both the 15-year and 30-year fixed mortgages. The 1-year ARM loan will have the lowest interest rate of all four categories.
The downside is that the interest rate will begin to change after the initial phase. This makes it a more complicated mortgage product for a first-time home buyer. Additionally, there is a certain amount of risk involved with adjustable mortgages that isn’t a factor with fixed-rate loans. You know the interest rate is going to change after the first one, three, or five years. But you don’t know exactly how the rate will change. If it causes a significant rise in the monthly payment, it could make the mortgage unaffordable.
First-time home buyers considering adjustable mortgages must also consider their long-term plans. If you plan to be in the house and keep the mortgage beyond the first adjustment period, you must ensure you can afford the adjusted (and possibly larger) payments.
Let’s move on to talk about the pros and cons of the fixed-rate mortgage, as far as first-time home buyers are concerned. This option is much more straightforward. As the name implies, the interest rate stays the same for the entire life of the loan. This is true even if you carry the mortgage for its full 30-year term (which is rare these days). If you lock in an interest rate of 4% at the time of approval, you’ll have that same interest rate for the full term. You keep the same rate until you either sell the home, refinance the loan, or pay it off.
This is the primary benefit of using the fixed-rate loan. It gives you stability and predictability. The downside is that it costs more than an adjustable mortgage product. Again, refer back to the average rates reported by Freddie Mac each week. You will see that the 30-year fixed-rate mortgage carries the highest interest rate of all four loan categories.
[box]First-time home buyer mortgage tip: Consider your long-term plans and the amount of risk you are comfortable with. If you think you’ll only be in the home a few years, you might be better off using an ARM loan to secure a lower rate. If you think this will be your “forever home,” you might prefer the long-term stability of a fixed-rate mortgage. Also consider the possibility that your monthly payments will increase when using an adjustable mortgage. If an adjustable loan is already stretching your budget during the initial phase, it could become unaffordable if and when the rate increases.[/box]
3. How Much of a Down Payment Will I Need?
How much money will you have to put down on a first-time home buyer mortgage loan? This will depend on several factors, including the type of loan you are using. Earlier, I mentioned that the FHA program has a minimum down-payment requirement of 3.5% of the loan amount. In order to enjoy this benefit, you will need to have a credit score of 580 or higher. Above all else, this is what draws first-time home buyers to this program in the first place.
Conventional home loans (those that are not insured by the government) typically have a minimum down payment of 5%. But this requirement can go up for certain types of borrowers. For example, if the lender views you as a higher risk than the average borrower, they might require you to put down 10% or more. So the down payment varies based on the type of loan and also the qualifications of the borrower.
Some financing programs offer 100% financing. With such a loan, the borrower doesn’t have to make any down payment at all. The VA program for military service members and their families is one example. The USDA/RDA loan program for low-income rural families is another example.
[box]First-time home buyer mortgage tip: If you’re planning to buy a home in the near future, you should start saving as much money as possible. This helps you in several ways. First, it will help you meet the down-payment requirements posed by the lender. It will also help you cover your closing costs, which can easily add up to thousands of dollars. Third, it can help you get approved for a loan in the first place. This is one of the best things you can do to prepare for the process. So start saving early.[/box]
4. What Credit Score is Needed for a First-Time Buyer Mortgage?
I’ve covered this topic in a separate article, so I’ll give the abbreviated version here.
Lenders typically require a credit score of 620 or higher for first-time buyer mortgages. Actually, this requirement applies to all borrowers, not just the first-timers. But this number is not set in stone. Sometimes the bar is set above or below this number.
Lenders typically permit lower credit scores on FHA loans, as compared to conventional mortgages. This is another reason why many people choose the FHA program when getting their first mortgage.
But even the FHA is tightening up its credit requirements. In 2013, they announced a new rule regarding borrowers with credit scores below 620. In short, any FHA borrower with a credit score below 620 and a debt-to-income ratio above 43% must undergo manual underwriting. This means borrowers who fall within this range cannot be automatically approved by the FHA’s automated underwriting system. The underwriter must identify compensating factors that make up for the low score, such as significant cash reserves or a long history of making mortgage payments on time.
5. What Percent of My Income Should Go Toward the Loan?
I’ve encountered some first-time mortgage tutorials that suggest you should put a certain percentage of your income toward a loan. But this is backward. Here’s a better way to think about it: What percentage of your income can you comfortably part with, without sacrificing your quality of life?
As far as income limitations, most lenders today prefer to see a debt-to-income (DTI) ratio below 43%. This means that your combined recurring debts (including the mortgage payment) should use up no more than 43% of your gross monthly income. If you attempt to take on a loan that would result in a debt-to-income ratio above 43%, you may have trouble getting approved.
Some lenders have stricter income requirements on first-time buyer mortgages, because the borrower cannot show a history of successfully making payments on a home loan. This increases the borrower’s risk profile in the eyes of the lender, compared to someone with a 10- or 20-year history of paying a mortgage on time.
6. How Much of a House Can I Afford to Buy?
I’ve covered this topic in a separate tutorial, so I’ll offer the abbreviated version here:
The best thing you can do is analyze your current monthly expenses, in relation to your monthly income. Once you do the math, you will know how much disposable income you have left over each month. This is a good place to start when measuring the affordability of a first-time mortgage. And you can learn more about it in this in-depth tutorial.
7. How Do Lenders Decide What Interest Rate I Get?
The interest rate assigned to your loan will be influenced by several factors. It mostly comes down to two things — risk and points. Borrowers who pose less risk to the lender will be “rewarded” with lower interest rates. In contrast, borrowers who are considered to be a higher risk will be charged higher interest rates.
The credit score is the primary tool used by lenders to measure risk. A credit score of, say, 820 indicates a responsible borrower with a history of making payments on time (less risk). In contrast, a person with a score of 550 has probably neglected some bills in the past, and therefore represents a higher risk. The lender will charge more interest in the latter scenario.
You can also reduce your interest rate by paying “points” at closing. This is when you pay money up front to lower the amount of interest paid over the long term. One point equals one percent of the loan amount (e.g., $2,000 on a $200,000 mortgage). Generally speaking, each point paid at closing will lower your interest rate between 0.125% and 0.25%.
This article covers some of the most frequently asked questions about first-time home buyer mortgages. But we have only scratched the surface. We add new articles and tutorials to this website on a weekly basis. You can use the search tool at the top of the page to access our full library.