Getting your first loan for your new home should be exciting! You’ll learn a lot about financing — and set yourself up for a new level of knowledge that will help you throughout your lifetime.
Our mission at Generation Homes NW is to help guide and teach you about your options so you can easily decide which loan product is best for you. Our mini-guide below is your starter to get familiar with your new life as a homeowner.
How to Choose a Mortgage: Fixed Rate or Adjustable?
Understanding how mortgage rates and loan terms affect your long term wealth is wise for any homeowner. Choose poorly and you’ll leave a lot of money on the table for the bankers. Choose correctly and you’ll keep more cash in your pocket during the life of the loan.
Wealth accumulation is not just about your home’s price appreciation – that will be the same whether you choose a fixed rate or an adjustable rate mortgage loan. The question is, overall, how much did you spend on the mortgage loan while you held it? That’s where extra money is made or lost.
So which loan type should you choose? Let’s have a look at how both loans function, and then we’ll discuss how to make the right decision.
Fixed Rates
A fixed rate mortgage is exactly what it says. The interest rate and monthly payment you’re required to make will never change. They’re “fixed” – month after month, year after year.
For many homeowners this provides a comfortable level of certainty knowing exactly how much they’ll have to budget for each and every month without regard to what happens in the macro economy.
A fixed rate loan will contribute a portion of your payment to interest and a portion to your principal in order to have the loan completely paid off at the end of the term. Typically, lenders will offer a 30 or 15 year amortization periods in which to pay off your loan.
For those interested in paying off a 30 year loan in 15-20 years, a well known strategy for that is to make a 13th payment in December each year. Not only will this slash your payoff period nearly in half, it might also be possible to write-off the extra interest in your current tax year. Ask your loan officer and tax advisor about the current laws affecting this strategy.
Adjustable Rates
Adjustable Rate loans are called by different names, such as “Variable” or 5/1 “ARM” (Adjustable Rate Mortgage). The essence of an adjustable is they have a built-in mechanism to, well, adjust. They are fixed for a specific period of months and then become subject to periodic adjustments. Your payment can either be reduced or increased depending on the specific terms of the loan and prevailing interest rate conditions.
The specific terms of adjustable rate loans can vary widely. The differences lie in Periodic Adjustment Caps, Lifetime Caps, Margins, and Benchmark Indexes. This is where a professional loan officer becomes invaluable in helping explain all the details.
The primary attraction for borrowers who take out an ARM is the lower initial rate that keep payments lower what the current fixed rate is offering – at least for the initial period before an adjustment takes place. The longer the initial period, the longer you’ll be saving money versus the fixed rate option.
Another benefit to an adjustable rate is having the ability to pay down the loan at adjustment periods. For example, let’s say you take the monthly savings difference vs the fixed rate option and put it in a savings account. Then, when the loan adjusts, put those savings toward the principal balance. By doing this your principal balance will be reduced by the amount of those savings. Because your monthly payment is based on outstanding principal amount, your payment will drop proportionally.
Interest-Only Loans
A third option is an interest-only mortgage. As the name implies, this type of loan gives you the option to pay only interest for the first few years. It’s attractive to first-time homeowners because of the low payments during their lower earning years. It may also be the right choice if you expect to own the home for a relatively short time and intend to sell before the bigger monthly payments begin.
Types of Loans
Now, let’s have a look at some current loan types to consider based on your borrowing ability and loan amount being requested.
FHA Loans
- Loan amounts to FHA high-balance limits per state
- Fixed and ARM programs
- Minimum 3.5% down payment. Great for first-time home buyers.
- Gift funds may be used toward down payment and closing costs.
- No prepayment penalties
- Credit scores to 600 (*580 or lower in some cases), flexible debt ratios.
VA Loans
- Eligible to service members and veterans with no PMI
- Maximum housing loan limit varies by state
- Fixed and ARM programs, rate & term, cash-out
- Zero down payment required for eligible veterans
- Single-family homes or Planned Unit Developments (attached/detached)
- 2-4 units (not allowed on 2nd homes or investment properties)
- Condominiums approved by VA
Conforming
- Loan amounts up to $647,200 ( changes annually) on single family home (higher limits for multi units)
- Fixed and ARM programs
- Available to 97% loan-to-value, over 80% loan-to-value borrower is required to pay monthly mortgage insurance premiums
- 5-20% down payment options
- Primary, vacation, rental, and investment occupancies allowed, as well as 2nd homes
Jumbo
- Fixed and ARM programs. Fixed options include 30 and 15 year. Fixed ARM options include 5, 7 and 10 year
- Purchase, Limited Cash Out Refinance and Technical Finance
- Mortgage loans to $1,500,000 (subject to change)
- Max debt-to-income ratio of 43% (subject to change)
Loan Term
You have options with the length of your loan. Every month you pay back a portion of the principal (the amount borrowed) plus the interest accrued for the month. Your lender will use an amortization formula to create a payment schedule that breaks down each payment into paying off principal and interest.
The length, or life, of your loan, also determines how much you’ll pay each month. Fully amortizing payment refers to periodic loan payments where the loan is fully paid off by the end of its set term. If the loan is a fixed-rate loan, each fully amortizing payment is an equal dollar amount. If the loan is an adjustable-rate loan, the fully amortizing payment changes as the interest rate on the loan changes.
Common terms are for 30 years, but many lenders will allow you to choose any amortization term below 30 years. For example: 20 year, 15 year, 10 year, etc.
Stretching out payments over more years (up to 30) will generally result in lower monthly payments. The longer you take to pay off your mortgage, the higher the overall purchase cost for your home will be because you’ll be paying interest for a longer period.
How Mortgage Interest Rates Are Determined
Mortgage interest rates gyrate depending on larger economic factors and investment activity. The secondary market plays a role. Fannie Mae and Freddie Mac bundle mortgage loans and sell them to investors looking to make a profit. Whatever interest rate those investors are willing to buy the mortgage-backed securities for determines what rates lenders can set on their loans.
Mortgage rates typically decrease when…
- The stock market falters
- There are dips or insecurities in foreign markets
- Inflation slows
- Unemployment increases or jobs decrease
Mortgage rates typically rise when…
- The stock market is strong
- Foreign markets are strong and stable
- Inflation is up
- Unemployment is low and jobs are increasing
Interest rate movements is a tricky business. Typically, if the economy, stock market, and foreign markets are strong, investors require higher interest rates to make back their money. This causes lenders to raise their rates. Bond investment activity can also impact mortgage rates.
Calculate Your Mortgage Payment
Use Bankrate’s mortgage calculator to estimate your monthly mortgage payment. You can input a different home price, down payment, loan term and interest rate to see how your monthly payment changes.
These estimates are broken down by principal and interest, property taxes and homeowners insurance.
How Long Will You Stay?
One of the first decisions a borrower should make is estimating how long they will be staying in the home before they move on. We can’t predict the future of course, but some reasonable assumptions can be made if the right questions are asked?
- How many years do your children have left to complete high school?
- Are you just starting out and plan to build a family?
- Do you have a historical pattern of moving – what is it?
- How certain are you to stay put for the next 15 plus years?
- Will your property eventually become a rental?
- Are you a good manager of money?
Next, ask what sort of risk tolerance you have? Fixed rates require no worrying, no risk to external upheavals in the interest rate market. Adjustable rates have the risk of going up to the maximum Cap Rates, eventually clawing back the initial years savings.
Answering these questions will help you determine the length of loan terms to consider.
