Choosing the Right Mortgage

For most of us, the purchase of a home is the largest purchase we’ll ever make.  So, choosing the right type of mortgage loan is one of the most important decisions we’ll make in the home buying process.  With so many different options out there, it can be hard to find an affordable home loan that meets your financial goals.

Start by asking yourself “How much can I afford?” After taking inventory of your debts, credit score, income and other monthly bills, you can make an informed decision about the terms of your mortgage.

Here are three key loan decisions you’ll need to make.  Read more below.

  • Mortgage type: Government-backed or conventional
  • Interest rate: Fixed or adjustable
  • Loan size: Conforming or non-conforming

Government-Backed or Conventional

There are two main types of mortgages: a conventional loan guaranteed by a private lender or banking institution, or a government-backed loan.  There are three government-backed mortgage types (FHA, VA and USDA).

Most government-backed mortgages come in one of three forms:

  • FHA loans, insured by the Federal Housing Administration, were established to make home buying more affordable, especially for first-time buyers, by allowing down payments as low as 3.5% of the purchase price.
  • VA loans are insured by the Department of Veterans Affairs and offer buyers low- or no down payment options and competitive mortgage rates. They’re available to current military service members and veterans only.
  • USDA loans are backed by the U.S. Department of Agriculture and are geared toward rural property buyers who meet income requirements.

All three programs follow the limits for conforming loans and have low down payment requirements. More on that later.

Conventional loans, on the other hand, are offered and backed by private entities such as banks, credit unions, private lenders or savings institutions. Borrowers need good credit to qualify. This is because the loans aren’t guaranteed by an outside source — so the possibility of borrower default poses a greater risk for lenders.

Conventional loans have terms of 10, 15, 20 or 30 years. They also require much larger down payments than government-backed loans. Borrowers are expected to put down at least 5%, but that amount can vary based on the lender and the borrower’s credit history.

If you don’t have a lot of cash saved up for a down payment but have solid credit and a stable income, a government-backed loan is likely the way to go.

If you don’t have a lot of cash saved up for a down payment but have solid credit and a stable income, a government-backed loan is likely the way to go. Keep in mind that if you choose a conventional or government-backed loan and you’re making less than a 20% down payment, you’ll have to pay for private mortgage insurance.

If you can afford to save up a large down payment and build your credit score while lowering your debt-to-income ratio, a conventional loan is a great choice that can eliminate some of the extra fees and higher interest rates that may come with a government-backed loan.

The FHA Home Loan

FHA Loans
The Federal Housing Administration (FHA) mortgage insurance program is managed by the Department of Housing and Urban Development (HUD), which is a department of the federal government. FHA loans are available to all types of borrowers, not just first-time buyers. The government insures the lender against losses that might result from borrower default. Advantage: This program allows you to make a down payment as low as 3.5% of the purchase price. Disadvantage: You’ll have to pay for mortgage insurance, which will increase the size of your monthly payments.

An FHA loan is simply a mortgage loan that gets insured by the Federal Housing Administration, which is part of HUD. As a borrower, you would apply for one of these loans through an FHA-approved mortgage lender. So you have to meet two sets of guidelines — the FHA’s requirements as well as the lender’s. The government insurance comes into play if the homeowner defaults (i.e., stops making payments on the loan). In a default situation, the FHA will cover the lender’s losses. We will talk more about this insurance later.

The benefits of using an FHA loan include:

1. Smaller down payment.

If you use a conventional mortgage loan (defined below), you’ll probably have to put at least 10% down. Some lenders are still willing to allow down payments as small as 5%. But with an FHA home loan, you could put down as little as 3.5% of the purchase price. The only way to put down less is by using the VA or USDA loan programs, but those are limited to certain types of borrowers.

This was a big attraction for us when we bought a home in San Diego. We actually saved up enough money to make a larger down payment. But a 10% down payment would have seriously limited our buying power. So we ended up choosing the FHA program to reduce our down-payment expense. This is a common strategy for first-time buyers in particular, because they often lack the money needed for larger down payments. When we were choosing between FHA and conventional mortgage loans, the down payment was the biggest factor.

2. Easier approval than conventional loans.

It’s generally easier to get approved for an FHA loan, as compared to a conventional mortgage. This is especially true in 2017. If you put down less than 20% on your loan, you’ll be required to have private mortgage insurance or PMI (as explained here). With a conventional mortgage, the insurance comes from a private company — not from the federal government, as with FHA loans. These insurance providers took huge losses during the foreclosure crisis that began in 2008 (and is still ongoing). As a result, PMI companies are fairly strict about the loans they will approve.

If you were to use a conventional mortgage loan with less than 20% down, you would essentially have to be approved by two different companies. You need to get approved by the lender as well as the PMI provider. These insurance providers often require higher credit scores than the lenders themselves. They won’t back any loans if there is the slightest amount of risk from the borrower.

So if your credit score is below 700 or so, you might have trouble getting a green light from the PMI company. When this happens, it doesn’t matter what the lender says. You can be approved by the lender but denied by the mortgage insurance provider.

But with an FHA home loan, the mortgage insurance comes from the federal government. And they are less strict about the types of borrowers they are willing to ensure. In fact, the FHA allows credit scores as low as 500. (Just realize that some lenders will require credit scores of 620 or higher, even though the FHA’s guidelines allow a score as low as 500. This is referred to as an overlay.) Still, when you compare conventional mortgages versus FHA loans, the qualification process is almost always easier on the FHA side.

3. More flexible guidelines for credit scores.

I touched on this one above, but I want to expand on it. If you have a credit score below 640, you may have a hard time getting approved for a conventional mortgage loan in 2017. This is the baseline requirement used by the most lenders. But, as we talked about earlier, the PMI company might require an even higher credit score.

This is another benefit of using an FHA loan to buy a house. You can get approved with a lower credit score. The FHA requires a score of 500 or higher for basic qualification. If you want to benefit from the 3.5% down-payment option, you will need a score of 580 or higher. Some lenders have actually lowered their credit requirements to match those set by the FHA.

Credit scores weren’t an issue for us when we bought our home. My wife and I both had credit scores over 750. In this range, we could’ve qualified for either an FHA loan or a conventional mortgage. But I know a lot of people don’t have scores that high. The lower requirement on the FHA side could be a deciding factor for these folks. At any rate, it needed to be mentioned in this discussion.

4. Higher allowance for DTI.

When you apply for a home loan, the lender will review your debt-to-income ratio or DTI. This is a comparison between the amount of money you earn each month, and the amount you pay toward your debts. A higher DTI can hurt your chances of getting approved for a loan. It can also reduce your buying power.

This is another key consideration when looking at FHA loans versus conventional mortgages. With an FHA loan, it’s possible to get approved with a debt-to-income ratio higher than 50%. It might not be wise to take on a mortgage loan with that much debt. But it is possible through the FHA program. I know people who have been approved for FHA loans with DTI ratios as high as 58%. This would never work for a conventional mortgage loan. For conventional, the debt-to-income ratio is usually capped at 45%.

The DTI factor wasn’t a big issue for us. Our ratio was in the high 30s, so we probably could’ve been approved for either conventional or FHA. I just wanted to mention it in this section, because it can be a deciding factor for mortgage approval.

As you weigh your options between FHA loans and conventional mortgages, you need to consider the debt factor. And when I talk about “debts” in this context, I am referring to your car payment, credit card debt, student loans, etc. In other words, anything that shows up on your credit reports.

5. More forgiving of bankruptcy and foreclosure.

If you’ve had a bankruptcy filing or a home foreclosure in the past, you may find it easier to qualify for an FHA loan. Most conventional mortgage loans end up being purchased by either Fannie Mae or Freddie Mac. These organizations have rules regarding borrowers with a foreclosure or bankruptcy on the record. The FHA has rules about this as well, but they are more lenient.

It’s possible to qualify for an FHA home loan within one or two years of a bankruptcy or foreclosure. You would probably have to wait a little longer for a conventional mortgage with either of these things in your past.

It’s Not a Free Pass for Reckless Borrowers

I’d like to point out that the FHA program is not a free pass for irresponsible borrowers. While it’s usually easier to qualify for an FHA versus a conventional mortgage, you still need to have your finances in order.

Over the last few years, the Federal Housing Administration has tightened up its lending requirements. They are requiring borrowers to have higher credit scores and larger down payments than in the past.

If you decide to use this mortgage option, you can be sure the lender will review every aspect of your financial situation. They will check your credit score to ensure it meets the FHA’s minimum guidelines. They might even impose their own higher guidelines on top of those required by the FHA. They will check your employment history to make sure you’ve been gainfully employed for the last couple of years. They will consider the amount of debt you have in relation to the amount of money you make. And, of course, there are certain loan limits for the amount of money you can borrow.

I wanted to point all of this out, because there was a notion in the past that anyone could qualify for an FHA loan. But that is simply not the case today.

VA Loans
The U.S. Department of Veterans Affairs (VA) offers a loan program to military service members and their families. Similar to the FHA program, these types of mortgages are guaranteed by the federal government. This means the VA will reimburse the lender for any losses that may result from borrower default. The primary advantage of this program (and it’s a big one) is that borrowers can receive 100% financing for the purchase of a home. That means no down payment whatsoever.

USDA / Rural Housing Loans
The United States Department of Agriculture (USDA) offers a loan program for rural borrowers who meet certain income requirements. The program is managed by the Rural Housing Service (RHS), which is part of the Department of Agriculture. This type of mortgage loan is offered to “rural residents who have a steady, low or modest income, and yet are unable to obtain adequate housing through conventional financing.” Income must be no higher than 115% of the adjusted area median income [AMI]. The AMI varies by county. See the link below for details.

Combining: It’s important to note that borrowers can combine the types of mortgage types explained above. For example, you might choose an FHA loan with a fixed interest rate, or a conventional home loan with an adjustable rate (ARM).

The Conventional Mortgage Loan

A conventional loan is one that is not insured by a government entity. These loans are made entirely in the private sector, without any government approval whatsoever.

The primary benefit of using a conventional loan is that you can avoid mortgage insurance entirely. If you make a down payment of 20% or more, you won’t have to pay for mortgage insurance. But if you put down less than 20%, you’ll have to pay for PMI. This would increase the size of your monthly payment by $60 – $90 (on average).

If you can afford a down payment of 20% or more, the conventional versus FHA question is sort of a no-brainer. In this scenario, it would be best to use a conventional mortgage loan so you could avoid the extra insurance cost.

People with smaller down payments have a tougher decision to make. For example, if you can only put 10% down for a conventional loan, you will probably be required to pay for PMI. The question is — how does this cost compare to the extra mortgage insurance you would pay on an FHA loan? In most cases, the cost of PMI is much less than the insurance you would have to pay for an FHA loan. But then there’s the down payment consideration. The FHA program offers a down payment as low as 3.5% for qualified borrowers.

A conventional loan is one that is not insured by a government entity. These loans are made entirely in the private sector, without any government approval whatsoever.

The primary benefit of using a conventional loan is that you can avoid mortgage insurance entirely. If you make a down payment of 20% or more, you won’t have to pay for mortgage insurance. But if you put down less than 20%, you’ll have to pay for PMI. This would increase the size of your monthly payment by $60 – $90 (on average).

If you can afford a down payment of 20% or more, the conventional versus FHA question is sort of a no-brainer. In this scenario, it would be best to use a conventional mortgage loan so you could avoid the extra insurance cost.

People with smaller down payments have a tougher decision to make. For example, if you can only put 10% down for a conventional loan, you will probably be required to pay for PMI. The question is — how does this cost compare to the extra mortgage insurance you would pay on an FHA loan? In most cases, the cost of PMI is much less than the insurance you would have to pay for an FHA loan. But then there’s the down payment consideration. The FHA program offers a down payment as low as 3.5% for qualified borrowers.

Fixed vs. Adjustable Rate

As a borrower, one of your first choices is whether you want a fixed-rate or an adjustable-rate mortgage loan. All loans fit into one of these two categories, or a combination “hybrid” category. Here’s the primary difference between the two types:

  • Fixed-rate mortgage loans have the same interest rate for the entire repayment term. Because of this, the size of your monthly payment will stay the same, month after month, and year after year. It will never change. This is true even for long-term financing options, such as the 30-year fixed-rate loan. It has the same interest rate, and the same monthly payment, for the entire term.
  • Adjustable-rate mortgage loans (ARMs) have an interest rate that will change or “adjust” from time to time. Typically, the rate on an ARM will change every year after an initial period of remaining fixed. It is therefore referred to as a “hybrid” product. A hybrid ARM loan is one that starts off with a fixed or unchanging interest rate, before switching over to an adjustable rate. For instance, the 5/1 ARM loan carries a fixed rate of interest for the first five years, after which it begins to adjust every one year, or annually. That’s what the 5 and the 1 signify in the name.

Pros and Cons: Adjustable vs Fixed-Rate Mortgages

As you might imagine, both of these types of mortgages have certain pros and cons associated with them. Use the link above for a side-by-side comparison of these pros and cons. Here they are in a nutshell: The ARM loan starts off with a lower rate than the fixed type of loan, but it has the uncertainty of adjustments later on. With an adjustable mortgage product, the rate and monthly payments can rise over time. The primary benefit of a fixed loan is that the rate and monthly payments never change. But you will pay for that stability through higher interest charges, when compared to the initial rate of an ARM.

Adjustable-rate mortgages vs. fixed-rate mortgages. It’s one of the most important decisions a home buyer can make. In order to make the right choice, you need to understand how each of these loans work — in addition to their pros and cons. And that’s exactly what we will discuss in this article.

Let’s start by examining the key differences between these financing options. This will make the fixed-versus-adjustable decision much easier for you.

Fixed-Rate Mortgage

  • The interest rate stays the same for the life of the loan.
  • The payment amount also remains the same, from month to month.
  • The ratio of principal and interest will vary slightly from month to month (though the payment amount remains fixed).
  • Offers the benefit of predictability, since the rate never changes.
  • Most common type of mortgage is the 30-year fixed loan.
  • Generally the best option for people who plan to stay in a home (and keep the same mortgage) for many years.
  • The Home Buying Instituterecommends the FRM for most first-time buyers, and for people who expect a long-term stay.
  • More information on FRM loans

Adjustable-Rate Mortgage

  • The interest rate will change at pre-determined intervals, over the life of the loan.
  • Unpredictable, because you never know how the rate will adjust. You only know when.
  • ARM loans have an interest rate cap that limits how much the rate can change from one month to the next, and over the life of the loan.
  • May have a fixed rate for the first few years, after which the rate begins adjusting (a.k.a. “hybrid” loan).
  • Common examples of the hybrid loan are the 3/1 ARM and the 5/1 ARM. The first number represents the fixed-rate period. The second number indicates the frequency of adjustment (in years), after the fixed period.
  • Interest rate during the initial fixed period is generally lower than the average rate for fixed-rate mortgages — but it will eventually adjust.
  • Best used when the homeowner only plans to stay in the home for a few years.

 

Choosing Between Fixed vs. Adjustable

So how do you decide which type of loan is right for you? In order to get past the fixed-rate vs. adjustable mortgage dilemma, you need to think about your long-term plans. This is the key to choosing the right type of loan. Consider the two scenarios below:

For a Longer Stay…

Do you plan to stay in the home for many years? If so, you’re better off with a fixed mortgage that carries the same interest rate over the life of the loan. If you want to refinance later on, in order to secure a lower rate, you’ll still have that option. But if you start off with an ARM loan to get a lower interest rate during the initial phase, you face the uncertainty of the adjustment period.

To get a better understanding of the adjustable-rate vs. fixed-rate mortgage issue, we can simply look back at what happened during the housing crisis. Many home buyers chose the adjustable mortgage with the intention of refinancing before the first adjustment period. Their logic was simple, though somewhat flawed: “I’ll use an ARM loan to lower my monthly payments for the first five years, and then I’ll refinance into a fixed-rate before the loan start adjusting.”

Here’s the problem with this strategy. There is no guarantee you’ll be able to refinance the loan later on. If your home values drop too much, or your credit score takes a hit for some reason, refinancing might be impossible.

This is something that got a lot of homeowners into trouble over the last few years (contributing to the mortgage crisis of 2008 – 2009). People started out with adjustable mortgages, for the reasons mentioned above. But they were unable to refi out of the loans. Many homeowners saw their monthly payments increase significantly, even doubling in some cases. The rest is history. We saw record-breaking numbers of mortgage defaults and foreclosures, followed by a full-blown recession.

Beware of any mortgage broker or lender who recommends this strategy. They don’t bear any of the risk — you do. They are not concerned with your long-term financial success. They can sell your mortgage into the secondary market to get it off their books. So if you were to default later on, because the payments grew too large, it wouldn’t be their problem. In other words, your lender is not your financial advisor. You need to make your own decisions, based on research, planning and common sense. Keep this in mind as you ponder the adjustable-rate versus fixed-rate question. Make the smart choice, based on your long-term plans.

For a Shorter Stay…

There are situations where you can use the ARM loan to save money, while avoiding the risk and uncertainty of the adjustment phase. Here’s a good example: A military family moves to a new city and buys a home. It’s only a three-year tour, after which they’ll be moving again. These folks could use a 3/1 or 5/1 ARM loan to secure a lower interest rate. The rate would remain fixed for three to five years, depending on the terms of the loan. So they would end up selling the house before the first adjustment period (or shortly thereafter). The only risk in this situation would be a serious drop in property value, which could make it harder to sell the home. Aside from that, it’s a perfectly sensible strategy for financing the home.

If you’d like to learn more about using a fixed vs. adjustable-rate mortgage loan, be sure to use the search tool at the top of this website. You’ll find dozens more articles on this.

Government vs. Private Mortgage Insurance

It really comes down to insurance costs and down payments. If you can afford to put 20% down on your loan, you’ll have an easier time choosing a type of loan. It makes sense to use a conventional mortgage loan in that scenario, because you wouldn’t face any type of mortgage insurance at all.

But once you get below the 20% mark, the FHA loan starts to look pretty darn good. With a down payment of less than 20%, you’re going to pay mortgage insurance in some form — whether it comes from the government or from a private insurer. Then it’s just becomes a matter of priorities.

Loan size: Conforming or non-conforming

There is another distinction that needs to be made, and it’s based on the size of the loan.  Depending on the amount you are trying to borrow, determines whether you fall into the jumbo or conforming category.  The amount of money you borrow tells your lender a lot about your level of risk — and it has a big impact on your interest rate.  For this reason, home loans fall into two main size categories: conforming and non-conforming.

Conforming loans meet the loan limit guidelines set by government-sponsored mortgage associations Fannie Mae and Freddie Mac.  In 2018, conforming home loans for single-family homes in most of the continental U.S. are limited to $453,100.  In designated high-cost areas, such as Hawaii and Alaska, the conforming loan limit for single-family homes goes up to $679,650.  Conforming loans have lower interest rates, but you may need to have a larger down payment if you find properties above the local limit.

A jumbo loan, on the other hand, is one that exceeds the conforming loan limits established by Fannie Mae and Freddie Mac.  Due to it’s size, jumbo loans represent a higher risk for the lender and borrowers typically have to have excellent credit and larger down payments, when compared to conforming loans.

What’s Most Important to You?

At this point, you have to ask yourself what’s more important to you:

  • Do I want to make the larger down payment of 10% on a conventional loan, and pay a smaller amount of mortgage insurance each month?
  • Or … do I want to make a smaller down payment of 3.5% for an FHA loan, and pay more in mortgage insurance every month?

Answer these questions, and you’ll know which type of loan is right for you. You can see it’s a trade-off either way. This is a question you must answer for yourself. Your lender cannot do it for you.

As for my wife and I, we chose the smaller down payment allowable under the FHA program. This resulted in a slightly higher mortgage payment each month, because the FHA insurance costs are higher than private mortgage insurance. But we increased our buying power by reducing the down payment requirement. In California, it’s almost impossible to find a conventional mortgage with a down payment of 5%. Most lenders in the state are requiring at least 10% down. So for us, the difference between 3.5% and 10% was the primary deciding factor.

This article explains the pros and cons of conventional versus FHA home loans. If you would like to learn more about any of the topics discussed in this article, use the search box at the top of this page. You’ll find a wealth of information on this site!

It really comes down to insurance costs and down payments. If you can afford to put 20% down on your loan, you’ll have an easier time choosing a type of loan. It makes sense to use a conventional mortgage loan in that scenario, because you wouldn’t face any type of mortgage insurance at all.

But once you get below the 20% mark, the FHA loan starts to look pretty darn good. With a down payment of less than 20%, you’re going to pay mortgage insurance in some form — whether it comes from the government or from a private insurer. Then it’s just becomes a matter of priorities.

The Bottom Line

While there are many loan options, the mortgage you choose will depend greatly on your overall financial profile, including your credit score and history, debt-to-income ratio, employment and what you want your payments to look like.  It’s important to have a clear understanding of your current financial situation as well as what you’d like it to look like with a new home and what that encompasses before you start shopping for a home loan.  It’s also important to find the right mortgage lender who will help you find the right mortgage product for you.


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