Owning & Renting Property

Home Mortgage Basics: Loan Types, Interest Rates and More

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When it comes to getting a mortgage, there are a lot of options out there. Your bank, a credit union, independent mortgage brokers and online lenders would all love to sell you a mortgage. And remember — they are selling you on something, because whoever you decide to do business with will be making money off you.

That’s why it’s smart to go into your conversations with lenders knowing a few things about mortgages. This article gives you training in basic mortgage terms and concepts. Happy house (and mortgage) hunting!

What is a mortgage?

First things first. What exactly is a mortgage? In the simplest terms, it’s a loan you use to buy a home. The home itself is used as collateral (so if you don’t make your payments, the lender could take the property).

Interest rates

As with any loan, your home loan will require you to pay interest. Mortgage interest rates can vary — by a lot. The total amount of interest you’ll pay on your loan depends on the interest rate you lock in and how it will be applied for the duration of the loan. Home interest rates can either be fixed or adjustable. 

Fixed Rate Mortgage

Pros

  • Interest rate and payment stay constant for the life of the loan
  • Simple to understand
  • Offers payment security (no unexpected changes, easy to budget for

Cons

  • If interest rates fall, have to refinance in order to take advantage of lower rates

Adjustable Rate Mortgage (ARM)

Pros

  • Lower interest rate and payments earlier on during loan period (usually 1, 5 or 7 years depending on the type)
  • If interest rates go down, your payments go down – without having to refinance
  • Cheap way to borrow money to buy a house you don't plan to live in very long

Cons

  • Interest rates and payments can rise drastically during the life of the loan
  • Hard to understand, so can be easier for borrowers to be tricked by questionable lenders
  • Borrowers may end up owing more in the long run than they did at closing

ARMs can be very tempting for people, because they are a lower initial cost that can allow you to borrow more money (i.e., buy a more expensive house). But before you discuss the major options with a lender and are wowed by that lower initial payment, think through whether you are prepared for the possible volatility of an ARM.

An interest rate increase of a few percentage points can translate to your payment increasing by hundreds of dollars a month. There are many calculators like this one that can show you the difference in payments between an ARM and fixed rate loan you can expect to pay.

Types of loans

The type of loan you qualify for will determine your monthly payments, the length of the loan and other terms of the mortgage. Before you evaluate mortgage information, make sure you understand the most common loans:

Conventional loan

  • Usually made by a bank, savings and loan association or other financial institution
  • Determines loan terms by looking at:
    • Debt-to-income ratio: what percentage of your monthly income goes toward loans (car, school) and other payments (credit card, child support). Too high (generally 40 percent or more) and you may not be approved for a loan.
    • Credit history and credit score: Lenders want to know that you make payments on time, that you have several different credit accounts — and that you don’t have all those accounts maxed out. The longer you have established credit, the better your score will be as well. And a higher credit (FICO) score generally means a lower interest rate on your mortgage.
  • Can be adjustable rate mortgaged (ARM) or fixed rate loans
  • Usually requires a down payment of 10 to 20 percent (Note: if you can’t put down 20 percent, most lenders will require mortgage insurance — to protect them in case you don’t pay — that can add several hundred dollars a month to your payment.)

Federal Housing Administration (FHA) loan

  • A mortgage insured by the FHA
  • Credit requirements are less stringent than a conventional loan
  • Usually requires two years of steady income to qualify
  • Total monthly mortgage payment (including taxes) must be less than 31 percent of your gross monthly income
  • Tend to be fixed rate loans
  • Requires a minimum down payment of 3.5 percent (10 percent for those with lower credit scores)
  • Must pay mortgage insurance

Veterans Affairs (VA) loan

  • Loans available to veterans, current military members and their families from the VA
  • Does not require down payment or mortgage insurance

Now that you understand your basic options when shopping for a home loan, you can go into a meeting with your bank’s loan officer ready to ask smart questions. That way you can make an informed choice on the best loan for you and your new home!

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