A couple of weeks ago, I had the opportunity to discuss homeownership with a client. He and his wife were expecting their first child and had found a home that they felt they could raise a family in and enjoy for the rest of their lives. They were happy and excited to become part of the 65.1 percent of the U.S. population who consider themselves homeowners.*
For my client, home ownership was one of those “good life” goals for which he and his wife had focused their financial planning. Finding that dream home was step #1, but now they were unsure about step #2 — actually purchasing the home — and even a little scared about what may lie ahead for them. They found themselves in the same boat as a majority of Americans — needing a mortgage to purchase their home. According to a 2019 Bloomberg article, 63 percent of homeowners have a mortgage on their home. Additionally, as of 2015, 60 percent of second homes (vacation) have mortgages.**
But which mortgage is the best choice?
For first-time home buyers, understanding the different financing options can be overwhelming. So after the congrats and well-wishes were extended to my clients, I walked through the different types of mortgages, discussing the pros and cons of each with them. Whether you are a first, second, or third-time home buyer, or purchasing your weekend getaway, getting a mortgage may be in the cards for you. Listed below is an overview of different types of mortgages you are likely to encounter. It is important to note that this list is an overview and is not exhaustive. Each bank or lending institution is likely to have its own set of options.
- Conventional or Fixed Rate
The most popular option. The interest rate is set for several years, often 15, 20 or 30. The shorter the time frame, typically results in a lower interest rate, but higher monthly payment obligations. While some conventional loans can be done with as little as a three percent down payment, expect to have to pay a premium for PMI (Private Mortgage Insurance) if not putting down at least 20 percent.
- Adjustable Rate Mortgage (ARM)
Adjustable rate mortgage means that the interest rate can, and will, change over time. Most lending institutions will have many different options for an ARM: 5/1, 3/1, 3/3, etc. For example, a 3/1 ARM means that for three years, you will have a fixed interest rate (often lower than conventional or fixed). After the initial three years, the interest rate can adjust (up or down), every year, based on the current interest rate environment. There are usually caps on how much the interest can adjust — sometimes annually, sometimes for the life of the loan.
Interest-Only gives you the option to only pay interest for the first five to 10 years. Your pay-off timeline will be slowed, and you will need to play catch-up on your principal payments.
FHA is a mortgage issued by the Federal Housing Administration. FHA loans require lower minimum credit scores and down payments than most conventional loans. While the requirements are lowered, there are more restrictions that can be encountered than with a conventional loan.
A VA mortgage is available to active duty, reserve, national guard, and veteran members of any branch of the U.S. Armed Forces. They require zero down and are backed by the Department of Veterans Affairs.
A balloon mortgage is similar to interest-only in that it requires you to pay interest only for a set time or number of years. The difference is that at the end of that term, the entire balance of the loan is due.
Jumbo describes a mortgage that is too big to be guaranteed by the federal government. As of 2019, the limit was set at $484,350 for the continental U.S. Applicants will undergo much more rigorous requirements (credit score, debt-to-income ratio, income, etc.) than conventional mortgage applicants. Interest rates are usually on par with conventional loans.
Each of these mortgage options has its own pros and cons. Remember, the above list is only an overview ; a trusted advisor can help you navigate the in’s and out’s of mortgages to help you make the decisions that are best for you and your situation. And if you are a first-time home buyer, I encourage you to check out our blog on the Four Stages of Home Buying for some great tips.