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Understanding your home financing options is the first step to making a smart choice. First to know is that there are different types of mortgage loans. These days, most home loans fall into one of two categories. They are either fixed- or adjustable-rate mortgages. The primary difference between them has to do with the interest rate, and how it behaves over time.
With a fixed-rate mortgage loan, the interest rate you have at the beginning of the loan is the same rate you’ll have at the end of the loan (when you either sell the house, refinance the mortgage, or pay the loan off entirely). This is the primary benefit of this financing option — there are no surprises later on down the road. The initial rate you obtain follows you for the entire life or “term” of the loan.
As the name implies, an adjustable-rate mortgage loan (ARM) works much differently. With this home financing strategy, the rate will change at a specific interval — usually every one to five years. When used properly, an ARM loan can save you money in the short-term. When used incorrectly, they can bring a lot of risk into the equation. Adjustable mortgages are rarely a smart option if you plan to stay in the home for a long time. In that kind of long-term scenario, a fixed rate loan is a better financing option for you.
Most of the adjustable mortgages in use today start off with a fixed rate for a certain period of time. After that introductory stage, however, the rate will begin to adjust or “reset” at specific intervals. Because of this, they are also referred to as hybrid loans. A person who only plans to live in a home for a few years might use an ARM loan to save money in the short-term. But once you get past the fixed stage of the loan, you have no idea what the rate will do (aside from changing in some way). If the rate adjusts upward by several percentage points, it could significantly increase the size of your monthly payment.
Remember, the interest rate is part of your overall mortgage payment. So when it goes up, your payment goes up as well. Depending on how much the payment increases, this could make the loan unaffordable for you. This is a very real risk that comes with this particular home financing option, so it’s a risk you need to take seriously.
Government Backed Loans – FHA and VA
When you’re thinking about your mortgage options, it’s important to understand the difference between conventional loans and government-backed loans.
Government-backed loans include options like VA loans—which are available to United States Veterans—and Federal Housing Administration (FHA) loans. FHA loans are backed by the Federal Housing Administration, and VA loans are guaranteed by the Veterans Administration.
With an FHA loan, you’re required to put at least 3.5% down and pay MIP (mortgage insurance premium) as part of your monthly mortgage payment. The FHA uses money made from MIP to pay lenders if you default on your loan.
To qualify for a VA loan, you must be a previous or current member of the U.S. Armed Forces or National Guard—or have an eligible surviving spouse. A VA loan requires no down payment, but you must pay a one-time funding fee, which usually ranges from 1%–3% of the loan amount.
A conventional loan is a type of mortgage loan that is not insured or guaranteed by the government. Instead, the loan is backed by private lenders, and its insurance is usually paid by the borrower.
Conventional loans are much more common than government-backed financing and account for over 75% of the mortgage loans made today. Most lenders offering conventional financing for a home require a minimum of 5% down, however, some lenders may have special plans with lower requirements. If a borrower puts less than 20% down most lenders will require Private Mortgage Insurance, which is the lenders insurance in case a borrower defaults on the loan.
Qualifying for a Mortgage
Your first step in qualifying for a conventional loan is to sit down with a lender. If you’re in the home-buying process, we recommend talking to Movement Mortgage.
When you meet with a lender, they’ll ask for documentation like recent pay stubs, tax returns, bank statements, and other financial information. They want to make sure you have a steady income and can make your monthly mortgage payments on time. Find the Financing Checklist here.
Debt to Income Ratio
A good first step before choosing the loan that is right for you is to find your debt to income ratio. To calculate your debt-to-income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out. Different loans have different debt-to-income ratios. For example, an FHA loan will allow up to 50% or less to qualify. However a conventional loan requires 43% or less, and a VA loan requires 41% or less to qualify.
If you want to start your home search on strong financial footing, talk to your lender about becoming a pre-approved homebuyer. Doing this will require a few extra steps up front, but it can give you an edge over other buyers in a hot market and get you to the closing table faster. With homes today receiving multiple offers within days (if not hours) on the market, many sellers will not even consider at offer without seeing the purchaser’s pre-approval letter.