Ready to Choose Your Loan Type?
Get ready to make lots of interconnected decisions. Here are four key terms to understand:
Lenders want to give their customers choices as every borrower has a unique situation. This does not make the decision process simple.
For fixed-rate mortgages alone, you could choose a term of 10, 15, 20, or 30 years to pay back your loan. Some banks offer oddball terms, like 17-year and 25-year loans. You could go with any of these, but if you want a standard mortgage, 15 or 30 years is where you want to be. 30-year terms account for most mortgage loans, with 15-year loans a close second.
As you make your decision, remember that different loan terms will result in a very different loan experience. A 30-year loan will have a lower payment paired with a higher interest rate, costing more over the life of the loan. On the flip side, a 15-year loan will have a higher payment paired and a lower interest rate, saving you money over time. If a 15 or 30-year doesn’t feel right, it might be time to investigate another option.
If you choose to go with that 30-year fixed-rate loan, but aren’t happy with the interest rate you get, can you do anything about it? Definitely.
Mortgage discount points are yet another option to consider in your loan choice. If you have upfront cash, you can buy down your interest rate — making your “just okay” loan option a “more than okay” loan option.
The cost of each discount point is equal to one percent of your loan size, while a percentage point of your loan size is usually around 0.25% off your interest rate, though the value isn’t standardized and varies by lender and loan program.
The key question is: Will it be worth the cost?
There’s a break-even point down the line, usually five or more years into your loan, where buying down your rate starts saving you significant interest. However, if you sell or refinance before then, you won’t realize the full savings.
The discount points investment makes sense if you plan to keep your home long term. Otherwise, not so much.
You don’t have quite as many options when choosing interest rates — in fact, a lot of the choosing is done for you based on your credit score and borrower profile. Still, a few things to consider.
Those 15- and 30-year fixed-rate loan terms will have noticeably different rates, with the 15-year option having the lower rate. The choice here depends on whether you want — or need — a lower monthly payment, with some consideration for how much interest the longer loan will cost you.
Adjustable rate mortgages (ARMs) are also something to consider. They can be risky — and aren’t for everyone — but introductory rates are typically much lower than either 15- or 30-year fixed loans. If you’re savvy with finances and don’t plan to keep the mortgage past the first rate adjustment, this might be the option for you.
Yet another choice — how big a down payment you can make on your new home — has a big impact, affecting your interest rate, monthly payment, even what loan programs you’re eligible for.
Down payments can range from as little as 3% to more than 20%. What will these buy you?
With a down payment as little as 3% down for home purchases, you can get into a HomeReady™ loan for creditworthy, low to moderate-income borrowers. The HomeReady™ program allows permits the “income pooling” for all of the members of a household and is for both first-time or repeat home buyers.
With a 3.5% down payment, you can get a Federal Housing Administration (FHA) loan, a government-backed loan that’s become increasingly popular since the 2008 recession. These loans must be a conforming loan — for an amount less than $453,100 in most areas of the country.
With a 5% down payment, you’ll be eligible for Freddie Mac and Fannie Mae conforming loans.
Lenders still prefer a down payment of 10–20%, while for jumbo loans — loans in excess of the $484,350 limit in most places — a down payment of 20–35% may be necessary.
As you can see, you can’t really make any of these decisions in a vacuum. Each choice affects the other choices.
The best approach? Work out how real, concrete options you’ve been approved for will meet your mortgage needs.
Fixed or Adjustable Rate Loans?
Does it matter? Yes. Here’s a closer look.
This is the go-to option for nearly 90% of homebuyers and loan refinancers. There’s a good reason for that popularity:
- Interest rate stays the same, never changes
- Monthly payment stays the same, never changes
- No need to think about selling or refinancing in a few years, unless you want to
Fixed-rate loans come in a number of flavors with amortization terms ranging from 10 years up to 30 years. The fan favorite loan terms that account for most fixed-rate mortgages: 30 and 15-year loans.
30-year fixed-rate mortgages lock in your interest rate and monthly payment for all 30 years. The slightly less popular 15-year is conceptually the same but calls for a payment length that is half of the time, so your monthly payment will be higher. Another perk, you save some serious cash in saved interest over the lifetime of the loan.
You can probably figure out that an adjustable rate mortgage (ARM) comes with an adjustable interest rate. What’s that mean exactly?
In short, the rate for an ARM is tied to interest rate of a specific financial index — Treasury bills, certificates of deposit, the LIBOR index, etc.
When that index goes up (or down), your interest rate follows.
Why would anyone climb on such an interest rate rollercoaster? Two reasons:
- Introductory ARM interest rates are usually lower than fixed-rate interest rates.
- That low intro rate can let borrowers buy more house than they could with a fixed rate.
Most ARMs today are actually hybrids, with a low, fixed-rate introductory period followed by a rate that can adjust yearly based on its financial index. Some of the most popular ones are 5/1 ARM, 3/1 ARM, 7/1 ARM, and even 10/1 ARM, with five, three, seven, and 10-year fixed introductory periods, respectively. Most ARMs currently offered have long amortization periods, usually 30 years.
ARMs aren’t as simple as fixed-rate loans, which means they come with a mouthful of new mortgage lingo.
Here’s one way you might see an ARM offer listed out in the real world:
- It’s a 5/1 ARM with a 3/2/6 cap with the interest rate determined by the LIBOR plus 2%
Wow. Let’s break that down.
This is an adjustable rate mortgage with a fixed rate for 5 years followed by a rate adjustment every 1 year. That very first adjustment is capped at 3%, later adjustments are restricted to a change of 2% or less per adjustment, and the lifetime interest rate cap for this loan is 6% over your initial rate, never more. This loan has a margin of 2%, meaning 2% is added to the base index, the LIBOR rate, to come up with your newly adjusted interest rate. See, not so hard.
Which is better? It depends. A 5/1 ARM offers the opportunity to save several thousand dollars in interest over the first five years, but those savings could be wiped out by a rate adjustment.
If you definitely plan to sell or refinance well within the introductory rate period, but could make higher payments if needed, an adjustable rate mortgage could be a good option for you.
However, if you plan to put down some roots or tend to worry about your future, sticking with a more conventional fixed-rate loan is probably the way to go.