Buying a home is probably the largest and most important purchase you’ll make in your lifetime and choosing the right type of loan is one of the most important decisions you’ll make in the home buying process.
With so many different options out there, it can be challenging to find the right loan for you. Make sure you do your due-diligence and research before committing to a certain loan amount, bank or type of loan.
Start by asking yourself, how much can I afford to pay for a home. After figuring up all your debts, credit score, income and other monthly bills, you can make a strong decision about what type of loan is best for you.
Two very important loan decisions you’ll need to make are what type of loan to choose and what interest rate you are comfortable paying.
There are two main types of mortgages: a conventional loan guaranteed by a private lender or banking institution, or a government-backed loan. Most government-backed mortgages come in one of three forms, FHA, VA and USDA. FHA loans are 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 down payment options and competitive mortgage rates. They’re available to current military service members and veterans only. USDA loans are insured 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. 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.
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.
Once you’ve chosen your loan, you’ll decide whether you want a fixed or adjustable rate. Your choice determines the interest you’ll be charged. The interest rate on a fixed-rate loan never changes. If you’re settled in your career, have a growing family and are ready to set down some roots, a 15 or 30 year fixed loan will probably be your best choice because you’ll know what your monthly mortgage payment will be. Adjustable-rate mortgages, have interest rates that reset at specific intervals. They typically begin with lower interest rates than fixed-rate loans. After the initial term ends, the interest rate increases or decreases annually based on an index, plus a margin. They most often appeal to younger, more mobile buyers who plan to stay in their homes for just a few years or refinance when the teaser rate is about to end. Paying a lower interest rate in those initial years could save hundreds of dollars each month that may be useful in other financial areas.
All of these options might seem overwhelming at first glance, but keep in mind that the type of loan you wind up getting will depend largely on your credit score, overall income and long-term financial goals. If you have multiple loan options, shopping for the best and cheapest loan can be complicated, and there will be many different factors you’ll have to consider. With different loan terms, time limits and monthly payments, finding the best deal can take some work.
Compare the different loan terms, and when possible, I would recommend choosing the shortest loan term available to you. While a shorter loan term will likely increase your monthly payments, you will find yourself paying a lower amount of overall interest. If for some reason, the shorter loan term comes with a higher percentage rate, then you may consider taking the longer-term loan but making larger payments, as long as there isn’t a prepayment penalty.
In my opinion, the interest rate and/or annual percentage rate (APR) is one of the most important factors to consider when determining which loan is best. For some loan types, comparing interest rates is appropriate, but the APR is a better number to review. The APR factors in fees, including points and origination fees, while the interest rate is just the basic interest charged In most cases, the comparison comes down to whether you are comfortable with the variability in interest over the loan term, as well as the current monthly payment.
Some loans have a loan term that is shorter than the amortization term. Those loans generally have a balloon payment due that is essentially the remaining money owed at the end of the loan term. If you are analyzing a loan with a balloon payment versus one that doesn’t, keep in mind that you will need to have that money available to pay when it becomes due, or you’ll need to refinance.The total amount owned includes the original amount borrowed plus interest and fees. I would encourage you to choose the loan with the least amount of money owed over the entire term, if you can afford the monthly payments.
Lastly, look at the monthly payments to see the amount you’ll need to pay each month. While some loans with variable interest rates or balloon payments may provide a lower monthly payment than other loans, please be certain you are not getting in too deep. In general, I would strongly recommend taking the loan with the lowest interest rate and shortest loan term as long as you can afford the monthly payment. Do your homework and make the best choice for you and your family at that current time.
Make sure you shop around and know that you can take out multiple loans from different lending institutions if you consider buying a home. Be aware that when the economy is on the rise it may be easier to qualify for larger loans so you may want to take advantage of these cyclical periods but don’t spread yourself too thin.
I would definitely recommend in re-financing loans when possible and trying to payoff loan as quickly as possible when paying off a loan for your primary residence. Your strategy may change when you take out loans on other investments, such as rental properties.