Your mortgage is probably the biggest debt you’ll take on in your life. It’s a debt that will likely take you decades to pay back and cost you tens of thousands of dollars in interest.
Unfortunately, far too many home buyers just head down to their local bank and get a loan without doing much shopping around — or even fully understanding the debt they’re agreeing to repay. Homeowners who got mortgages they should not have were among the leading causes of the 2008 financial crisis, and buyers who don’t fully grasp how mortgages work continue to get into financial trouble to this day.
You must make sure you’re a responsible borrower, which means carefully researching your mortgage options to find the loan that best meets your needs.
Shopping for a mortgage loan
When shopping for a mortgage loan, you’ll need to decide what kind of loan you want. There are many different options, such as loans meant for buyers with low down payments or for buyers purchasing extra-large homes.
You’ll also need to decide what type of structure you want for your loan, which will determine how big your monthly payments are and how much you’ll pay toward interest and principal with each payment.
Other key decisions include how long you want to spend repaying your mortgage, whether you want to pay up front to reduce your interest rate, and which lender you borrow from.
What type of mortgage loan do you want?
Different types of loans have varying requirements, as well as their own pros and cons. Your options include the following:
Conventional mortgage loans
A conventional mortgage is a loan you can obtain from any lender that’s not federally insured or guaranteed by the government. These mortgages are available from private lenders, including mortgage companies, online lenders, banks, and credit unions.
Conventional mortgage loans are typically best for borrowers with good credit — generally defined as a FICO score of 670 or higher on a scale of 300-850 — as the requirements can be more stringent.
Lenders take a bigger risk when giving out a loan that’s not insured by the government, as the government isn’t guaranteeing to compensate the lender for losses if the borrower doesn’t repay the loan. If you take out a conventional mortgage and have a down payment of less than 20% — in other words, if you’re borrowing more than 80% of the value of the home — then you’ll have to pay private mortgage insurance (PMI). PMI protects the lender if you get foreclosed on, and it will cost you around 0.5% to 1% of the total mortgage value each year. For example, if you borrowed $200,000, you’d pay $1,000 to $2,000 annually for PMI.
Some lenders may sell these mortgages to Fannie Mae or Freddie Mac, both of which are government sponsored entities (GSEs). If you get a Fannie Mae or Freddie Mac mortgage, you aren’t getting a loan from these GSEs, but rather from a private lender approved by them. Typically, this means the lender has met certain requirements, such as not engaging in predatory lending. It may also be easier to qualify for a Fannie Mae or Freddie Mac loan, because lenders know they won’t have to keep the loan on their books. For example, Fannie Mae now has guidelines that allow lenders to give qualified buyers a loan with as little as 3% down, which can make it easier for some borrowers to get into a home.
If you want a Fannie Mae or Freddie Mac loan, your loan also needs to be a “conforming” loan, which means it must meet certain criteria. These include a maximum loan amount set by Fannie and Freddie. As of 2018, the limit for a one-unit property is $453,100. If you borrow more than this amount, you can still get a conventional mortgage — but it won’t be a conforming loan, so it won’t be resellable to Fannie and Freddie. Because the loan is non-conforming, you’ll pay a different interest rate than people who borrow less money.
Jumbo loans are conventional mortgages that exceed the threshold of what’s considered “conforming.” In 2018, if you borrow more than $453,100, you’ll need a jumbo loan. This upper limit changes — usually annually — and it’s higher in certain high-priced regions of the country.
Jumbo loans can be harder to qualify for, not only because you’re borrowing more money, but also because the lender cannot resell the loan to Fannie Mae or Freddie Mac on the secondary mortgage market. Usually, interest rates are higher on jumbo loans, though not always. Historically, jumbo loan rates have been about 0.25% higher than conventional loans, although during the financial crisis, jumbo loan rates at times exceeded rates on conventional loans by more than 1%.
As of late July 2018, however, the average rate on a 30-year jumbo loan was only about 0.08% higher than the average rate on a 30-year fixed-rate loan. That’s largely because many investors in the secondary mortgage market want to buy jumbo loan debt from the lenders who issue it.
FHA loans are loans that are issued by private lenders and insured or guaranteed by the Federal Housing Administration (FHA). If a borrower takes out an FHA loan and does not pay it back, the government repays the money to the lender.
A federal guarantee eliminates the risk of issuing these loans, so lenders are willing to be much more flexible about who can qualify for an FHA loan. For example, you can get this type of loan even if your credit isn’t that good. The minimum down payment is just 3.5%, and it can be paid with gift funds from a family member or even by the seller of the home.
Interest rates are also typically lower on FHA loans compared with the rates you’d get from a conventional lender, particularly if your credit isn’t perfect. As of July 2018, for example, rates on a 30-year fixed rate FHA loan averaged 4.10% compared with 4.42% for a conventional 30-year fixed rate loan. Of course, with a lower down payment, you’re borrowing more money and will likely pay more in total interest over time — even if the interest rate is lower.
Unfortunately, if you take out an FHA loan with a low down payment, you’ll be required to pay a Mortgage Insurance Premium (MIP). This is similar to private mortgage insurance because it protects the lender in case of default. However, with an FHA loan, you need to pay a 1.75% premium up front, either by paying at closing or by rolling this cost into the loan and paying it off over time. You’ll also need to pay annual premiums, typically for the entire life of the loan unless you refinance to a non-FHA loan. The annual premiums range from 0.45% to 1.05% depending upon the length of the loan and your down payment
FHA loans can help you get approved for financing when you’d otherwise be unable to get a mortgage at all. But paying MIP can make these loans expensive, so if you can qualify for a conventional loan and put money down, you should carefully compare which is a less costly source of financing.
VA loans are available to qualifying veterans. These loans are provided by private lenders, but the U.S. Department of Veterans Affairs guarantees a portion of the loan, so borrowers can qualify more easily and get more favorable terms.
Active-duty service members typically qualify for VA loans after serving for at least six months, and National Guard Members qualify after six years of service or after 181 days of active duty. Veterans and spouses of military members killed while on active duty or because of a service-connected disability are also eligible in many cases.
VA loans do not require a down payment, and the VA doesn’t impose credit score requirements, although many lenders do require at least fair credit, defined as a score of 580-669. Borrowers also do not have to pay for private mortgage insurance or Mortgage Insurance Premiums (MIP) if they take a VA loan with no down payment. For buyers making a low down payment, that makes this option much more affordable than conventional or FHA loans.
How will your loan be structured?
When you apply for a loan from a mortgage lender, you also need to make some choices in terms of how interest will be charged, as well as when and how you pay principal and interest. You have a few primary options, though some of them should be avoided.
Fixed-rate mortgages are typically the safest option for borrowers. With a fixed-rate mortgage, your interest rate stays the same through the entire loan term, and your minimum monthly payment never changes. If you start with 4.25% interest and a $1,000 monthly payment today, you’ll have the same payment and interest rate in five years, 10 years, 20 years, and 30 years — or however long your mortgage term lasts.
Monthly payments on fixed-rate mortgages are determined based on the interest rate, the amount of money that you’ve borrowed, and the length of your loan. The longer your loan term, the lower your monthly payments will be, and the more you’ll ultimately spend in interest — more on that later.
Adjustable-rate mortgages are mortgages that start with a promotional interest rate that is usually lower than what you could get with a comparable fixed-rate mortgage.
However, that rate is only guaranteed for a limited amount of time. For example, you might get a five-year adjustable-rate mortgage (ARM) or a seven-year ARM. That means your interest rate would stay the same for the first five years or the first seven years, but after that it could fluctuate up or down. These loans are usually labeled as “5/1” or “7/1” ARM. The 5 or 7 stands for the number of years for which the interest rate is fixed. The 1 stands for the adjustment interval, which is the length of time that must pass between each subsequent rate adjustment. With a 5/1 or a 7/1 ARM, you’d have the same interest rate for five years or seven years, then the rate could change once per year.
With an adjustable-rate mortgage, your rate is usually tied to a specific financial index, such as the LIBOR index. If interest rates go up, your payment goes up. This could mean your loan becomes unaffordable as your payment gets bigger. There are, however, caps on how much your interest rate can increase when your initial rate ends, how much it can increase each time it adjusts, and how much it can increase in total. The Consumer Financial Protection Bureau indicates that most commonly, the initial increase is capped at 2% or 5%; subsequent rate hikes are capped at 2% each; and the lifetime maximum increase is 5%, meaning “the rate can never be five percentage points higher than the initial rate,” per the CFPB.
That said, lenders set their own limits on how much rates can rise, and they can be higher than those listed above. Your lender should disclose the maximum monthly payment you will pay if your interest rate hits the maximum. You should also get a similar explanation of an ARM before you sign it.
Don’t be tempted by a low starting rate if you plan to stay in your home for a long time and you wouldn’t have the money to absorb an increase in your monthly mortgage payment. While the home may initially seem affordable since the rate is lower, you could be at serious risk of foreclosure if rates rise and you cannot refinance or pay the bigger bills.
Interest-only mortgages are loans structured so your payment covers only the interest accruing; you do not pay any of the principal. This means you make payments every single month, but your loan balance does not get any smaller.
Most interest-only mortgages are structured so the mortgage is paid off within 30 years, but borrowers pay only the interest for the first 10 years. The monthly payment is much lower, initially, because the borrower doesn’t have to pay toward the principal — but it jumps up after a decade when the borrower suddenly begins actually paying down the loan.
Interest-only mortgages are very rare, and for good reason — they’re extremely risky and were a leading cause of foreclosures during the 2008 financial crisis. Today, lenders claim there are more safeguards in place to ensure that borrowers understand how these loans work — but borrowers are still taking a risk, because their payments will jump dramatically after a decade.
Interest-only mortgages could be fixed-rate or adjustable-rate, and the risk is even greater for adjustable-rate loans because the interest rate could be far higher after five, seven, or ten years — right when principal payments must start being made.
Bottom line: You likely should not get an interest-only mortgage. And don’t assume you’ll be able to sell your house or refinance before you have to start paying principal, because you can’t predict how the housing market or your financial situation may change by the time the bigger payments come due.
Balloon mortgage loans allow you to make smaller payments over several years, but require you to pay off your entire loan by making a lump sum payment after a short time.
The initial monthly payments on a balloon loan are typically calculated as if you were repaying the loan off over a standard 30-year period, but they may also be based on paying interest only. However, you’ll only make these payments for a relatively short time — often, five years, seven years, or 10 years. At the end of the designated period, the entire remaining principal balance must be paid off all at once in a balloon payment. This could be hundreds of thousands of dollars.
Balloon mortgages generally have lower interest rates and monthly payments than conventional mortgages, and it can be easier to get approved for a balloon loan. The problem is that you may not be able to come up with the huge payment that’s due within a few short years.
Most people who get balloon loans do so with the intention of selling or refinancing the house before the balloon payment comes due. Unsurprisingly, this does not always work out. If you’ve lost your job and can’t qualify for refinancing when your balloon payment is due, you could be forced to sell your house. If your home can’t sell quickly enough to fund that balloon payment, then you could be looking at foreclosure.
Because of the huge risks, you should generally steer clear of balloon mortgages, too.
How long should your loan term be?
Most borrowers have the option to choose how long of a loan term they want. The loan term is the period of time over which your mortgage loan is repaid. The typical options available to borrowers are a 15-year mortgage and a 30-year mortgage.
A 15-year mortgage requires you to pay off the loan within 15 years. The interest rates on a 15-year mortgage are generally lower because there’s less risk for lenders: A shorter loan term means less opportunity for interest rates to fluctuate or for the borrower to default. A 30-year mortgage requires the loan to be repaid within (you guessed it) 30 years. Most people get 30-year mortgages, although they ultimately cost more because you’re paying interest for such a long time and at a higher rate than for a 15-year mortgage.
A 15-year mortgage comes with much higher payments — after all, if you want to pay off your mortgage in half the time, you’ll have to cough up more money each month. However, a 15-year mortgage dramatically reduces the total cost of your home. Not only will your interest rate be lower, but you’ll also take bigger chunks out of your principal with every payment, more quickly reducing the balance that’s subject to interest.
But that doesn’t mean a 15-year mortgage is the best choice for you. Those higher monthly payments could make it harder to accomplish other financial goals, such as saving for retirement — and mortgage interest rates are almost always lower than the returns you could earn by investing your money in a stock-heavy portfolio.
The charts in this article show you the financial difference between paying off your mortgage over 15 years and paying it off over 30 years while investing the money you save thanks to the lower monthly payments. You can also check out our guide to help you decide whether to pay off your mortgage early or invest instead.
If becoming debt-free is a top priority for you, then by all means, pay off your mortgage as soon as possible — but that doesn’t necessarily mean you should opt for a 15-year mortgage. Instead, you could choose a 30-year mortgage and just make extra payments. Sure, your interest rate would be slightly higher, but you’d have much more flexibility: If you couldn’t afford to make an extra payment during a particular month, then you wouldn’t risk putting your mortgage into default.
Some lenders also offer other terms, such as a 10-year mortgage or a 40-year mortgage, but these types of loans aren’t as common.
Should you pay points?
When you shop for a mortgage, you want to get the best interest rate possible, because the lower your interest rate, the lower your monthly payments and total loan cost. That’s why it’s so important to get your credit score as high as possible before you apply for a mortgage.
There’s another way to lower your interest rate, though: by paying mortgage points, or discount points. Put simply, this means paying your lender an additional up-front fee in exchange for a lower interest rate for the duration of the loan.
Discount points cost 1% of the amount you’re borrowing, and each discount point lowers your interest rate by around 0.25%. So if you were borrowing $200,000 and the standard rate you were offered was 4.25%, then one point would cost you $2,000 and would lower your rate to 4%.
Your monthly payment on a $200,000 loan at 4.25% would total around $984 on a fixed-rate 30-year mortgage. If you paid $2,000 to reduce your rate to 4%, your monthly payment would drop by about $29 to $955. It would take you 68 months of saving $29 to get back the $2,000 you spent to buy points. After that 68-month period, you’d enjoy your $29-per-month savings for the remainder of the time you spent repaying the loan.
The longer you plan to stay in your home, the more sense it makes for you to pay points and benefit from the reduced interest rate and monthly payments. In the example above, if you stayed in the home for the entire 30 years, you’d pay a total of $154,200 in interest if you didn’t pay any points. However, if you paid a single point in order to lower your interest rate, you’d pay $143,700 in interest. In other words, you’d save $10,500 by paying just $2,000 up front.
What are the fees and costs?
Many different lenders offer various types of mortgage loans, so regardless of which you select, you’ll have an array of loan providers to choose from. This means you can comparison-shop to find the best overall deal.
Once you know what kind of mortgage you want, ask lenders to review your financial information and let you know if you’ll be approved for that specific type of loan — and at what rates. You can compare total costs from one lender to another to see which offers the best deal overall. Paying attention to interest rates is very important, as a lower-rate loan typically costs less in the end — assuming the other features of the loan are the same.
You also need to look carefully to see whether you’re comparing apples to apples. If one lender offers you a 4% loan with no points, while another can offer you 4% if you pay a point, then you’d want to go with the first option.
There will also be fees associated with obtaining a mortgage loan. For example, you’ll have to pay for a home appraisal and a credit report, and you may have to pay a loan origination fee. Lenders also typically ask you to pay for a survey, title search, and inspection to make sure the home — which acts as collateral — is actually worth what they’re lending you.
If two lenders are offering you the same interest rate — or close to it — then you should probably choose the lender that charges the lowest overall fees.
Are there prepayment penalties?
Finally, check with any lender you’re thinking of borrowing from to find out whether you’d have to pay a prepayment fee if you paid off the loan early or refinanced.
You don’t want to become trapped in a mortgage that no longer works for you, so look for a lender that doesn’t charge a penalty. The only exception is when you’re confident that you won’t pay on an accelerated schedule and can get a better overall deal from a lender that penalizes advanced payments.
Start shopping for a mortgage early
It can take time to select the right mortgage lender and get approved for a loan. And many sellers won’t accept an offer on a home unless you have a pre-approval letter, which is a letter from a mortgage lender showing that the lender has reviewed your financial situation and has preliminarily agreed to lend money pending a more thorough review.
Because it makes sense to ensure you can actually qualify for a loan before you find a home you love, start working with mortgage lenders before you find a realtor. That way, you’ll know exactly how much you can afford to borrow and won’t waste time looking at homes outside your price range.
With the right lender, and the right loan, your home purchase should be both a great investment and an opportunity to start setting down roots.
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