Start the loan process by looking at your financial situation. To help find the optimum loan program, answer these questions:
- How long will you remain in the home?
- What is your current financial situation?
- What are your longer-term income expectations?
- How much interest rate fluctuation and risk are you willing to accept?
- How much money do you have available for a down payment and other upfront costs?
Armed with an understanding of your financial situation, you can best evaluate these common types of loans:
A fixed-rate mortgage carries the same interest rate for the life of the loan, which is most commonly 15 or 30 years. Many lenders are now offering other terms including 20-year and 40-year fixed-rate loans. Fixed-rate loans are the most popular choice because they provide a predictable monthly payment.
With an adjustable-rate mortgage (ARM), the interest rate is tied to an index that rises and falls over time causing the monthly payment to change over the life of the loan. ARM loans typically have a cap to keep the rate from rising above a certain amount. These loans are attractive for those who do not plan on staying long in their homes because they often start with an interest rate two to three percent below a fixed rate mortgage. Plus, you may be able to afford a more expensive home with an ARM because your initial interest rate will be lower.
With an interest only mortgage, for a set term the mortgage payment is applied only to the interest on the loan and not the principal. The amount that would be applied to the principal can be used for investment purposes or some other purpose. At the end of the term the loan reverts back to its original terms with the monthly payments raised to reflect the full amortization over the remaining years of the loan (for instance, following a five-year interest-only loan, a 30-year mortgage would now fully amortize over 25 years).
FHA and VA loans assist first-time home buyers and others who might not be able to meet down payment requirements for conventional loans. The Federal Housing Authority provides mortgage insurance to private lenders making these loans. Down payments can be as low as three percent and closing costs can be rolled into the mortgage. There is a statutory limit on FHA loan amounts. The government also steps in to help veterans secure a home. VA loans can offer up to 100 percent financing with no mortgage insurance. Even those with less than perfect credit can secure good rates.
A balloon mortgage has a short term, generally five, seven or ten years. However, the payment is based on a term of 30 years. This type of mortgage can be attractive because it is easier to qualify for and often has a lower interest rate. But at the end of the loan term, you need to pay off the loan, refinance, or convert the balloon mortgage to a traditional mortgage at current interest rates.
How Much Payment Can You Afford?
When considering what type of loan to get, figure out how much you can afford. Generally, lenders want to see that your payment (which is considered to include principal, interest, taxes and insurance) does not consume more than 28 percent of your income. Your monthly payment divided by your monthly gross income is called your housing ratio. In addition, lenders usually want to see that your debt ratio (house payment, plus other loans or credit card payments, divided by your monthly gross income) does not exceed 36 percent. These ratios are typical, but they do change over time as the economy changes.