First-time homebuyers are trying to figure out what mortgage best fits their needs. The reality is you don't always need to put down 20% to buy a home. Depending on your credit score and ideal loan terms, there are many types of mortgage structures that could work for you.
Almost two-thirds of Americans are homeowners. That number that has dropped over the past several years, but the dream of homeownership remains a big one for most Americans. A poll from Gallup found that 56% of Americans own a home and have no plans to sell, and another 25% of Americans are non-homeowners who plan to buy a home within the next 10 years.
Buying a home isn’t just about finding the right neighborhood, schools, and supermarkets. It’s also about searching for a mortgage that you and your family feel comfortable with financially. Let’s take a look at the details, and make some mortgage comparisons in order to find the right home loan for your needs.
What is a mortgage?
A mortgage, also called a home loan, is a loan from a bank or other financial institution that allows you to finance the purchase of a home. It is comprised of several different parts:
- Mortgage insurance
The principal is the amount of money that you borrowed from the bank. For example, if you took out a $150,000 mortgage loan, the principal balance will start at $150,000.
The interest rate is the amount of money you pay the bank for the loan. According to Bankrate.com, the current average mortgage interest rate for a 30-year fixed loan is currently 3.97%.
The interest is how banks make money off of mortgages. That's why paying a lower interest rate is so advantageous, as it lowers the cost of the loan in the long run. Take this example of a $150,000 mortgage:
Over the course of your 30 year mortgage, you'd pay $256,870.80 in interest on a $150,000 loan.
The other parts of the mortgage include taxes, which are calculated based on your home value and mortgage insurance. Homeowners who put down less than 20% are also required by lenders to take out private mortgage insurance (PMI).
What is a down payment?
Your down payment is the cash you put down to the seller when you buy the home, typically described as a percentage of the home price. The rest of the money comes from your mortgage loan.
So if you are buying that $150,000 home and you put 20% down, your down payment will be $30,000. That will reduce the mortgage cost to $120,000, which will lower your monthly payments and reduce the total amount of money you pay the bank in the long run.
The myth about down payments is that homebuyers have to put 20% down. Although 20% is considered the standard and allows you to avoid paying PMI, it isn’t required. In fact, the average down payment for a mortgage in 2016 was just 11%. Further, FHA loans allow first time home buyers to put down as little as 3.5%.
Fixed vs. adjustable rate
Remember the interest rate example we talked about earlier? That was with a fixed interest rate that remained the same for the duration of the 30-year loan. But not all mortgage interest rates remain static.
Adjustable rate mortgages can change from year to year or even from month to month.
Adjustable rate mortgages typically start off with lower rates than fixed rate mortgages early on. But later on in the loan term, adjustable rate mortgages can jump significantly.
For example, an adjustable rate mortgage can start at 4% and increase to 9% in just a few years.
Adjustable rate mortgages may allow you to save money early in your mortgage term and can be advantageous if you don’t plan on living in one place for too long. But over the long term, the costs are far less stable or predictable than fixed rate mortgages.
Comparing different types of mortgages
Not all mortgages are made equal, and you’ll want to make sure that you pick out the mortgage that makes the most sense for your finances. You’ll save a lot of money if you get it right the first time.
Government insured (FHA and VA Loans) vs. conventional loans
Both types of loans are issued by financial institutions, but government loans (FHA and VA loans) are insured by the federal government. Conventional loans do not have any lender guarantees but they're the most common mortgage loans for American homebuyers.
- The most common form of mortgage for homebuyers
- All financial institutions are familiar with conventional loans and you will know what to expect
- If you do not put 20% down, you will have to pay PMI
- Need good credit, reliable income, and, in most cases, the ability to put down at least 5% on a down payment
Government Insured Loans
- FHA loans allow you to put down as little as 3.5%
- Some closing costs are included in FHA financing
- You can qualify for an FHA loan with a credit score as low as 500
- VA loans are federally guaranteed and allow borrowers to obtain a loan without putting any money down
- You won’t have to pay PMI for a VA loan, which is one of the big drawbacks of conventional loans when you don’t put down 20%
- You’ll still need to pay a mortgage insurance premium with an FHA loan
- The maximum amount you can borrow is capped at the average cost of housing in your area with an FHA loan
- VA loans are limited to current US armed forces members, veterans, reservists, and surviving spouses
Jumbo vs. conforming loan
Conforming loans are just another way of saying traditional loans. They take a borrower’s credit score, debt-to-income ratio, and other factors into account. The maximum size of conforming loans is typically around $425,000 for single family homes, except in high-cost areas such as New York City or Los Angeles.
Jumbo loans are outside of the conforming loan guidelines, and typically for larger mortgages of half a million or more.
Jumbo loans aren’t backed by federal agencies and, because of their size, lenders have even more risk. Lenders typically require tight requirements for jumbo loans, such as two years worth of tax documentation of income and proof you have more than 6 months worth of mortgage payments on hand.
While conventional mortgages generally require a credit score of 620, you’ll need a credit score of 700 or more to qualify for a jumbo loan.
Jumbo loan lenders also ask for a higher down payment. While conventional mortgages are associated with 20% down payments, jumbo mortgages are associated with 30% ones.
Home equity loan vs. mortgage
Home equity loans are more like credit cards than mortgages. They are lines of credit that you can use to borrow a certain percentage of the equity of your home. Your home acts as collateral for the loan. There isn’t a set monthly payment. Instead, you’ll need to make minimum monthly payments. You can use this money to pay for bills, for college, or even to buy a new car. But if you default on the loan, you risk your home. Home equity loans allow you to take out as much money as you need, and you can pay it down.
Mortgages, on the other hand, can only be used to purchase a home. Instead of minimum monthly payments, as with a home equity loan, you’ll have set monthly payments that you’ll need to make for a set term or risk default. The home is the collateral for both home equity loans and mortgages.
How much will your mortgage cost?
By now, you probably have a better idea of what type of mortgage you are interested in. But do you know how much your mortgage is going to cost you? The price difference between a 15-year fixed rate mortgage, a 30-year fixed rate mortgage, and a 5-1 adjustable rate mortgage can be significant. Let’s take a look at each, with a mortgage comparison scenario where we buy a $250,000 home and put 20% down.
30-year fixed rate
About two-thirds of homeowners take out 30-year fixed rate loans. 30-year loans comprise the majority of mortgages for a reason--lenders have found them to be the most reliable, and homeowners find them to be the most affordable.
How much would a 30-year loan cost for our hypothetical $250,000 home? Assuming we put down 20%, our mortgage would be $200,000. With a 3.97% interest rate, we’ll pay $951.47 over 360 months. That’s a total of $342,493, or $92,493 more than the home price of $250,000. That $92,493 number is the total price we pay for taking out the mortgage.
15-year fixed rate
Now let’s say we buy the same home, with the same down payment, and the same interest rate--only with a 15-year fixed rate mortgage instead of the 30-year. Our monthly payment would be $1,476.37 over a period of 180 months. That means you’ll pay a total of $265,746.60. That number is only $15,746 more than the initial $250,000 home price.
So for our hypothetical $250,000 home with a 20% down payment, we save over $75,000 in interest by choosing the 15-year mortgage over the 30-year. The downside of the 15-year is that it costs about $500 more per month.
The shorter term means you’ll be paying the bank significantly less in interest, but the higher monthly cost is also a greater risk to you.
5/1 Adjustable Rate Mortgage
5/1 adjustable rate mortgages are more expensive in the long run. They might be advantageous to those who believe that they won’t stay in their home for more than five years while they get the lower interest rate, or for those who believe they can refinance within 5 years and get a fixed-rate mortgage. Otherwise, these mortgages probably aren’t the best deal for you.
For the last of our hypothetical scenarios, we’ll evaluate 5/1 adjustable rate mortgages. These mortgages have a fixed rate for the first 5 years. Afterwards, the rate is adjustable and typically rises over time. For the sake of brevity, let’s say the rate adjusts 0.25% upward every 12 months after the initial 5-year fixed rate period. The term is for 30-years.
Under this scenario, our final costs for the $250,000 home we put 20% down on are greater than both the fixed 30-year and the fixed 15-year mortgage. We end up paying a total of $418,456, with interest totaling $218,456. That’s over $100,000 more than the 30-year fixed rate mortgage. Even if we do a 5/1 adjustable rate mortgage with the same numbers for 15 years, we pay a total of $274,060, or $74,060 in interest. That’s around $60,000 more than the fixed rate 15-year mortgage.
Other types of home loans to consider
There are other mortgage and home loan products that are available for you to consider. Most first time home buyers don’t use these products when buying their first home, but they could be valuable ways to get access to credit in the future.
If you have equity in your home, you might be eligible to take out a second mortgage. For example, if you bought your home for $250,000, and the value increased to $350,000. If you paid $50,000 of the original purchase price, you’d still owe $200,000. But with a home value of $350,000, you’d have $150,000 in equity. You could take out a second mortgage for that amount.
Second mortgages tend to have higher interest rates because they are riskier than traditional mortgages. If the home goes into default, the original mortgage is paid off first, meaning lenders have more risk.
Home Equity Line Of Credit
A HELOC--home equity line of credit--operates like a credit card, with your home as collateral. There is a credit limit, and you can borrow up to a certain amount. Like other lines of credit, you can pay part or all of the balance and then borrow up to the credit limit again. Typically you can borrow and pay minimum monthly payments for the first 5 to 10 years of a HELOC. After that draw period ends, the repayment period starts. Repayment can last 20 years, and similar to a mortgage, you must pay both principal and interest until the entire loan is repaid.
HELOCs are similar to the home equity loans mentioned in the paragraphs above. But there are a few major differences. Home equity loans typically have a fixed interest rate while HELOCs have variable rates. The loan repayment is also different. Home equity loans are repaid with the same amount each month, consisting of a fixed interest and principal payment. Many HELOCs only require borrowers to repay interest during the draw period, with the full principal amount due at the end of the period. For example, if you took out a $15,000 HELOC, you would only be required to pay interest during the draw period. After the end of the draw period, the full $15,000 would be due.
What’s the best move for first-time homebuyers?
First-time homebuyers should evaluate what type of mortgage best fits their needs, down to the rate and the term. For most homebuyers, the conventional 30-year fixed rate mortgage is going to be the best option. But FHA loans and VA loans are just a few of the available options that can lower your down payment or provide you with other special privileges. That’s why we looked at the mortgage comparisons--to help you figure out what type of mortgage works best for you.
After you’ve determined what type of loan is the best fit, Open Listings makes home buying easy. You can see new listings on our platform, book private tours, and even make offers online.
When you buy a home with Open Listings, we’ll return half of the commission that we receive to you. You’ll get a refund against your closing costs, which could help reduce them to as little as $0. Buyers who used our platform have saved over $10,000. Are you next?