Spring tends to be the busiest home buying season with transaction activity typically peaking in April. Due to the historically low interest rates, however, this past year has seen a more consistent shortage of homes for sale. With low inventory, home buying has become more competitive than ever.
As you consider how much home you can afford during this buying frenzy, you will need to decide how you will finance the purchase of your home. There are many options when it comes to mortgages. The terms of your mortgage can significantly impact how much money you'll need upfront for a down payment, as well as the amount of the monthly payments.
At the most basic level, mortgages vary by a number of factors, including:
- The type of interest rate you'll pay. Interest is charged as an additional amount above the agreed upon purchase price of the home in exchange for the ability to repay the lender over time. With most mortgages, you can pay either a fixed or an adjustable rate.
- The length of time over which you'll make monthly payments. The most common terms are 15 or 30 years.
- The required down payment amount. With some types of mortgages, you are required to make a minimum 20% down payment. Others only require as little as 3% of the home's purchase price.
- The entity guaranteeing the loan. Depending on your situation, your home may be insured by a number of different entities, such as the Federal Housing Administration (FHA), U.S. Department of Veterans Affairs (VA) or U.S. Department of Agriculture (USDA).
- Approval qualifications. To qualify for some types of mortgages, you need near-perfect credit. Other types are geared toward borrowers with average or even less-than-stellar credit.
Fixed-rate vs. adjustable-rate mortgages
With a fixed-rate mortgage, the interest rate remains the same for the entire time it takes you to pay off the loan. That means your monthly principal and interest payment stays the same, which makes budgeting a lot easier. However, the interest you pay- at least initially - may be higher than what is available with an adjustable-rate mortgage (ARM).
An ARM often comes with an initial low rate, which translates into a lower monthly payment. However, there is always the risk that the rate will increase over time and create a monthly payment that may be more than what you are comfortable paying.
Short vs. Long-term mortgages
Your mortgage term refers to the length of your loan in years. While the most common terms are 15 and 30 years, mortgages can be as short as 10 years or as long as 50 years. A shorter-term mortgage is attractive because it allows you to pay off your house more quickly and provide you with more disposable income later in life. It also typically is associated with a lower interest rate, which means you'll pay less in interest over the life of the loan. Depending on the amount of money you borrow, this could translate into thousands of dollars saved in interest. However, in order to pay off your home faster, you'll need to make larger monthly payments for the term of the loan.
Comparing unconventional mortgage rates
First-time homebuyers are often the most challenged to save enough money for a down-payment. With an FHA loan, you can get a mortgage with as little as a 3.5% down payment. On the downside, however, you will be required to pay a mortgage insurance premium (MIP) over the life of the loan unless you have more than a 10% down payment. An MIP can tack on an extra $100 a month per $100,000 borrowed.
A VA loan allows military veterans to buy a home with virtually no down payment or mortgage insurance required. However, VA loans also come with a funding fee that ranges anywhere from 1.25% to 3.3% of your loan, depending on your military status, down payment amount, and whether it's your first time financing a home with a VA loan. That adds up to somewhere between $2,500 and $6,600 for a $200,000 loan. In addition, when you purchase a home with zero money down and things go south in the housing market, you could end up owing more than the market value of your home.
The USDA offers loans to people who live in rural areas and show a financial need based on a low to moderate income. With this type of loan, you can purchase a house with no down payment at below-market interest rates.
Other variable factors
The amount of money you invest in a down payment goes a long way in determining the size of your required monthly payments. Keep in mind when budgeting for monthly payments that you will also regularly need money for property taxes and homeowner's insurance. Also keep in mind that, if you put down less than 20%, you will need to pay private mortgage insurance (PMI), as well. This will cause your monthly payment to go up.
Although no two families have the same financial situation, in general terms and if your unique situation allows, you should consider making a larger down payment and opting for a shorter-term, fixed-rate loan. This combination will result in the lowest total interest expense paid over the life of the mortgage and will also help you garner a better mortgage rate. In the end, though, you need to choose the option that best fits your lifestyle and spending/saving habits. Some industry experts estimate that the average American will move 11.4 times during his or her lifetime. Depending on how long you plan to stay in your current home also weighs in on the decision of how best to finance it.
With so many options, it's best to discuss your specific situation with your banker to ensure you understand the short- and long-term ramifications and choose the mortgage that's best for you.
The information and recommendations contained herein is compiled from sources deemed reliable but is not represented to be accurate or complete. In providing this information, neither Cortland Bank or its affiliates are acting as your agent or is offering you any tax, accounting or legal advice.