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How to Choose the Best Mortgage
You’ve found a home you love. That’s great! But for most buyers, it’s only half the battle — next you have to secure a mortgage. The idea of researching loans and rates, talking with lenders about points and other fine-print items, and gathering all the financial documents you’ll need just to apply for a mortgage might seem like a hair-pulling task, but it doesn’t have to be.
By understanding your own needs and taking stock of your situation, you can more easily find a home loan that’s right for you. If you’re wondering how to choose the best mortgage, start by asking yourself these three questions:
Question 1: How much can you put down?
You’ll hear “20% down” over and over as you research the home buying process. The reason is that, if you’re able to make a down payment of at least 20% of the home’s price, you’ll enjoy lower interest rates, and you’ll pay little or no private mortgage insurance (PMI). A good-sized down payment essentially protects the lender in case you stop paying your mortgage — in its absence, PMI is a type of insurance that offers lenders that protection instead. PMI can run as high as 1.5% of the entire loan annually — in addition to your loan payments — so it can really add up.
If you have enough cash saved up (or equity in your current home) to put down 20% toward the cost of your new home, and you have very good credit, you can take advantage of a conforming or conventional mortgage. Interest rates on conventional loans are typically among the best you’ll find, and you can avoid the added expense of PMI.
If you can’t afford to put down 20%, or if your credit score isn’t as stellar as you’d like, you don’t have to fret. There are many options still available (especially for first-time home buyers), including the conventional 97 LTV, a loan available through Fannie Mae and Freddie Mac requiring as little as 3% down. The nice thing about the conventional 97 LTV loan is that you can use a cash gift toward your down payment, and it’s available to current homeowners as well as first-time home buyers. The downside is that it only applies to 30-year, fixed rate mortgages.
You can also look into a FHA loans, which are backed by the Federal Housing Administration. You can put down as little as 3.5% for this type of mortgage. You may also benefit from reduced closing costs, although your interest rate may then be higher. Two mortgage insurance premiums are required for FHA loans.
Veterans and their families have a great opportunity to purchase a house using a VA loan. You’re not required to put any money down with a VA loan, and you don’t have to pay mortgage insurance. One-time funding fees do apply, but these can be reduced by making a down payment.
Question 2: How long are you planning to stay in the home?
This is perhaps the biggest question you must ask yourself before buying a home — because if you’re only planning to stay somewhere for a couple of years, you’d probably be better off renting in most cases. But how long you intend to stay in your home can also determine which type of mortgage will work best for you: fixed or adjustable rate.
A fixed-rate mortgage is just that — fixed. The rate you agree to when you get your loan is the rate you will pay throughout the life of your mortgage, unless interest rates drop and you decide to refinance your mortgage. The advantage of having a fixed rate is that you know exactly what you’ll be paying now and in the future. This is especially appealing for those who plan to stay in their home for a decade or more. A 30-year, fixed interest rate loan often gets easier to pay the longer you own your house, as both your earnings and price inflation on everything else inch steadily upward, hopefully allowing you to add to your financial wealth.
However, the certainty that a fixed rate affords comes at a small price premium: Adjustable rate mortgages (ARMs) typically start out with interest rates that are often about half a percentage point lower than fixed-rate loans. Most ARMs allow you to lock in that low interest rate for a set period of time — typically five or seven years – after which your rate will re-adjust annually based on market conditions, usually with caps on how much it can increase in a given year and overall. So on a 5/1 ARM, for example, you might lock in an enticing interest rate of 2.75% for the first five years, after which it could increase no more than two percentage points a year up to a cap of say, 10%, depending on market rates at the time.
If you sell or pay off your home before those five years are up, none of that matters. So if you’re looking to buy a “starter” home — one you expect to serve you well for about five to 10 years, but fully anticipate outgrowing at some point – an ARM may suit you best, as your rate and payments would likely be much lower those first five to seven years. And if you plan to pay off the house in short order, an ARM is a great way to go. Just remember that, once the initial fixed-rate period ends, you’ll largely be at the mercy of current interest rates – and your monthly mortgage payment could rise dramatically and indefinitely.
Question 3: How much is it really going to cost you?
You’ve figured out your needs and zeroed in on a mortgage that seems just right for you. You’re aware of the current interest rates and whether you’ll be be on the hook for private mortgage insurance. You’re feeling pretty knowledgeable about what will be expected of you financially. Nevertheless, you’d like to know if there are any other costs or obligations on your part. And, naturally, you want to be sure you’re making the best possible decision. That’s where a loan estimate comes in handy.
Within three days of applying for a mortgage, you’ll receive a loan estimate from the prospective lender — this replaces the good faith estimate that was previously used. A loan estimate will give you a clear idea of the interest rate, monthly payment, and closing costs of the loan. Estimates for any property taxes and home insurance you’re responsible for will also be stated. In addition, you’ll see if your mortgage has any special conditions that might positively or negatively affect the loan down the road.
While different lenders may offer you different mortgages and terms, even on the same home – for example, one might lump the closing costs and fees into the loan, so you’re paying for them over 30 years instead of upfront (but, be assured, you’re still paying for them) – the loan estimate is a standard form that all lenders use. That means you can use it to make an apples-to-apples comparison of mortgage offers from multiple lenders. Compare things like closing costs, fees, and the total interest paid over the life of the loan, and decide which mortgage is the best option for you.