Understand which mortgage loan is best for you so your budget isn't stretched too thin.
It’s easier to settle happily into your new home if you’re confident you can afford it.
Here’s what you need to know about your mortgage financing options, including how to choose the loan that matches your income and tolerance for risk.
Mortgage Financing Basics
The most important features of your mortgage loan are:
1. Term (how long the loan lasts)
Mortgages typically come in 15-, 20-, 30- or 40-year lengths. The longer the term, the lower your monthly payment. The interest rate on a 15-year mortgage might be 1% lower than the rate on a 30-year mortgage.
The trade-off for a lower payment on the 30-year mortgage is that you make more payments. Since you borrow the money for longer, you pay more interest to the lender.
2. Interest Rate (how much you pay to borrow money)
Mortgage interest rates generally come in two flavors: fixed and adjustable.
A fixed rate gives you the same interest rate and payment until the end of your mortgage. That’s attractive when you’re risk averse, if your future income won’t rise, or when interest rates are low.
The interest rate you pay on an adjustable-rate mortgage (ARM) changes at some point in the future based on where interest rates are at that time. ARMs are named for how long the rates last. For example, with a 5/1 ARM, your rate changes after the first five years and again every year after that.
ARM Risks and Rewards
An adjustable-rate mortgage rate goes up or down based on a particular financial market index, such as treasury bills. Typically, ARMs include a limit on how much the interest rate can change, such as 3% each time the rate changes, or 5% over the life of the loan.
Rewards for the uncertainty:
- ARMs can be a good choice if you expect your income to grow significantly in the coming years.
- The interest rate may drop if the financial market index that it tracks dips.
- An ARM usually starts at a lower rate than a fixed-rate mortgage of the same length and that can mean big savings.
Risks: If rates go up, your ARM payment will jump dramatically. So before you choose an ARM, be comfortable with your answers to these questions:
- How much can my monthly payments go up at each adjustment?
- How soon and how often can my monthly payment go up?
- Can I afford the maximum monthly payment?
- Do I expect my income to increase or decrease by the time the mortgage payment adjusts?
- Do I plan to own the home for longer than the initial low-interest-rate period, or do I plan to sell before the rate adjusts?
- Will I have to pay a penalty if I refinance into a lower-rate mortgage or sell my house?
- What’s my goal in buying this property? Am I considering a riskier mortgage to buy a more expensive house than I can realistically afford?
More Mortgage Options: Government-Backed Loans
If you’ve saved less than the ideal downpayment of 20%, or your credit score isn’t high enough for you to qualify for a fixed-rate or ARM with a conventional lender, consider a government-backed loan from FHA or the Department of Veterans Affairs.
Before you decide on any mortgage, remember that slight variations in interest rates, loan amounts, and terms can significantly affect your monthly payment. To determine how much your monthly payment will be with various terms and loan amounts, try realtor.com’s mortgage calculator.