This article originally appeared on The Financially Independent Millennial and was republished here with permission.
If you’ve been paying attention to the housing market recently, you will have noticed it’s on fire. From Seattle, WA, to St. Petersburg, FL, there isn’t a market that hasn’t been affected by the low mortgage rates and high millennial demand for housing. The market hasn’t seen this much activity ever (even more so than the housing financial crisis of 2008).
Given the recent interest in home buying, we thought it would be prudent to discuss exactly how Americans can afford such large homes. And, why now? After all these years, why are mortgages and refinances becoming popular all of a sudden? Let’s first discuss the basics of a mortgage and what its advantages are. They’re equally complex and beneficial, so it’s important to ensure we cover all the bases.
What Is a Mortgage Loan?
Simply put, your home secures the mortgage loan. It might be a house, a store, or even a piece of non-agricultural land. Banks and non-banking financial institutions both offer mortgage loans.
The lender gives the borrower cash, and charges them interest on it. Borrowers then pay back the loan in monthly installments that are convenient for them. Your property acts as security against the mortgage. And, your lender retains a charge until the borrower pays the loan in full. As a result, the lender will have a legal claim to the property for the duration of the loan. If the buyer fails to pay the debt, the lender has the power to seize the property and sell it at auction.
What Are the Different Types of Mortgage Loans?
No matter what anyone tells you, always remember: A mortgage is a debt. Debt is a very polarizing topic to discuss with friends because many of us were raised on the premise that debt is bad. The truth is, some debt is bad, some debt is okay, and some debt is good. Many today would argue that mortgage debt is good since the rate is so low and it affords you a bigger home.
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Some people believe that debt should be prevented at all costs. Others view it as a means of improving one’s quality of life or as a means of increasing fortune. What’s awful about debt, factually, is reckless credit usage.
Here’s a rundown of the many types of mortgage programs, along with their benefits and drawbacks, to help you determine which is best for you.
A mortgage with a fixed rate
The interest rate is fixed for the duration of the loan. These loans provide a consistent monthly payment and a low-interest rate. Borrowers who wish to pay off their mortgage quicker can typically make extra payments toward the principal, as prepayment penalties are uncommon.
Pro: It’s predictable because the monthly payment is fixed.
Con: Taking out a fixed-rate loan while the interest rates are high means you’re stuck with it for the duration of the loan. The only way out is to refinance at a lower rate.
A mortgage with an adjustable rate (ARM)
After a fixed-rate cycle of months to years, the interest rate on an adjustable-rate mortgage (ARM) varies. Lenders sometimes publish ARMs with a pair of numbers, such as 7/1 or 5/1. Usually, a 5/1 ARM has a fixed rate for five years and then adjusts every year, rounding off if that option exists.
Pro: An ARM’s opening interest rate is often lower than that of a standard fixed-rate loan, so it’s easy to get lured in by the teaser rate. But, it might wind up costing more in interest over the term of your mortgage than a fixed-rate loan. An ARM may be the ideal option for someone who plans to market their home before the rate changes.
Con: Future rate hikes might be significant, leaving many adjustable-rate mortgage borrowers with significantly elevated monthly payments than if they chose a fixed-rate mortgage.
Refinance loan or second mortgage
Sometimes, a homeowner already has a mortgage but wants to change the terms. Maybe they want a lower rate or a longer term. Or maybe, they want to take out more equity from their home. Whatever the case, many options are available! The most common would be refinancing the home mortgage. With mortgage refinance, the homeowner closes out their original mortgage, and obtains another one – ideally with more favorable terms.
With interest rates so low these past couple of years, refinancing has become much more popular. How often a homeowner refinances is usually a personal decision, but they should consider at least these factors:
- market interest rate vs their current mortgage interest rate
- length/term of their loan vs the new one they want to get
- cost of the loan (“closing costs”) vs keeping still
- [cash-out refinance only] what to do with the funds
Pros: If you can secure a lower interest rate than your current loan, and the closing costs aren’t significant, then it could definitely be worth refinancing. On the other hand, if you need the money for home renovations, a cash-out refinance may be your best bet.
Cons: Refinancing costs money, so make sure the math works in your favor.
The standards for conventional loans are generally more stringent than those for government-backed house loans. When reviewing traditional loan applications, lenders usually look at credit history and debt-to-income ratios.
Pro: A conventional mortgage may be used for a range of property kinds, and PMI would help borrowers qualify for a conventional loan even if they have less than 20% for the down payment.
Con: Compared to government loans, conventional loans have tougher qualification standards and may demand a larger down payment.
The average age of home purchases has decreased, and an increasing number of millennials are now purchasing their first houses. Typically, the loan duration is determined by the debt-to-income (DTI) ratio and the sum of interest negotiated on the mortgage. For homebuyers, a longer contract means a lower payment, but a longer time to pay off that debt.
Some lenders may offer an interest-only mortgage, meaning the borrower’s monthly fees will cover only the interest. As a result, it’s best to have a strategy in place to ensure that you can have enough money to return the entire sum borrowed at the end of the period.
Interest-only loans may be appealing since your monthly payments are low. But, unless you have a strong strategy to reimburse the capital, at some point, a fixed loan could be the better option.
Pro: Interest-only mortgages allow the borrower to place their capital elsewhere, such as in dividend stocks, a rental property, or other investments.
Con: Borrowers who aren’t careful with their budget may find themselves never being able to pay off the loan.
Read more: 15 Ways to Generate Passive Income from Real Estate
FHA loans and VA loans are mortgage loans insured by the government and available for potential homebuyers. FHA loans are available to lower-income borrowers and typically require a very low down payment. Also, borrowers get competitive interest rates and loan costs.
The government does not directly grant Federal Housing Administration (FHA) loans. FHA loans can be issued by participating lenders, and the FHA guarantees the loans. FHA mortgages might be a viable option for those who have a high debt-to-income ratio or a bad credit score.
Pro: FHA loans need a smaller down payment and credit score requirements are lower than conventional loans. Moreover, FHA loans may enable applicants to use a non-resident co-signer to assist them to be qualified.
Con: Unless a borrower puts down 10%, the monthly mortgage insurance will remain a part of the payment for the loan’s life. If a borrower ever wants to remove the monthly mortgage insurance, they must qualify and refinance into a conventional loan.
Read more: How to Improve Your Credit Score
FHA 203(k) loan
An FHA 203(k) loan is a government-insured mortgage allowing funding borrowers with one loan for both home renovation and house purchase. Current homeowners may also be eligible for an FHA 203(k) loan to help pay for the repairs of their current house.
Pro: An FHA 203(k) loan can be utilized to purchase and renovate a home that would otherwise be ineligible for a traditional FHA loan. It just takes a 3.5% down payment.
Con: You must be eligible for the full property value, as well as the price of anticipated improvements, with these loans. The rate may be greater than on a normal FHA loan. You’ll also have to pay both a one-time, and monthly mortgage premium insurance payments.
VA (Veterans Affairs) loan
Home loans for veterans, reservists, and military or National Guard members, as well as qualified surviving married partners, are backed by the US Department of Veteran Affairs.
In fact, nearly 90% of all VA-backed home loans are made without a down payment.
Pro: You won’t have to put any money down, or deal with PMI payments every month.
Con: On purchase loans, a one-time VA “funding charge” varies from 1.4% to 3.6%.
Fannie Mae homestyle loan
The Fannie Mae homestyle mortgage needs just 3%–5% down, but a credit score of 620 is an option for fixer-uppers.
Pro: You don’t have to pay for mortgage insurance beforehand, and you can terminate it after twelve years or when you have 20% equity on your house. The rate is frequently cheaper than an FHA 203(k) loan.
Con: Credit score requirements must be met.
Reverse mortgage loan
Homeowners aged 62 and above can use a reverse mortgage to convert some of their property value into cash. The age of the youngest homeowner, the loan rate and fees, the heir’s wishes, and payout type are all aspects for the lender to consider.
Pro: There are no monthly payments required, and the homeowner can select between a one-time balloon payout, a monthly payout, a line of credit, or a combination of the three.
Con: The interest rate may be greater than that of a typical mortgage. Mortgage insurance, a direct charge, an initiation fee, and third-party expenses are usually paid by the homeowner.
Mortgage loans are given to those who have enough income and assets vs. their debt. Mortgages also aid in the development of credit. They enable homeowners to invest in a home, with the advantage of having a forced-savings component. However, like with any loan, borrowers should be responsible when taking out a mortgage. It’s easy to get carried away and buy more than is necessary (and become house-poor).