For first-time homebuyers, the path from looking for a home and finding financing to finally completing the purchase can be a confusing maze of choices. To help you navigate, here are some basic industry terms, financial considerations and loan options you can expect to encounter along the way.
What a mortgage means
A mortgage is a transfer of rights to a piece of property (your house) in exchange for a loan. It’s a legal agreement: You borrow money and agree to pay the money back, with interest, over a period of years. If you don’t make the payments, the lender can take your property.
Because there’s a lot at stake when you take out a mortgage, make sure that your finances are in order before you apply for the loan and that the house you choose is one you can comfortably afford. The U.S. Department of Housing and Urban Development, or HUD, offers a comprehensive guide to home mortgages, including loan programs state by state. The understanding of the local market offered by a community-focused lender such as Ohio Catholic Federal Credit Union can also be key in helping you make the right decisions.
Types of mortgage loans
One of the first choices you’ll confront when you get serious about buying a house will be what kind of mortgage you want: a conventional loan or one with government backing.
Conventional mortgages typically require a homebuyer to have a good credit history and the ability to contribute a significant percentage of the home’s cost as a down payment. If you pay 20% of the price upfront, you typically can avoid having to pay for private mortgage insurance, or PMI, which protects the lender in case of default. That insurance can add hundreds of dollars to your monthly payment in the initial years of a mortgage.
If you can’t manage 20% and must pay for PMI, you can ask your lender to drop the insurance once you’ve paid down your loan enough that you owe no more than 80% of the purchase price, provided your payments have been made on time and are up to date. The lender has to drop PMI once the balance reaches 78%, even if you don’t ask.
The most popular government-backed mortgage program, supported by the Federal Housing Administration, or FHA, was established to put homeownership within the reach of more low- to middle-income families, including those who might have trouble qualifying for conventional loans because they have a spotty credit history. The easier approval comes at a price, though: the loans require a buyer to pay for FHA mortgage insurance, which typically includes an upfront charge of 1.75% of the loan amount and monthly payments that last for the life of the loan.
The Department of Veterans Affairs also backs mortgages with very favorable terms for homebuyers who qualify. VA loans are available to most current and former service members. This program can provide 0% down payment financing.
With any mortgage, the higher your credit score and the larger your down payment, the lower the interest rate on the loan is likely to be. A lower interest rate means lower monthly payments — or the ability to borrow more money for the same monthly payment.
Fixed-rate or ARM?
The next question you’ll have to wrestle with concerns the terms of the mortgage: Should you get a fixed-rate or adjustable-rate loan?
Fixed-rate mortgages have a set interest rate for the life of the loan, which means your monthly payment for principal and interest remains the same. Shorter-term loans carry lower interest rates but higher monthly payments, because repayment is compressed into fewer years. Your lender could offer fixed-rate mortgages ranging from 10 to 30 years.
Adjustable-rate mortgages, or ARMs, typically start with an introductory fixed rate for a period of time, then switch to a rate that can change periodically, based on changes in a market index, such as the prime lending rate. Generally, the introductory rates on ARMs are lower than those on fixed-rate loans, making ARMs popular with homebuyers who expect to move in a few years.
The downside to an ARM is that once the rate starts to adjust, your mortgage payment can rise if the index it’s pegged to goes up. As a hedge against high payments, consider using a lender who’ll give you the option to convert to a fixed-rate loan for a small fee down the line.
The bottom line
You’re looking for loan terms that fit your financial situation and will allow you to still live comfortably in the house you want. Once you find a loan officer you trust, ask a lot of questions and keep your eye on the prize — your first home! If you do, you’ll make it through the financing process just fine.
Terri Kaufman, NerdWallet
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