Owning a home is part of the American dream, but the path to living in your own home isn't simple or easy. The median home value in the U.S. was recently around $200,000, which means a lot of homebuyers should be aiming for a hefty $40,000 down payment (20% of the value of the home).
Once you have your down payment ready, it's time to shop for a mortgage. That can be confusing, though, as there are many different kinds of mortgages with different terms and features. Here's an introduction to some standard mortgages that many people get.
First, though, a review of some mortgage basics is in order. For starters, know that mortgages come in many forms, with a variety of terms. The loan can feature a fixed or adjustable interest rate and can last for any number of years, though most tend to have terms of either 30 years or 15 years.
The interest rate, along with the duration of the loan, will determine your monthly payments. The examples in the following table, from the Bankrate.com mortgage calculator, show how significant the differences can be.
30-year fixed rate
15-year fixed rate
Note that you can reduce your interest rate by paying "points" when you take out your loan. A point is equal to 1% of your loan -- so if you have a $200,000 mortgage, paying a point would cost you $2,000 -- and it will typically lower your rate by 0.25 percentage points. Pay two points, and you can turn a 4% rate into a 3.5% one. That can be a smart move -- but only if you plan to stay in the home long enough to make up in interest savings what you paid in points.
Your credit score matters
You not only want to choose the kind of mortgage that will serve you best, but you also want the lowest interest rate possible on your loan. Lenders offer the best rates to those with the highest credit scores.
The following table shows the typical APRs and mortgage payments for someone borrowing $160,000 via a 30-year fixed-rate loan. You can see what a difference your credit score makes in the interest rates you're likely to get and their accompanying mortgage payments. Over many years, a low score can cost you tens of thousands of dollars.
Total Interest Paid
It can be well worth it to increase your credit score before you apply for a mortgage.
Without further ado, here's a review of six very common kinds of mortgages. Note that some home loans may fall in several of the following categories.
1. The 30-year fixed-rate mortgage
The 30-year fixed-rate mortgage is the most popular type of home loan. It's been a smart choice for many folks for a long time now, given our low-interest-rate environment, because it locks in the interest rate for the entire life of the loan.
A downside is that 30-year loans tend to sport higher interest rates than shorter-term loans and will probably have you paying much more in interest over the life of the loan. You can offset that by making sure any mortgage you sign up for allows you to make prepayments -- i.e., to pay more than you're required to in any given month. Prepaying is a powerful savings strategy, as it can decrease your loan balance much faster than the original schedule and thus save you a lot in overall interest payments.
2. The 15-year fixed-rate mortgage
Another strong contender is the 15-year mortgage. It will save you a bundle in interest payments because you'll get a lower interest rate and you'll pay down the loan in half the time, vastly reducing your interest charges. Your monthly payments will be much steeper, but you can save tens of thousands of dollars in interest throughout the loan term. If you're attracted to this option but the steeper payments frighten you, then consider buying a little less house and borrowing less.
Another strategy is to opt for a 30-year loan and aim to pay it off ahead of schedule by making prepayments -- i.e., paying more than you owe every month. Then you can still save a lot of money in interest by paying the loan off early, but if you ever struggle to pay the increased amount, you can dial it back and only pay your monthly minimum.
3. The adjustable-rate mortgage
The alternative to the fixed-rate mortgage is the adjustable-rate mortgage (ARM). It sports an initial interest rate that's generally lower than prevailing rates, and it keeps that rate fixed for only a few years, after which the rate is typically adjusted each year in accordance with prevailing rates. Adjustments are often capped, so you won't see a jump from, say, 4% to 7% in one year. However, over the course of several years, the interest rate can increase significantly, resulting in rising monthly payments. In mortgage lingo, a 5/1 adjustable-rate mortgage will hold the rate steady for the first five years before starting to adjust it annually -- upping it if prevailing rates rise or dropping it if prevailing rates fall.
An ARM makes sense if interest rates are falling and are expected to keep falling, or if you only plan to be in the home for a few years.
4. The little-to-nothing-down mortgage
With fixed-rate mortgages or ARMs, you'll often want to make a down payment of at least 20%. Otherwise you'll be expected to buy private mortgage insurance, which presents an additional monthly cost. There are some loans, though, that allow you to pay little to nothing down without purchasing PMI.
For example, VA loans and USDA Rural Development loans (which apply to lots of not-so-rural areas near cities) offer mortgages with $0 down payments. Conventional mortgages backed by Fannie Mae or Freddie Mac may allow you to make a down payment of as little as 3%, while Federal Housing Administration (FHA) loans are available with only 3.5% down.
This may sound terrific, as it makes home ownership possible for many people who cannot afford the standard down payment. However, understand that if you go this route, you'll be starting out with little to no equity, and if the home's value falls, you'll owe more than it's worth. Starting off with a larger loan balance also means paying more in interest throughout the life of the loan.
5. The jumbo loan
The median home price may be around $200,000, but plenty of people buy homes that cost $500,000 or $750,000 or more. If you buy a pricey home, you will most likely need to take out a "jumbo" mortgage instead of the typical "conforming" one. If you borrow more than a certain amount -- recently, the limit in most locations is $424,100 -- you're in jumbo-loan territory. (In some regions with particularly pricey homes, such as San Francisco and New York City, the threshold was recently $636,150, and parts of Hawaii go even higher.)
Taking out a jumbo loan means you'll probably have to clear greater hurdles, such as having more than one appraisal done of the home, having a high credit score (likely 700 or more), and having plenty of cash in the bank. You may also be required to make a down payment of more than 20% -- possibly even 30%. Why all this fuss? Well, you're borrowing an extra-large sum, and your lender wants to take more precautions against your defaulting.
6. The refinanced mortgage
A final common kind of mortgage is the refinanced mortgage. When you refinance, you essentially take out a new home loan that pays off the old one, leaving you with a new debt to repay. Homeowners will typically refinance if interest rates have fallen significantly since they first bought their home (a difference of at least one percentage point is best), so that they can have a loan with a lower rate and thus lower monthly payments. They might also refinance in order to change the terms of their loan -- say, from a 30-year mortgage to a 15-year one, or from an ARM to a fixed-rate loan.
Refinancing is not a good move if you won't be in the home much longer. Calculate your breakeven point to see whether refinancing will be worth it. For example, if your closing costs are $5,000 and you're saving $100 per month by refinancing, divide $5,000 by $100, and you'll get 50. That means it will take 50 months before you'll break even. That's no problem if you expect to be in the home at least that long. But if you might be moving sooner than that, reconsider.
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