Among the hundreds of choices of home loans and financing, how do you know where to start? Clue: Your finances and assets play a part, and your personal style has more importance than you may think.
The loan types covered here don't begin to address all the options, so ask your lender about variations and updates that fit your situation. Meanwhile, here's an overview of the basics that most loans are built upon.
This original conventional loan is still among the most popular. With fixed-rate loans, your interest rate is locked in at the start, so your monthly loan payments stay the same throughout the life of the loan. (Note that if you're lucky enough to lock in at a low interest rate, future buyers probably won't be able to assume the loan.)
Long-term fixed-rate loan. The most common of these carries a 30-year term. For the first years most of your payments get applied toward interest, which is tax-deductible. If your loan agreement allows prepayment without penalty, you can also make additional payments on the principal. (Tip: One extra payment per year enables you to pay down your loan almost as fast as a 15-year loan.)
Down payments are on the high side—10 to 20 percent, and increasingly the latter—but if you pay 20 percent you're exempt from paying high monthly private mortgage insurance. While payments are lower than for a short-term loan, long-term interest rates are generally higher: if you take out a $100,000 loan with 8 percent interest, you'll ultimately pay almost $100,000 more than for a 15-year loan. This is a good loan for buyers with a fixed, steady income or who can't afford the payments of a short-term loan.
Short-term fixed-rate loan. Short-term loans typically have 15-year terms, but the term can be as low as 10 years. As with their long-term cousins, the interest rate and monthly payment are set for the life of the loan. But interest is lower, you pay less than half the amount of total interest, and payoff is years quicker. So why would anyone not choose the short-term route? Monthly payments are substantially higher—approximately 15 to 30 percent—and the requirements for qualifying are more stringent. Adjustable-Rate MortgageUnlike fixed-rate mortgages, ARMs carry an interest rate that's adjusted at specified intervals—generally one, three, or five years. The starting interest is lower (usually by 1 to 4 percent) than that of almost any other type of loan, which makes it a great option for cash-poor buyers or for those who expect to move in five to seven years.
But it's a gamble. Increases (or decreases) in your rate are tied to an economic index such as Treasury securities. At each interval—every five years for a five-year ARM —the rate is adjusted according to the index; additionally, the lender adds a margin of 2 to 3 percent. So if the index has taken a leap since your last interval, you could end up paying more per month than with a 30-year fixed-rate loan. But if you move out of your home within five years, or if the index rate drops, you can save a substantial amount of money over a fixed-rate loan.
ARMs include some protection for the borrower in the form of a lifetime cap, specified in your loan agreement. If an ARM has a lifetime cap of 5 percent, it means your interest rate will never be more than 5 percent higher than your originating rate, even if the index your loan is tied to exceeds 5 percent. You may also be offered, or negotiate for, a periodic cap, limiting the allowable increase at each interval. If possible, avoid including a payment cap in your loan agreement—it could result in negative amortization.
Ask your lender:
-If you can prepay without penalty.
-What your payments might reasonably be throughout the life of the loan.
-If the ARM can later be converted into a fixed-rate loan and relevant fees.
-What index your loan would be tied to; then check out its volatility and past performance.
Sometimes called "hybrid mortgages" or "resets" because they combine qualities of ARMs and fixed-rate loans, two-step mortgages are relatively new on the scene and very popular. They are 30-year loans, referred to as 5/25s or 7/23s. (The only difference is the length of the loan term.) With a 5/25 (pronounced "five twenty-five"), for instance, your rate is lower during the first five years and then reset for the remaining 25 years. As with an ARM, the loan is tied to an index rate but with a lifetime cap of 6 percent over the original rate.
Although these loans carry some risk, they can also pay off, and you have the stability of fixed payments. If you know you'll be moving within five or seven years, you can save thousands of dollars with this type of loan, which can also adjust downward. It only becomes a raw deal if you stay too long and the index has had a sizable increase by the time your rate is reset.
Convertible or nonconvertible? Both 5/25s and 7/23s have this option. With a convertible two-step 5/25 loan, for example, your interest rate is fixed for the first five years, then converts into a fixed-rate loan for the ensuing 25 years. A nonconvertible 5/25 is reset after five years into a one-year ARM that adjusts annually for the next 25 years.
FHA LoansFHA loans
Available as one-year ARMs or 15- or 30-year fixed-rate mortgages, FHA loans are insured by the Federal Housing Administration and offer an attractively low down payment—as low as 3 percent. The mortgage insurance can be quite costly, but FHA loans have looser requirements; you may qualify for an FHA loan even if you have a past bankruptcy.
FHA loans were created to help first-time buyers and others who may not qualify for other financial options, but there's no requirement that your income be below a certain level or that you be a first-time buyer. There are limits, however, to the amount you can borrow. These limits are adjusted periodically. (In 1998, the basic limit was $86,317 for single-family homes and $170,362 in high-cost counties.) A co-buyer doesn't have to live on the premises, as with most conventional loans. In fact, you can often pay your down payment with gift money. FHA loans can be assumed from the seller, which is attractive to future buyers.
Sound too good to be true? Well, there is that high mortgage insurance. And in a hot seller's market, in which houses are in high demand, sellers are sometimes reluctant to work with FHA financing, occasionally rejecting FHA buyers outright. There may be more paperwork involved, which can slow down appraisals and reaching a settlement. And because an FHA loan can end up costing more than a conventional loan, some industry gurus recommend that you first try qualifying for a conventional loan or other financing.
Strictly for veterans of the U.S. armed forces and in some cases their widows or widowers, these 30-year VA loans are guaranteed by the Department of Veterans Affairs. There's no monthly mortgage insurance premium, and in most cases no down payment is required. They include a choice of three repayment plans, including fixed-rate, and they usually have attractive lending terms. Prepayment is allowed without penalty, and the loans are assumable by other qualified veterans; you may have to requalify, however, if a buyer assumes your VA loan.
Note that fees can be steep, including credit report, survey title, VA appraisal, loan-origination, and recording fees. Since 1981 there's also been a VA funding fee (with an exemption for veterans who receive compensation for disabilities). In 2001, the fee for eligible first-time homebuyers ranged from 2 percent of the selling price for regular military to 2.75 percent for the Reserves or National Guard. (Reductions apply if you make a 5 or 10 percent down payment.) The funding fee for subsequent loans with zero down payment is 3 percent.
In other words, these loans aren't cheap, but they're useful if you're low on cash. They also have a high upper limit ($203,000 as of 2001), so you'll have more houses to choose from. To find out if you're eligible, check with your regional VA office or go to the Web for basics: http://www.homeloans.va.gov/lgyinfo.htm
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