What is a mortgage?
If you ask Google, you’ll get many different and complex answers to the question, “What is a mortgage?” Here is the simplest one I found:
“Mortgage is a loan taken to purchase property and guaranteed by the same property.”
In a personal home example, the homebuyer usually puts some money down, and the lender pays the seller for the home. If the homeowner fails to make the required payments, the lender can foreclose and then would own the property. This is called a secured loan because the home is collateral for the loan. There are many kinds of mortgages in the US, and this post covers the 4 most common ones for primary residences.
What are the most popular US mortgages?
Conventional
Most mortgages in the US are conventional mortgages. These loans are guaranteed by a private lender or a government-sponsored enterprise. They are not offered or backed by the government, like some other mortgages are. Home buyers are likely to qualify for a conventional mortgage with a 700+ credit score, a debt-to-income (DTI) ratio below 36%, and a 20% down payment. It is possible to put down 10%, however, the home buyer then will pay private mortgage insurance (PMI) premiums on top of principal, interest, taxes, and property insurance. Note that once the homeowner builds 20% equity in the home, the PMI is easily canceled. The interest rates are typically fixed for the life of conventional loans. For more information about credit scores, check out this blog. For more information about DTI, check out this blog.
Adjustable Rate Mortgage (ARM)
Adjustable Rate Mortgages (ARMs) have a low introductory interest rate, then adjust after a specified period of time. The new interest rate will be tied to a certain index and will be that index’s rate plus a margin. A common ARM is a 5/1 mortgage, meaning that the introductory period is 5 years, and the interest rate will adjust every 1 year after that. ARMs are usually capped. For example, let’s say fixed rate mortgage rates are 4% currently. A 5/1 ARM might have an introductory rate of 3.5% tied to the 1-year Treasury Security yield with a 3% margin and a cap of 6%. If in 5 years 1-year Treasury Securities are offering a 1.5% yield, the adjusted interest rate would be 4.5%.
FHA
These loans are issued by private lenders; however, they are backed by the Federal Housing Administration (FHA) and are designed to help low- to moderate-income families become homeowners. The government will cover the mortgage in the event of a default. A borrower could be approved for an FHA loan with a lower credit score than is required for conventional loans. Additionally, the down payment can be as low as 3.5%. Unlike with conventional loans, which require private mortgage insurance for a down payment below 20%, FHA loans require the borrower to pay a mortgage insurance premium up front, and then some amount each month as well. This up-front premium can be added to the loan balance. The mortgage insurance premiums, unlike PMI, are difficult (if not impossible) to cancel. Interest rates on FHA loans are very close to those of conventional loans and are usually slightly less.
VA
The Veterans Administration guarantees home loans for service members and surviving spouses. There is often no down payment requirement, nor is there any private mortgage insurance (PMI) requirement. Closing costs are also limited.
Not all of us are veterans, and for those who are (thank you!), the terms of a VA loan are hard to beat. Most aspiring American homeowners will have to choose between conventional, adjustable rate, and FHA mortgages. Each has its pros and cons. Conventional loans are the right choice if the homebuyer plans on staying in the home for a while and has cash for a sizable down payment as well as a good credit score. ARMs a good choice if the homeowner believes interest rates will decrease, they plan on moving out within the introductory period, or they’re planning to pay the mortgage off soon. FHA loans are a great way to get into a home for a low down payment. Whatever the loan, the result is the same: realizing the dream of home ownership.