As a first-time homebuyer, it’s easy to get caught up in looking for houses on Zillow or driving around your favorite neighborhoods. But before you get too far into the process, you need to make sure you understand the basics – including financing.
What the Heck is a Mortgage?
A mortgage is just a fancy word for a debt instrument that’s collateralized by real estate. The borrower is obligated to pay back the debt over a predetermined period of time – typically in monthly installments that include both principal and interest. Mortgages allow individuals to spread out the purchase of a piece of real estate over many years, as opposed to providing the full payment up front (which few people can do).
In other words, when you buy a house using a mortgage, you don’t technically own the house until you have fully paid off the loan. The bank has a claim on the property should you default, in which case they will sell your house through foreclosure and use the proceeds to offset the mortgage debt.
While foreclosure happens, it’s not extremely common. The ideal scenario involves you paying off the mortgage within a predetermined set of time. When this happens, the bank signs the title over to you and you become the true owner.
4 Common Types of Home Mortgages
While virtually every homebuyer uses a mortgage to purchase a home, there’s actually a lot of variety in the types of mortgages available to you. It’s helpful to think about mortgages as unique products. Each comes with its own features, costs, and benefits.
Here are the most common mortgage products you’ll encounter.
1. Fixed-Rate Mortgage
Every loan can essentially be classified as either a fixed-rate mortgage or an adjustable-rate mortgage (ARM) – though there are many different types (and even some hybrids).
With a fixed-rate mortgage, your interest rate and total payment stay the same over the life of the mortgage – which is typically 15 or 30 years. If you can get locked in at a low interest rate, a fixed-rate mortgage is highly beneficial. However, when rates are high, you could end up getting stuck and paying more than you have to.
2. Adjustable-Rate Mortgage
With an ARM loan, your rate and mortgage payment can actually fluctuate over the life of the loan. This can be good or bad, depending on how you time the market.
With an ARM loan, you’ll see a pair of numbers, for example 5/1. The first number refers to the period of time during which the interest rate is fixed. In this case, it would be five years. The second number indicates how often the interest rate will adjust after the fixed-rate term expires. In this case, it would be every (one) year. In the details of an ARM contract, you’ll also find out what the cap is on the interest rate over the life of the loan.
3. Conventional Loan
In addition to choosing between a fixed-rate and ARM loan, you’ll also have to decide whether you want to use a conventional loan product or government loan product.
A conventional loan is one that isn’t insured or guaranteed by the government in any way. In other words, if you default on the loan, the government isn’t going to repay the bank. They have to dig their way out through foreclosure and hope that the proceeds cancel out the debt.
4. Government Loan
Then there are government loans – which generally include three different types: FHA, VA, and USDA.
With an FHA loan, your mortgage is managed by the Department of Housing and Urban Development (HUD). The biggest benefit of an FHA loan for first-time buyers is that you can make a down payment that’s as low as 3.5 percent.
Veterans and their families are often eligible for VA loans. What’s unique about these loans is that borrowers aren’t required to put a single penny down. The entire purchase price is financed.
Then there are USDA loans for rural borrowers who meet stringent income requirements. Generally speaking, people qualify for USDA loans when they live in areas without adequate housing and don’t have the financial means to qualify for a standard mortgage.
Seek Out Multiple Opinions
One of the bigger mistakes you can make in the mortgage process is failing to consider all of your options. The more people you meet and discuss mortgages with, the better you’ll understand your choices.
“Home loans are available from several types of lenders — thrift institutions, commercial banks, mortgage companies, and credit unions,” the FTC explains. “Different lenders may quote you different prices, so you should contact several lenders to make sure you’re getting the best price. You can also get a home loan through a mortgage broker.”
It’s also important to compare apples to apples. Know how much of a down payment you can afford and get estimates for closing costs and other relevant factors. This will guarantee you have all of the information you need to make an educated decision.