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Mortgages can vary significantly from lender to lender. While a low interest rate is important, so is the loan type, points, fees, and other terms. Here are the basics:
There are essentially two types of mortgages: fixed rate and adjustable rate.
Fixed Rate Mortgages
With a fixed rate mortgage, you pay the same interest rate over the life of the loan. Fixed rate mortgages (FRM) are generally available in 30 and 15 year terms, with the 30-year FRM being the most common.
The advantage of a fixed rate mortgage is certainty; you know what your rate will be from month-to-month, year-to-year. You pay equal installments over the term of the loan, with your payment going toward interest and the principal.
If you plan to live in your home for more than five or ten years, a fixed rate mortgage might be your best option.
Adjustable Rate Mortgages
With an adjustable rate mortgage (ARM), the interest rate can change throughout the life of the loan. Interest rates are usually determined by a financial index and a margin, and change based on market conditions.
With an ARM, the initial interest rate is often fixed for a pre-determined period, after which it is reset. For example, a 5/1 ARM has a set interest rate for the first five years. After the 5th year, the rate is adjusted each year and your payment is recalculated. It may go up, down or remain the same, depending on market conditions.
ARMs typically offer a lower interest rate early in the loan term, which makes for lower monthly payments, but your monthly payment could rise after a specific period of time.
An adjustable rate mortgage may be a good option if you're planning on living in the house for a short period of time (typically five years or less).
Conventional, FHA and VA Loans
Conventional mortgages are underwritten by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) - two quasi-governmental entities. These loans must conform to Freddie and Fannie guidelines, which are more strict that the government-backed FHA loan standards.
For example, conventional loans typically require at least a 10% down payment and often as high as 20%. Most lenders require a minimum credit score of 620 for conventional financing. Lenders may also require a lower debt-to-income ratio (between 30% and 40%) for a conventional loan.
Conventional loans with less than 20% down will also require private mortgage insurance (PMI). This protects the lender in case the borrower defaults, since there's no government guarantee or backing of conventional loans.
FHA loans are insured by the Federal Housing Administration. These loans are often favored by first time buyers who lack the funds for a large down payment. Mortgage insurance is required due to the lower down payment amount, which is typically 3.5% of the purchase price. Qualifying for an FHA loan tends to be easier than qualifying for a conventional loan.
Veterans Administration (VA) loans are available to veterans and active duty military personnel, and are guaranteed by the federal government. Eligible borrowers can buy a home with no down payment and VA loans are easier to qualify for. VA loans tend to have low interest rates and no mortgage insurance requirement.