People are often confused by all of the types of mortgage loans available to home buyers. To keep it simple, there are 4 primary loan possibilities that you can pursue if you wish to buy a home. They include conventional loans, FHA loans, VA loans, and finally loans through the Rural Development Direct Program.
Let’s begin by discussing conventional loans. A conventional loan is government created and usually requires a 3 to 5% down payment on the purchase of your house. What makes conventional loans unique is the publicly traded companies such as Freddie Mac ensure that mortgage money is available to lenders during all economic conditions.
Another loan type is the Federal Housing Administration or FHA loan. The Department of Housing and Urban Development ensures all FHA loans. Anyone may apply for an FHA loan. An FHA loan usually requires a minimum of 3% down payment. However, you’ll also find that there are maximum loan amount limits with FHA loans.
The third type of loan available to consumers is the Veterans Administration or VA loan. A VA loan is guaranteed by the Department of Veteran Affairs. Only military veterans, active duty military personnel, and National Guard members who meet the service requirements may apply for VA loan. With the VA loan, no down payment is required. However, there are maximum loan amount limits.
The final type of loan available to loan buyers is the Rural Development Loan. Rural Development loans are backed by the US Department of Agricultural and are specialized loans aimed at revitalizing certain target areas or to assist low income or first time home buyers to achieve home ownership.
With these types of loans, there are additional requirements for active duty personnel and full time college students. There are also location limitations as well as maximum loan amount limitations. However with the Rural Development Loan, there are no down payment requirements.
While the varying types of loans can be confusing, it’s important to remember that the primary difference between loan types is the amount of down payment required in purchasing a home. For instance, conventional loans require a minimum down payment of 3 to 5% depending upon the terms of the loan. The FHA loan requires a minimum of 3% down payment, and the Rural Development and VA loans don’t require any down payment at all.
You’ll also find that all other types of loans offered are based on some way on one of these 4 basic loan types. These are often called Specialty Loans. Specialty Loans are based on one of the 4 big loan types but are modified in some way to help more people qualify for home loans. However with specialty loans, there are disadvantages. These can include, possible restrictions on maximum household income, limited locations, maximum purchase price, and recapture of profits from subsidized interest rates and costs.
If you happen to be a low income or first time home buyer, there are a variety of assistance programs that can help you secure a home loan. Many of these assistance programs will help you with securing a down payment or paying for closing costs. For every loan or assistance program available, there are advantages, disadvantages, and guidelines that you need to consider. Please remember that they are all excellent loan opportunities as long as you understand the requirements and restrictions, as well as qualify them and are willing to honor them.
In additional to conventional and specialty loans, there are other financing options available. These options can include assumptions or contract for deed. Assumptions are when you take over the loan what the seller already has on the property. However, you should know that not all loans are assumable. Loans that are considered assumable usually require advance credit qualification and approval of the buyer by the lender before the seller can be released from the liability. To assume a loan, the seller will want to cash down payment from the buyer that’s equal to the equity that he has on the property. He’ll then take over the remaining payments on the loan.
A contract for deed is when the seller carries financing on the home and holds the deed until the contract is paid off. In effect, the seller is the lender. Interest rates on contracts for deed are usually higher than market rates and the payments are made directly to the seller. Contracts for deed typically cover 1 to 5 years and usually require larger down payments. However, beware that the laws that govern mortgage foreclosures do not protect you in a contract for deed. It’s very important that you understand the terms of your contract before you sign it.
Now that we’ve discussed the various types of loans available to consumers, it’s necessary to discuss what parts make up a loan. For starters, you have the term or the length of the loan. The term is the length of time that you have to pay the loan back. Mortgages are usually offered for terms of 10, 15, 20, 25, or 30 years. The longer the term on your loan, the smaller your monthly payment will be. However, the longer term means you’ll also pay more interests over the life of the loan.
Another important part of your loan is the interest rate. The interest rate is the fee the lender charges you to use their money. Interest rates vary day by day and could even change several times with any given day. Furthermore, if you wish to have interest rate that’s lower than the current market rate, you may be able to buy a discount point to secure a lower rate. A discount point is usually equal to 1% of the loan amount. For example if you have a $100,000 loan, 1 discount point would be $1,000. It’s important to remember that interest rates are never guaranteed until they’re locked in. However in most cases, your interest rate cannot be set or locked until you have an accepted purchase agreement on the property. At that point, you can set a rate lock which is an agreement between you and the bank that the interest rate you agree on will be guaranteed for a specific amount of time until you close on your loan.
If you think that interest rates are going to drop, you want to float your rate. Floating your rate means that the bank is not guaranteeing your rate and you’ll float along until you’re happy with the interest rate. However, many lenders require that your rate be locked at least 5 days before closing so that the final underwriting and closing documents can be completed.
Some lenders offer third choice for locking in rates called a float down rate lock which allows you to lock in or guarantee a maximum interest rate. With this option, you have the opportunity to lock in a lower interest rate at some point before your closing should the interest rate go down.
Your loan will also include a loan-to-value. Every loan has a maximum loan-to-value. The loan-to-value means that a lender will only loan a certain percentage of the value of the property. For instance, if the loan-to-value of your loan is 95%, then the lender will only loan you 95% of the value of the property or sales price, whichever is less. You’ll then have to have at least 5% down payment in order to cover the full cost of the property.
Many people ask what happens if the purchase price and the value of the home are not the same. This can happen if the seller has lower the price of the house for a quick sale or is asking too much for the home. In this case, the lender will always base their loan on the lower of the purchase price or appraised market value of the home.
Finally, most loans also have down payment requirements, application fees, and closing cost. If you have difficulty raising the funds to cover these costs, there are assistance programs available to help you. Ask your lender or local housing agency about any programs available in your area. Sometimes it’s possible to finance some or all of these costs.
One of the biggest dilemmas you’ll have when you choose a home loan is whether to choose a fixed or adjustable rate loan. A fixed rate loan is a loan with an interest rate that will stay the same for the life of the loan. Fixed rate loans are a good choice when interest rates are low, when you have a fixed or limited income, if you don’t receive regular raises, or you’re not comfortable with your loan payments fluctuating. A fixed rate loan does have variations. In particular they are the step-rate and buy-down loans.
Step-rate loans usually start at an interest rate a few percentage points below the current market value. Your interest rate will then increase or step up by a certain amount each year for several years. When the rate reaches its highest rate, it will then remain at that level for the rest of your loan. This type of loan allows you to qualify for a higher loan amount since the interest rates starts out lower than the regular market rate. A buy-down loan is one if fees paid up front to buy down the interest rate by a percentage or two. This means that your loan would start out lower than the current rate, stay at that rate for a year, and then step up 1% each year until you’re paying the market rate.
Now, let’s discuss adjustable rate loans. An adjustable rate loan is a loan with an interest rate that will change from time to time based on the market index. There are many types of adjustable rate loans. Some change every 6 months. Some change only once a year. Some will be fixed for 3, 5, 7, or 10 years and then change every year thereafter. With an adjustable rate loan, you need to understand what changes can happen, how often they can happen, and you need to ask yourself if you’re in a position financially to absorb the increases in payments if rates should climb to the maximum.
Adjustable rate loans are good choices however if you plan to be in the house only a few years, if your income will be increasing, if you have additional income sources, or when fixed rates are high since adjustable rate loans usually start out lower than fixed rate loans. However if you choose to pursue an adjustable rate loan, you should familiarize yourself with the terms related to them.
First, adjustable rate loans usually have a cap rate. A cap rate is the minimum or maximum rate adjustment per year and for a lifetime. For instance, if your starting rate is 6.75% and there’s a 6% cap, the maximum rate you would ever have to pay is 12.75% even if rates went up to 15%. The annual or per year minimum, maximum cap rate adjustment is usually 1 or 2% which means that your loan interest rate cannot go more than 1 to 2% higher or lower in any 1 year.
Secondly, interest rates for adjustable rate loans are usually set using an index or baseline number taken from a particular financial product such as the 1-year US treasury securities. You can find the index in The Wall Street Journal and you want to familiarize yourself with this index so that you can you make sure that your loan is being adjusted correctly. Adjustable rate loans also include a margin. A margin is the amount the lender will add to the chosen index’s interest rate to set their loan interest rate. Margins typically range from 2.25 to 2.75%.
Finally, some adjustable rate loans offer conversion option which allows you to change to a fixed rate for a nominal conversion fee if the interest rates increase. Please be careful with conversion rates however because you can only convert on certain dates that are specified by the noteholder.
As you can see, choosing the most appropriate loan for you is an important part of the home buying process. With proper assessment, you can find the loan that’s best for you. That concludes lesson 4 of our home buying series. I’m Jewell DiDucca with American Consumer Credit Counseling. Please join us next time for lesson 5 when we’ll discuss shopping for a home.