This article is the second part of a three-part series discussing the buying process of your new home. For part one, click here. For part three, click here.
When you’ve identified the builder and community where you want to live, it’s time to move beyond your preapproval for a loan and your estimated budget and start the process of solidifying your financing.
Understanding Your Financing Options
The type of loan you choose depends on your personal finances. Unless you’re a veteran or active service member and can take advantage of VA loans, which don’t require a down payment or mortgage insurance, you’re probably looking at a conventional or FHA loan. If you have good credit and at least 5 percent for a down payment, a conventional loan is usually a better option because your private mortgage insurance payments automatically stop once your loan-to-value reaches 78 percent, says Phyllis Casillas, a sales manager for On Q Financial in Tempe, Arizona.
“FHA loans have higher mortgage insurance premiums and you’ll have to pay it for the whole loan unless you make a bigger down payment,” she says. “However, FHA loans are a great option if you had a short sale or foreclosure in the past or other credit problems because they’re more lenient than conventional loans.”
Also keep in mind that loan programs change frequently, so when you’re ready to get serious about buying a home, you should always consult a lender.
Remember that a preapproval from a lender doesn’t obligate you to work with that lender. Of course, it’s easier in terms of paperwork to get your loan from a lender who’s already qualified you and understands your financial needs, but you can still choose to finance your house with any lender, regardless of whether you’ve decided to buy a home in a community with a preferred lender program or an in-house lender.
For the most up-to-date information and specific loan programs offered by a local community bank or credit union, you should consult your lender.
Major Types of Loans
In general, borrowers choose from the following loan programs, depending in part by their eligibility for some programs:
FHA loans. FHA (Federal Housing Administration) loans are not actually approved by the FHA. Instead, lenders are authorized to offer FHA-insured loans. FHA insurance protects lenders in the case of a default by the borrower, so a lender is more likely to be a little more lenient with the credit score guidelines for loan applicants. As of 2014, FHA loans require a down payment of 3.5 percent, hence they appeal to many first-time buyers. The loans are available to all borrowers who qualify without any income limits. However, loans are limited according to the price of homes in your area, often to $417,000. FHA loans require both upfront and annual mortgage insurance, which adds to the cost of your monthly housing payment. (More information can be found at FHA.gov.)
VA loans. VA (U.S. Department of Veterans Affairs) loans are only available to veterans, current members of the military, and their spouses. Eligible borrowers can buy a home without a down payment and without paying mortgage insurance. (More information can be found at benefits.va.gov/homeloans/.)
USDA Rural Housing Development Loans. These government-guaranteed loans are available to borrowers with up to 115 percent of the local median income who can demonstrate that they can afford to repay the loan. These loans are also limited to homes within designated rural areas. USDA (U.S. Department of Agriculture) loans don’t require a down payment or mortgage insurance. More information on these loans can be found at the USDA’s website.
Conventional financing. Conventional loans meet the standards of Fannie Mae and Freddie Mac, which are government-sponsored agencies that buy mortgages and establish guidelines for lenders, in terms of credit qualifications and your debt-to-income ratio. Most conventional loans require a down payment of 10 percent to 20 percent, but some are available with a down payment of just 5 percent. If you make a down payment of less than 20 percent, you’ll have to pay private mortgage insurance (PMI), but PMI will automatically be eliminated when your loan-to-value reaches 78 percent. Conventional financing has loan limits that are adjusted annually. Loans under the limit are called conforming loans.
Jumbo loans. If you’re borrowing an amount above the limit for conventional financing, you’ll need a jumbo loan. These loans typically require a larger down payment of at least 20 percent to 25 percent and have stricter credit standards because of the higher level of risk associated with a larger loan.
Reverse mortgage for purchase. An FHA-insured reverse mortgage can be used to purchase a home if you’re over age 62. You can make a down payment of 40 percent or 50 percent and take out a reverse mortgage for the rest of the home value. You won’t make any payments on the reverse mortgage because the loan will be repaid with your home equity after you leave the property. You own the home as long as you pay the property taxes, homeowners insurance, and HOA fees.
In addition to choosing the type of loan that meets your needs, you have multiple options for mortgage terms.
Fixed-rate loans. A fixed-rate mortgage will have the same interest rate and the same principal and interest payment for the life of your loan. However, your payment may change if your property taxes and insurance premiums adjust over time.
Adjustable rate mortgages (ARMs). Most ARMs today are hybrid loans with a period of one, five, seven, or ten years at a fixed-rate followed by a period of adjusting interest rates. You can save money on your interest payments in the initial period, since these loans generally have a lower interest rate than fixed-rate loans. You should be sure you understand how much the loan can adjust in the future and whether you can afford those payments if interest rates reach the maximum allowed by your loan. In fact, your lender will have to qualify you based on the highest possible interest rate for that loan to make sure you can repay the loan.
Loan terms. You can also choose the term for your loan. While first-time buyers typically prefer a thirty-year loan to keep their mortgage payments as low as possible, you can pay less interest over the life of the loan and own your home free and clear faster with a shorter loan term such as twenty, fifteen, or ten years. Shorter loan terms usually have a lower interest rate than thirty-year loans, but the payments will be higher because of the compressed timeframe for repayment.
Private mortgage insurance (PMI). If you opt to make a down payment of less than 20 percent, you’ll have to pay PMI. Lenders offer several ways of paying PMI, including a monthly premium, an upfront premium at the closing, or paying a slightly higher interest rate while your lender pays the monthly premiums. PMI payments will be automatically eliminated when your loan-to-value reaches 78 percent, but if you pay down your principal early or your home increases in value, you can request an appraisal to prove that you have at least 20 percent equity in the property.
Keep in mind that your equity is the difference between your home value and your mortgage balance. If you purchase your home for $200,000 and make a down payment of $20,000 (10 percent), you’ll need to pay mortgage insurance until your balance reaches $148,200 (78 percent of your original loan balance of $190,000).
Discount points. If you want to lower the payments on your loan and reduce the interest rate, you can pay points when you close on the purchase of your home. A discount point is equal to 1 percent of the loan amount, or $2,000 on a $200,000 loan. If you’re short on cash, you’re better off getting a loan with zero discount points, but if you have extra cash and plan to stay in your home for the long-term, you may be able to reduce the total amount of interest you pay over the life of your mortgage by pre-paying one or two discount points at closing when you purchase your home.
For more on new home financing options, check out the complete Chapter 4 of New Home 101: Your Guide to Buying and Building a New Home, available for a free download at NewHomeSource.com.