NerdWallet’s Mortgage Guide
Whether you’re a first-time home buyer or looking for a mortgage refinance, NerdWallet’s mortgage blog can help you make the best decisions. We’ll help you figure out what kind of home loan to get (15-year or 30-year fixed mortgage, adjustable rate mortgage, FHA loan, HomePath mortgage, etc.) and how to get the best mortgage rate today.
NerdWallet’s Mortgage Guide
A. Basics About Mortgages and Mortgage Rates
A mortgage is a long-term home loan through a financial institution that is collateralized by a house or property. The mortgage rate on the home loan can severely impact the affordability of a new mortgage or mortgage refinance. The most common types of mortgage options are fixed rate mortgages and adjustable rate mortgages.
Fixed-rate mortgage: This is most commonly available in 15-year and 30-year options. With a fixed mortgage, your interest rate remains the same for the entire life of the loan and you’ll always have the same payment each month.
With a 30-year mortgage, your payments will be lower since you have 15 more years to pay off the loan. However, interest rates on a 15-year mortgage are usually lower than the 30-year, so you’ll end up paying less in interest and you’ll pay off your entire mortgage in just 15 years. It depends on whether or not you can afford the higher payment amounts.
A fixed mortgage looks like a great option since you are locking in the interest rate for the entire life of the loan. You will also have the peace of mind in knowing exactly what your payments will be every single month.
Adjustable rate mortgage (ARM): The interest rate on an ARM changes every year based on the market, but this loan might come with an initial fixed rate. For example, a 5/1 hybrid ARM comes with an initial five-year, fixed rate. After the fifth year, the rate adjusts based on the market.
The initial interest rate on an ARM is lower than a fixed rated mortgage. Currently the rate for a 5/1 ARM is just 2.87%. Since there is a strong possibility that rates will begin to rise shortly, this only looks like a good option if you plan on owning your home for just a few years. For example, if you are planning to sell your home in three to five years,, a 5/1 ARM might more sense for you than a 15- or 30-year fixed mortgage interest rate.
Just remember that with an ARM, you payments could go much higher should interest rates rise. If you’re not ready for that to happen, it could spell disaster. An example of this is that during the housing crisis in 2007-2008 mortgage delinquencies soared, mainly due to rising interest rates on ARMs.
B. How to get the Best Mortgage Rate
Several factors influence where mortgage rates trend over time, including the U.S. Federal Reserve’s asset purchases, housing demand and the secondary market for mortgage-backed securities. But the largest driver of getting the best mortgage rate is still in your control.
How do you qualify for the lowest mortgage interest rate? Lenders decide if you’re a good risk for their money. The lower the risk, the better the rate. They’ll study your income, credit score, employment history, liquid assets, down payment, the type of property you’re buying, and its value.
1. Know your credit score
Your credit score is the foundation for your personal financial profile. The most commonly used score is issued by Fair Isaac Corp. (FICO), and grades you in five different areas, each making up a percentage of your grade. These are:
- payment history (35%)
- money owed (30%)
- length of credit history (15%)
- types of credit in use (10%)
- new credit (10%)
Credit scores range from 300 to 900; FICO’s are between 400 and 800. The best mortgage rates today go to borrowers in the high 700s and above. The best candidates have low credit card and loan balances, and long histories of on-time payments and ongoing credit accounts, so make sure your credit report is error-free. You can access it for no cost at annualcreditreport.com, where you can see one copy every year from each of the three credit reporting agencies (Experian, TransUnion, and Equifax). If you find mistakes, contact the company to correct them.
2. Get out of debt
Too much debt makes you a bad risk. Lenders look at your debt-to-income ratio (DTI), which should be less than 43%, to determine if you’ll qualify for the best current interest rate. Lower your DTI by paying down your plastic. This will most likely raise your FICO score, as well.
3. Prepare your financial documents
Beginning January 1, 2014, the Consumer Financial Protection Bureau implemented new rules that protect you from loans you’re not qualified for, so you’ll be less likely to suffer a mortgage default. As a result, lenders are under more pressure to diligently review your financial records. They’ll scrupulously look at your income, assets, debts, and credit accounts. If they see anything out of the ordinary, they’ll ask for explanations, so keep copious records. A clean bill of financial health helps you qualify for a low mortgage interest rate.
4. Think about Mortgage Rate Locks and Points
After years of low numbers, current interest rates are expected to climb as the Federal Reserve slows down the pace of the economic stimulus. A rate lock makes the mortgage lender commit to holding an interest rate for you for a specified period of time. This guarantees you will get the rate you saw at application time, even though your loan hasn’t closed. Read the Federal Reserve’s A Consumer’s Guide to Mortgage Lock-Ins to learn more.
Another way to reduce your mortgage rate is to pay “points” (prepaid interest). One point equals 1% of your mortgage loan, and lowers your interest rate by .25 points. That means, on a $200,000 mortgage with an interest rate of 4.5%, paying two points for $4,000 can lower your rate to 4%. This strategy is beneficial if you stay in your home for a long time. Points may also be tax deductible.
C. If you are thinking about a Mortgage Refinance…
Refinancing your mortgage means that you are paying off your existing mortgage with a new one. Homeowners often do a mortgage refinance when interest rates have dropped lower than the rate on their current mortgage.
There are several advantages to refinancing your mortgage. These include lowering your total monthly payments, lowering your interest costs over the life of the loan, freeing up cash to pay off consumer debt, tax advantages, converting an adjustable rate mortgage to a fixed to reduce payments and interest rate risk, and more.
So, when should you refinance your mortgage?
Refinancing a mortgage makes sense under certain circumstances. Read 4 reasons below.
1. Get a mortgage refinance for a lower interest rate
Let’s say you have a 30-year fixed loan with a balance of $200,000 and an interest rate of 6%. Your monthly principal and interest payments would be $1,119.10 per month. Interest rates have gone down since your obtained your mortgage, so you decide to refinance with an annual percentage rate (APR) of just 4.2%.
On the new loan, your principal and interest payment is $978 a month – so doing a mortgage refinance could save you $221 a month in mortgage payments.
However, keep in mind that refinancing your mortgage can cost anywhere between 3% to 6% of the loan balance due to additional fees associated with the mortgage refinance. If we use 3% as an example, or $6,000, your break-even period is 28 months and you’d save $73,585 over the life of the loan. In this case, it is clear that mortgage refinancing makes sense since you’d make back your money in a little over 2 years.
Mortgage refinancing for a lower rate can also can make sense if your credit score has improved. For example, if you had a fair credit score between 640-659 when you first got your mortgage, your APR could be well over 5%. However, if you make all of your payments on time and your credit score improves to 750 or higher, it may be possible to get a mortgage refinance with an APR of under 4%.
The difference between having a mortgage with an APR of 4% compared to 5% can mean tens of thousands of dollars over the life of the loan. On a 30-year fixed mortgage of $200,000 at 5% APR, you’d pay $176,011.57 in total interest. On the same loan at 4% APR, you’d pay $134,239.01 in interest, or $41,772 less. However, you need to stay in your home for a long time to get the full benefit of this savings.
2. Get a mortgage refinance to convert from an adjustable rate mortgage to a fixed rate
An adjustable rate mortgage (ARM) typically comes with an initial period of a fixed interest rate, and then resets to a floating rate for the remaining of the loan. This is different from fixed-rate mortgages, which have the same exact interest and principal payment schedule for the entire loan.
For example, a 3/27 ARM means that the loan’s interest rate would be fixed for the first three years, then resets for the following 27 years based on the market. A five-year ARM sees the interest rate fixed for the first five years, and then is adjusted annually.
Why get an ARM? The interest rate on an ARM during the fixed-rate period is typically much lower than other mortgages – the current rate on a 5/1 ARM is just 3.1%. An ARM could also make sense if you only plan on living in your home for a short period of time, or if you sell the home before the fixed-rate period ends. If you keep the ARM after the initial rate period ends and interest rates rise, it’s possible that your payments could jump.
Converting to a fixed mortgage from an adjustable rate can be a wise financial decision, especially if you plan on staying in your home for the long term. For example, you can get a 5/1 ARM, pay it off during the low initial rate period of five years, and then do a mortgage refinance by the end of the fifth year to a 30-year fixed.
3. Get a mortgage refinance to get rid of private mortgage insurance
Whenever you buy a home with less than 20% down, you are required to pay private mortgage insurance (PMI), which protects the lender against default.
This insurance can be quite expensive – PMI annual premiums can cost between .5% and 1% of the mortgage. For example, a $200,000 loan at 1% PMI would cost the homeowner $2,000 a year or $166.66 per month.
Previously, homeowners were able to cancel mortgage insurance premiums (MIP) once the principal balance on the mortgage falls below 80% of the value of the home. However, the Federal Housing Administration recently reversed this policy and now disallows removal of MIP throughout the entire life of the loan.
Thankfully, you may still be able to get rid of PMI once you have 20% equity in your home by doing a mortgage refinance. You still should go over all the costs of refinancing your mortgage to see if the savings outweigh the costs. Make sure you calculate the difference of the monthly payments on both loans and factor in the closing costs for the mortgage refinance.
4. Get a mortgage refinance to consolidate high-interest debt
You may want to use a cash-out mortgage refinance to consolidate high-interest debt such as credit cards, student loans or car loans. This could make sense if you are reducing the interest rates on your debt by a large margin.
For example, let’s say you have a home worth $200,000 and you have $150,000 left on your mortgage, but you also have $50,000 in total consumer debt at an average APR of 10%. With a cash-out mortgage refinance, you would take on a new $200,000 mortgage and cash out the $50,000 in equity to pay off your consumer debt.
This can make sense since the APR on the new mortgage is usually much lower than the rate on credit cards, student loans and other debt. In this case, it would make sense if you can get a 30-year fixed mortgage, since the average APR is currently under 5%. You can end up saving a ton of money on the total interest you pay using this strategy.
Before going ahead with the mortgage refinance decision, beware of the pitfalls
Mortgage refinancing can be a great financial decision, but it doesn’t make sense for everyone.
First, it might not make sense for someone whose credit has declined since the original mortgage. If your credit score is lower than it was when you got your first mortgage, you are unlikely to get a better rate.
You should be careful that your current mortgage does not come with a prepayment penalty, as some lenders will charge you if you pay off your mortgage early. You can find out whether or not your mortgage has a prepayment penalty by going through original paperwork and documents on your mortgage agreement.
Even if mortgage refinancing makes sense for you, not all refinancing options will be a good deal. You should be aware of the closing costs and fees of mortgage refinancing, which can include “nuisance fees” such as document fees.
D. If you are a First Time Home Buyer…
The first decision first time home buyers often ask is, “Should I rent or buy?” and “How large of a mortgage can I afford?” To help answer these questions, the New York Times has a great mortgage calculator to help you decide. Afterwards, figure out which type of mortgage is best for you.
Know all of your mortgage options
Getting a mortgage for the first time can be quite confusing because of all of the available options. However, it is important that you compare all your mortgage options first.
1. Conventional mortgage options
Typical mortgages have interest rates that are either fixed-rate or adjustable-rate.
The first type is a fixed-rate mortgage, which comes in both 15-year and 30-year loans. This loan is exactly what it sounds like – you are getting a fixed interest rate for the entire life of the loan. A benefit of this is predictability: your monthly principal and interest payments will always remain the same, and you won’t have to worry about fluctuations in interest rates affecting your mortgage payments.
A fixed mortgage is also a good idea if you think interest rates could rise over the next few years and you want to lock in today’s low rates. In November 2012, 30-year fixed mortgage rates hit their lowest point in history at 3.35%. Since then, mortgage rates have gone up slightly to 4.4%, but are still well below the 1972–2013 average of 8.57%.
A 15-year mortgage will come with a lower interest rate, but higher payment amounts, while a 30-year mortgage comes with a higher rate, but lower payments. A 15-year mortgage could be a good idea if you can absolutely afford the higher payments and want to pay off your mortgage faster. However, you can always get a 30-year mortgage and make extra payments if you wish.
Your other option is an adjustable-rate mortgage (ARM). With this mortgage, your interest rate can go up or down based on where interest rates are in the market.
ARMs usually come with an initial period of a fixed-interest rate, and then reset to a floating rate over the remaining period of the mortgage. For example, a 5/1 ARM has an initial fixed-rate period that lasts five years, and then the rate is adjusted each year after. Currently the average rate for a 5/1 ARM is just 2.87%, which is much lower than average mortgage rates.
An ARM looks like a better option for someone who only plans on living in the home before the fixed-interest rate period ends. For example, if you are planning to sell your home in five or less years, a 5/1 ARM might more sense for you than a 15- or 30-year fixed because of the lower interest rate. You just need to be careful because after the fixed-rate period ends, your mortgage payments could be substantially higher, if rates are higher.
2. Comparing FHA loans vs. conventional mortgages
An FHA loan refers to a mortgage loan that is insured by the Federal Housing Administration (FHA). FHA loans are designed specifically for first-time home buyers because it usually only requires a minimum down payment of 3.5%. It usually comes as a 30-year fixed mortgage.
FHA loans are very attractive for first-time home buyers who might not be able to afford the typical 20% down payment that comes with a conventional mortgage. Imagine you find a home you really love for $300,000. You might be able to afford the home, but can you afford to put $60,000 down plus the closing costs? If you put 3.5% down, you’d only have to spend $10,500 to buy the house.
Do FHA loans sound too good to be true? Well there is a catch, unfortunately. Because you are putting less than 20% down, you’ll have to pay two forms of mortgage insurance.
First, you’ll pay an upfront mortgage insurance premium (MIP) of 1.75% of the loan. For example, on a $200,000 mortgage you’ll pay $3,500. This is usually included in the mortgage, so you might not have to pay out of pocket.
Next, you will pay an annual mortgage insurance premium (MIP), which is charged monthly. The payment amount on this varies. On a loan with a term greater than 15 years and a loan under $625,000, the annual premium is 1.3%. So for a $200,000 mortgage, you’d end up paying $2,600 a year, or $216 per month.
You used to be able to cancel PMI after you had built up at least 20% equity in your home. The Federal Housing Administration recently reversed that policy and now disallows the removal of MIP throughout the life of the loan, if the loan’s starting balance is higher than 90% of the appraised value. For example, if you bought a home for $200,000 and the loan’s value is $195,000, you’ll have to pay MIP for the life of the loan. However, you can always consider refinancing your mortgage to get rid of the FHA loan once you have enough equity in the home to do so.
3. Comparing VA loans vs. conventional mortgages
Established in 1944, the Veteran Affairs (VA) loan program was created to assist military service members with home purchases after returning from duty. A VA loan can offer up to 100% financing for a borrower, effectively canceling out the requirement of any down payment. This contrasts with the 20% or less that can be required for conventional mortgages.
As they’re backed by the federal government, VA loans are easier to qualify for, because they require banks to take on less risk than they do for conventional mortgages. While VA loan borrowers must have a minimum 41% debt-to-income ratio, there is no minimum credit score requirement. However, most VA-approved lenders are looking for at least a credit score of 620.
The other general requirement is that the VA loan borrower has been an active-duty veteran with a minimum of 90 days of service during wars or has offered active service for 181 consecutive days during peacetime. Alternatively, serving for 6 years in the National Guard or Reserves also qualifies an individual. And under certain conditions, a deceased veteran’s spouse can be eligible for a VA loan.
Of course, as with a conventional loan, VA loan borrowers must be able to provide sufficient required documentation to prove their veteran status, income, assets and liabilities. Applicants will also need to obtain their DD-214, showing proof of military service and their Certificate of Eligibility, serving as proof of eligibility for the VA loan.
4. Comparing HomePath mortgages vs. conventional mortgages
HomePath Mortgages allow borrowers to purchase a foreclosed Fannie Mae-owned homes with attractive terms, like low down payment, no lender-requested appraisal, no mortgage insurance, and expanded seller contributions. Mortgage insurance is not required, but for higher loan-to-value loans there may be a cost. Similarly, HomePath Renovation Mortgages allow borrowers to purchase a foreclosed Fannie Mae-owned home that requires light to moderate renovation. Borrowers are lent funds to finance the purchase of the homes as well as the cost of renovation.
To see if there are any homes near you that qualify for HomePath mortgages, visit homepath.com.
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