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Understanding Mortgage Options

Once you think through your goals and determine how much you can comfortably afford to pay each month, it's time to choose a mortgage. With so many different mortgages available, choosing one may seem overwhelming. The good news is that when you work with a responsible lender who can clearly explain your options you can better select a mortgage that is right for your financial situation.

Here are the major mortgage types:

Fixed-rate mortgages

With a fixed-rate mortgage your interest rate and your monthly payment of principal and interest will stay the same for the entire term of the loan. This type of mortgage tends to be the most popular because it protects homeowners from the possibility of future monthly payment increases.

Advantages of a fixed-rate mortgage include stability. You know exactly what you will be paying toward principal and interest every month for the entire length of the loan which makes it easier to budget. If the interest rates go up after you’ve closed your loan you are protected. Your rate along with your principal and interest payments will stay the same. If the interest rates go down, your rate and the principal and interest payments will stay the same unless you refinance your loan at a later date.

When might a fixed-rate mortgage make sense? If you plan on owning your home for a long time, usually 7 years or more, the security of a fixed rate loan is attractive. Keep in mind that your property tax and homeowners’ insurance payments can fluctuate throughout the life of your loan but your monthly principal and interest payment will never change.

Adjustable-rate mortgage (ARM)

Most lenders today offer a fixed-period or "hybrid” ARM, which is an adjustable-rate mortgage that features an initial fixed interest rate period, typically of 3, 5, 7, or 10 years. After the fixed-rate period expires the interest rate becomes adjustable for the remainder of the loan term. Fixed period ARMs are often named by the length of time the interest rate remains fixed.

The rate on this kind of loan tends to be lower during the introductory period, which could mean a lower starting monthly payment. However, when the introductory period ends your rate will go up or down, depending on changes in the financial index to which your loan is associated. If considering an ARM, carefully consider your ability to handle potential increases to your rate and consequently your monthly principal and interest payment.

ARMs have two kinds of rate caps. Adjustment caps limit how much your rate can go up or down in any single adjustment period, limiting how much your loan payment can change when it adjusts. Lifetime caps establish a maximum and minimum, interest rate over the entire life of a loan. Many caps allow a significant increase in each adjustment period and over the life of the loan, so despite having a cap, the increase in the monthly payment allowable under the cap may still result in substantially higher monthly payments. An increase may make it difficult for you to pay your mortgage on time if interest rates rise. If you're considering an ARM, find out what the caps would be and then run the numbers to see if you could still comfortably afford the monthly payments allowable under the rate caps.

Hybrid ARMs generally offer lower rates during the introductory fixed rate period than fixed rate mortgages. After the introductory period’s fixed rate expires, the rate is subject to adjustment. The rate could increase at this point which would also increase your payments. If you choose this kind of loan be sure it includes an adjustment cap and/or lifetime interest cap

When might a Hybrid ARM make sense? If you believe interest rates will go down in the future or if you plan to sell the home before the introductory period ends. Of course, there is an element of risk in this plan, as it can be difficult to predict exactly how long it will take for a home to sell.

Interest Only Mortgage

Interest only mortgages are adjustable rate or fixed-rate loans which contain an interest only payment option during a set period in the first years of the loan. During the interest-only period borrowers can delay making principal payments and make monthly payments that only repay interest. After the interest only period ends the monthly payments would significantly increase when the required monthly payments started to include principal plus interest.

If there were no principal payments made during the interest only payment period, the unpaid loan principal wouldn’t be reduced. That principal would now need to be paid back in the remaining years of the loan in addition to the interest due on the total balance of the loan. In general, interest only mortgages may be a good choice for only a small number of buyers with very special circumstances.

This type of mortgage may be a fit for a small sub-set of buyers with fluctuating incomes, as long as they are disciplined enough to pay more than the minimum payments often as they can and/or plan to pay larger amounts in the future. Because your monthly payment would only repay the interest accruing on this mortgage, the only equity you would have in your home would be the amount you paid as a down payment. You would not build equity unless the market value of your home was to go up. And if the market value of your home were to decline, then you could lose part or all of your down payment.

Additionally, if you're opting for lower starting payments to invest money into home renovations or remodeling, because you believe that these would significantly increase the home's value and you could refinance or sell in the future or if you know you'll be moving before the interest only payment term expires and you don't need to access the equity from the home in order to buy a new one these loans may be a consideration. Lastly, if the bulk of your income is paid in bonuses or commissions and you want to make small monthly payments and use large income distributions to periodically pay down principal and/or you expect significant income increases in the short term, like a spouse going back to work then ask your mortgage loan officer about interest only loans.

Keep in mind that this kind of mortgage can be difficult to get because it is more of a risk for lenders. It's critical to know the highest possible monthly payment you may have to make on this loan and to be confident you could pay it.

Alternative mortgage options

Some eligible homebuyers may qualify for an FHA (Federal Housing Administration) or a VA (Department of Veterans Affairs) loan. These loans tend to allow a lower down payment and accommodate lower credit scores when compared to conventional loans.

FHA loans:

This kind of loan is helpful for applicants who don't have a 20% down payment saved. These loans can also help applicants who need more flexible income or credit requirements. Be aware that minimum credit scores apply so not all applicants will qualify.

There's a maximum loan amount which can vary depending on where the home is located. FHA loan programs typically require you to pay both an upfront mortgage insurance premium (UFMIP) and a monthly mortgage insurance premium (MIP). You’ll need to factor these premiums in when you set your budget. There tends to be a more complex approval process for an FHA loan, and often times more paperwork to fill out.

An FHA loan may help get you into a home, but it's important to be sure the total monthly payment that comes along with the loan is one you can comfortably afford.

VA loans:

VA loans are insured by the Department of Veterans Affairs. To qualify for a VA loan, you must be a current or former member of the U.S. armed forces or the current or surviving spouse of one. If you meet these requirements, a VA loan could help you get a mortgage.

VA loans can help reduce your down payment requirement to as low as zero. These loans may also help you get a lower interest rate on your loan.

There are limits on the available loan amount. Although a VA loan can have low down payment requirements or interest rates, the borrower is still responsible for making the payments. So it is equally important with this type of loan as any other to be sure the total monthly payment is one you can comfortably afford.

And finally, be sure to ask your mortgage loan officer if they offer affordable loan products or participate in housing programs offered by the city, county or state housing agency. You may be eligible for grants, flexible, lower down payment options and down payment and/or closing cost assistance.

Jumbo Loans

When you start to explore your mortgage options, you may hear the term "jumbo loan." If you do, you are looking at properties that are more expensive for the area. If you are considering homes requiring a mortgage that exceeds $417,000, it's a good idea to find out more about jumbo loans and discuss them with your lender.

A loan is considered a jumbo if it exceeds what is known as the conforming loan limit. The current conforming loan limit for a single family home is $417,000 for all states except for Hawaii and Alaska where it is $625,500.

However, if you live in a federally designated high priced market there are conforming high-balance limits available for certain loan programs. These loans have higher interest rates and stricter underwriting requirements than standard conforming loans but are generally priced lower than jumbo loans. Additionally, limits may be different for multi-unit properties. Talk to your lender to understand the loan limits for your area.

Qualifying for a jumbo loan usually requires lower debt-to-income ratios, higher credit scores, larger down payments, and higher reserves than conforming loans. Jumbo loans can also have higher interest rates compared to a conforming loan. Differences vary by lender, so ask yours to provide you with their specific jumbo loan costs and requirements.

A jumbo loan is one potential way to buy a high priced home, but other options include:

Increasing your down payment: This is the simplest option. If you can put more cash toward the down payment you will borrow less. This could be especially helpful to you if the mortgage you are considering is only slightly above the conforming loan limit.

Obtaining two mortgages: This is also called a combination loan. This option is more complex. It entails taking out a second, smaller mortgage at the same time as the first. By doing this, your first, larger mortgage would conform to the loan limit and you may avoid some of the increased requirements and higher rates of a jumbo. However, the interest rate on a second mortgage is typically higher than on a first mortgage, so you'll want to calculate the costs and potential savings carefully. In addition, if you took out two mortgages, you would be responsible for paying both of them each month. So you would need to be sure that you could manage the combined payment. Not everyone will be eligible or qualify for this loan option.

If you are considering a jumbo loan, talk with your lender. Together, you can discuss different scenarios to see if it makes sense for you to save for a larger down payment before you buy, get two loans, or take out a jumbo loan. Whatever option you choose, you should be confident that you will be able to comfortably afford the loan(s) you obtain. Understanding the full costs and terms of various loan options can help you make the best decision for your situation.

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