Fixed or adjustable rate
The first choice you should make is whether you want a fixed or adjustable rate mortgage.
These home loans carry the same interest rate for the entire term of the loan. The principal and interest part of your monthly payment is guaranteed to stay the same (your tax and insurance escrow payment could change).
You’ll generally pay a higher rate than the initial rate on an ARM loan, but you won’t have any of the uncertainty that comes in the later years of an adjustable loan. You’re basically paying a premium for long-term predictability.
These are usually referred to as ARM loans. Unlike fixed-rate mortgages, the interest rate for an ARM can go up or down over the term of the loan. This means your monthly payment can change over time. Your rate is usually a certain percentage above a market index (usually LIBOR). Your interest rate will vary with that index.
ARM mortgage rates change only at pre-specified periods. For example, a 5/1 ARM loan, carries a fixed rate of interest for the first five years. The rate will change every year after that. There are 1-year, 3-year and 7-year ARMs as well.
Conventional or Government
Once you’ve decided on a fixed or adjustable rate mortgage, the next choice is whether to go with a conventional or government mortgage program. There are a few government programs available.
FHA mortgages are offered by the Federal Housing Administration. They’re by far the most popular and most widely used government home loan option. The biggest benefit of an FHA mortgage is the down payment. With an FHA home loan, your down payment could be as low as 3.5 percent of the purchase price, much lower than a conventional loan. The FHA programs are also more lenient than the conventional mortgages. So if you have a below-average credit score or other qualification problems, it might be your best (or only) option.
The one potential drawback to FHA mortgages is that you’ll have to pay two premiums for government mortgage insurance–one upfront and one annual. But the insurance requirement may still be offset by the lower down payment and more lenient requirements.
VA mortgages are offered to military service members and their families. They’re managed by the Department of Veteran Affairs. VA loans can be used to finance 100 percent of a home purchase, which eliminates the need for a down payment. There are specific eligibility rules but most members of regular military, national reserves, and spouses of military veterans are eligible. A VA loan is probably your best option, if you qualify for it.
Which to choose
If you can afford a 20% down payment on a house, you’re probably better off using a conventional loan. You’ll avoid mortgage insurance. (Mortgage insurance is only required on loans that are more than 80% of the value of the home).
If you can’t afford to put that much money down, you might want to consider the FHA program. You’ll pay extra insurance on the loan, but your down payment is a lot lower if you meet the requirements.
For a conventional mortgage, you will probably need a credit score of 640 or higher. The government programs are a bit more flexible. Generally home buyers with credit scores below 640 must rely on FHA loans.