A Guide to Mortgages: What to Know Before Buying a Home

Homebuying comes with its own language and acronyms, from amortization and title insurance to APR (annual percentage rate), PMI (private mortgage insurance) and many more. Even the words “mortgage” and “loan” can get confusing. These often get used interchangeably, but they’re actually two different things.

Let’s look at a fixed-rate $200,000 loan as an example:

• With a 30-year term and a 5 percent interest rate, your monthly principal and interest payment is about $1,075 and you pay $186,500 in interest over the life of the loan.
• With a 15-year loan term and a 4.5 percent interest rate, the monthly principal and interest payment jumps to about $1,530, but you pay only $74,000 in interest over the life of the loan.

That’s a significant savings because of the shorter loan term. But your monthly principal and interest payment jumps by nearly 50 percent.

Consider how long you plan to live in the home, how much of a housing payment you can afford and other factors when thinking about your mortgage term.

In addition, some home loans today don’t have any kind of prepayment penalty, which means you can pay off the loan early without taking a financial hit. Tacking on additional money every month or year toward your principal balance can help you build equity faster and pay off your loan sooner, even with a 30-year mortgage term.

Current Economic Conditions

The onset of the pandemic in 2020 prompted the Federal Reserve (the Fed) to rapidly reduce interest rates to combat a potential economic downturn. Since then, the Fed has incrementally raised the federal funds interest rate to help with inflation.

It's important to note that while the Fed doesn’t directly determine mortgage rates, such rates are highly sensitive to fluctuations in the federal funds rate. Although consumer loans are considered the riskiest category of borrowing, mortgages tend to have lower interest rates compared to other types of consumer loans since they are backed by the property.

Credit Score

Your credit score plays a crucial role in determining the interest rate you are offered on a mortgage. Lenders use this numerical representation of your creditworthiness as a key metric to evaluate the risk associated with lending you money.

A higher credit score indicates a history of responsible credit behavior, reducing the lender’s risk and often resulting in a lower interest rate being offered. Conversely, a lower credit score signifies a greater risk to the lender due to a history of missed payments, high levels of debt or other negative factors.

Credit score minimums will vary based on the lender, the loan type and other factors. FHA loans technically allow for credit scores in the 500s, but you’re more likely to see lenders requiring around a 620 FICO score for any government-backed loan, be it FHA, USDA or VA.

The credit score benchmark for conventional loans is usually higher. But you’ll typically need excellent credit, more like a 740 FICO score, to have a shot at the best rates and terms.

Fixed vs Adjustable Rate Mortgage

Homebuyers can also elect to have a fixed interest rate for the life of their loan or opt for an adjustable-rate mortgage (ARM).

A fixed-rate mortgage, true to its name, locks your interest rate for the length of the loan. You won’t need to worry about your rate changing with the economy. That means your principal and interest portions of your monthly mortgage payment won’t change either.

An adjustable-rate loan has a variable rate that can go up or down at different times during the life of the loan. There’s a host of different types of ARMs, each of which carry their own potential risk and reward.

There are also ARMs that adjust monthly or biannually. In addition, an entire class of “hybrid ARMs” has a fixed interest rate for a certain period before becoming eligible for annual adjustments. For example, a 5/1 hybrid ARM features a fixed interest rate for five years before adjusting annually. That period of fixed interest gives borrowers an initial degree of certainty regarding their payment.

Adjustable-rate mortgages with government-backed programs provide homebuyers additional protection. For example, a VA ARM features a government-mandated 1/1/5 cap, limiting how much the interest rate can change over the life of the loan.

Choosing between a fixed-rate and an adjustable-rate mortgage can be difficult. A lot of homebuyers who opt for an ARM want or need the upfront savings and look to refinance once the loan becomes eligible for annual adjustments. Others don’t plan to live in the property for a long time and want to tap into the lower interest rates.

But refinancing or selling your home isn’t always easy – or cheap. It’s impossible to know exactly what the future holds. Do your best to plot out the hypotheticals before choosing your rate option, and make sure to get your lender’s assistance in crunching the numbers.

Types of Home Loans

Not all home loans are created equal. Some mortgage types will be a better fit for you than others.

Home loans are broadly divided into two categories: conforming and non-conforming loans. Conforming loans, also known as conventional, follow a set of requirements defined by Fannie Mae and Freddie Mac. Non-conforming loans are government-backed and geared toward first-time homebuyers or those with low to medium income. Common government-backed loans include VA, FHA and USDA loans.

All loan types come with benefits and drawbacks, all of which impact consumers in different ways. In addition to VA loans, Veterans United also offers financing for conventional, FHA and USDA mortgages.

Conventional Loan

Many buyers often prefer conventional loans due to wide eligibility. You can secure one with just a 3% down payment on the home's purchase price. However, if your down payment is less than 20%, you must pay private mortgage insurance (PMI) every month. PMI protects the lender if you can't pay back the loan. Although it increases your monthly expenses, it enables you to move into your new home more quickly.

VA Loan

Active-duty military members, National Guard and Reserve members, certain surviving spouses and Veterans are eligible for a VA loan. The Department of Veterans Affairs (VA) backs these loans, making them a significant benefit of military service. VA loans allow you to buy a home with no down payment and include an upfront funding fee that you can roll into the loan, eliminating the need for private mortgage insurance.

FHA Loan

Many choose FHA loans for low down payment and credit score requirements. With only a 3.5% down payment and a credit score of 580, you can secure an FHA loan from most lenders. The Federal Housing Administration (FHA) backs these loans, promising to reimburse lenders if borrowers default. This guarantee lowers the lenders' risk, allowing them to offer more favorable terms.

USDA Loan

USDA loans are only available for homes in approved rural areas, but many suburban outskirts meet the USDA's "rural" criteria. To qualify for this loan, your household income must not exceed 115% of the median income in the area. USDA loans are also similar to VA in that they offer a 0% down payment option.

Common Mortgage Costs

Understanding beforehand the fees associated with a mortgage is very beneficial to prospective borrowers. Let’s take a look at some common mortgage costs.

Down Payment

A down payment is an upfront payment made by the homebuyer, representing a percentage of the home's purchase price, and is one of the common costs associated with buying a home. The required amount for a down payment varies depending on the loan type.

• VA loans: No down payment required for borrowers with full entitlement
• FHA loans: Minimum down payment of 3.5% with credit score of 580 or higher
• USDA loans: No down payment required
• Conventional loans: Minimum down payment of 3% but ranges to 20% based on home’s purchase price

Each type of loan comes with its own set of qualifications and requirements, and it’s always best to check the most current and specific criteria before proceeding with the homebuying process.

Upfront Funding Fees

Aside from the down payment, government-backed mortgages usually have an upfront funding fee in place. These fees are paid upfront as soon as the mortgage loan is approved by your lender.

The upfront mortgage insurance premium for FHA borrowers is currently 1.75 percent of the loan amount and 1 percent for USDA borrowers. Most first-time VA buyers pay a funding fee of 2.15 percent. However, VA buyers who receive compensation for a service-connected disability are exempt from the VA Funding Fee.

Unlike the government-backed options, one thing conventional loans don’t have is any kind of upfront funding fee or mortgage insurance premium. Those fees are usually tacked onto your loan balance.

Mortgage Insurance

Some loans require borrowers to pay mortgage insurance as part of financing the loan. Mortgage insurance is typically put in place to protect lenders from losses if a borrower defaults on their mortgage payments.

FHA loans have an upfront and annual mortgage insurance premium requirement. However, if you put at least 10% down, you will only have to pay this for 11 years compared to the life of the loan.

Conventional borrowers usually must pay for private mortgage insurance unless they can put down 20 percent of the purchase price. PMI fees can vary depending on your credit, loan-to-value ratio and other factors. It’s typically anywhere from 0.2 to 1.5 percent of the loan balance.

USDA loans and VA loans have no mortgage insurance. However, both mortgages require an upfront funding fee. The USDA upfront guarantee fee is 1% of the loan, along with a 0.35% annual fee. The VA funding fee ranges from 0.5% to 3.3% depending on the type of VA loan and entitlement.

But a home loan isn’t a one-size-fits-all product. Everyone’s homebuying journey is different. When you’re talking with lenders, the focus should be on finding the right loan for you – the one that makes the most sense given your credit, your finances and your homebuying goals.

Comparing Home Loan Types

For this example, let’s say you’re looking at a $200,000 mortgage with an interest rate of 4.75 percent. We’ll estimate your property taxes and homeowners insurance costs at $260 per month.

For an in-depth analysis on each mortgage loan type, check out how VA loans compare to FHA loans, USDA loans and conventional loans.

How to Qualify for a Mortgage

Qualifying for a mortgage involves several steps to assure lenders of your ability to repay the loan. First and foremost, a strong credit score is essential since it’s a significant indicator of your financial responsibility and creditworthiness.

Lenders also evaluate your debt-to-income (DTI) ratio, which compares your total monthly debts to your gross monthly income. A lower DTI ratio is preferred, as it indicates you have a manageable debt level.

Stable employment and consistent income are equally important, as lenders look for applicants with a reliable income source to make regular loan payments and minimize risk. Gathering necessary documentation, such as proof of income or tax returns, can expedite the application process.

Lastly, having funds saved for a down payment can enhance your chances of approval and lower the borrowed amount. Being aware of these factors and enhancing your financial profile can make you an attractive candidate for any mortgage.

Finding the Right Home Loan For You

So, what’s the best loan for you? Like so many things in life, the answer is: It depends. A good loan officer can help you weigh the pros and cons of all your options.

Generally, a conventional loan may be the best in a competitive market or if you are planning to purchase a second home or investment property. FHA loans might be a good fit for buyers with low credit and little cash to put down. USDA loans could be a good fit for buyers looking in more rural areas. VA loans can be a great fit for qualified buyers who don’t have great credit or a 20 percent down payment. Conventional loans can offer a lot to buyers with excellent credit and solid down payments.

Veterans and service members should be aware of the availability of VA loans, as they can provide significant benefits. Being able to compare rates, costs and terms across different loan types helps homebuyers get the most from their dollar.