Signing your name on a mortgage application means entering into a large transaction with wide-ranging financial planning and budgeting implications. The size and type of mortgage you select may help or hinder your ability to fund your retirement, send your children to college, or adequately address other important planning goals. In a more benign case, it may simply result in large and unnecessary interest-related expenses or other fees that could have been avoided. As home buyers engage in a deliberate and thorough process of selecting the right home, neighborhood and school district, it’s important that they also spend the time and attention necessary to select a mortgage that best suits their needs.
Conventional Loans & Government Insured Loans
A good place to begin is to determine whether you might qualify for a government-insured loan and whether that insured loan or a conventional loan is the best option.
Government-insured loans are insured by the Federal Housing Administration (FHA) and must be originated by an FHA approved lender. The loan limits will vary based on the location of the property and the type of home you are considering (i.e., single family versus a multi-unit home). High-cost housing locations provide the ceiling for FHA loan limits, while designated low-cost areas are used to establish a minimum loan limit. In all other areas, loan limits are set at 115% of the median home price in the county as determined by the U.S. Department of Housing and Urban Development (HUD). And, unlike conventional loans, FHA loans allow borrowers to increase the size of their loan to pay for repairs or upgrades to the property and may allow builders or lenders to pay some of the borrowers closing costs.
FHA loans often have a fixed interest rate, but adjustable rate loans are available. One very attractive feature of FHA loans is that they allow for a lower down payment, and have somewhat more relaxed underwriting standards than a conventional loan. Qualified borrowers with a FICO credit score of 580 and above may put down as little as 3.5%, though lower credit scores will require a borrower to pony up a 10% down payment. In contrast to the typical 20% down payment and 750 FICO credit score required to obtain the best rates on a conventional mortgage, the FHA loans can be attractive to those with less than stellar credit scores and limited liquidity. In addition, the debt to income ratio is more liberal for FHA loans than conventional mortgages. While the maximum Housing Expense to Income Ratio for conventional loans is 28%, the ratio is a more relaxed 31% for FHA borrowers.
FHA loans check a lot of boxes in the positive column, but it’s important to note that they do come with a few potential drawbacks. Among them is the requirement for upfront and annual mortgage insurance premiums, regardless of the amount of the borrower’s down payment. The initial mortgage insurance premium (MIP) is 1.75% of the base loan. Mortgage insurance premiums are based on the size of the loan and down payment. Loans up to $625,000 with a loan to value ratio of 90% of higher carry an ongoing mortgage insurance premium of 0.80% for most loans, while larger loans with a loan to value ratio of 95% or more will carry the highest mortgage insurance premium of 1.05% of the base loan. Loans of less than 15 years enjoy lower premium structure but represent a small percentage of FHA loans.
Thank You for Your Service
Military veterans and their family may qualify for a mortgage under very favorable terms through the Veteran’s Administration (VA) loan program. Loans are underwritten by approved lenders and insured by the VA. The program follows the Federal Housing Finance Agency limits for conforming loan amounts and most VA loans require no down payment from the borrower.
Qualifying veterans may use the loan proceeds to purchase, construct or improve a property that will be used for their personal occupancy. Approved lenders follow VA guidelines to determine eligibility, but may impose some additional requirements of their own, such as a minimum FICO credit score. Unlike a conventional loan, VA loans do not impose a strict income requirement but do require that borrowers have sufficient income to cover the loan and their existing monthly debt. In addition, borrowers are expected to maintain sufficient “residual income” to cover food, entertaining, home maintenance and other expenses. This residual income varies by loan amount, family size and the region of the country where the veteran resides. In general, if a veteran’s monthly debt to income ratio exceeds 41%, lenders will require that an applicant prove that they are able to repay the loan.
Simply put, VA loans are designed to help qualifying veterans become homeowners. In addition to no required down payment, loans do not require the payment of mortgage insurance (as do FHA loans). Instead, borrowers pay a one-time fee that is based on the borrower’s veteran status (regular military or Reserves/National Guard), the amount of the down payment, and whether they have used the program previously. This funding fee ranges from 1.25% to 3.3% of the loan amount. As with FHA loans, closing costs may be paid by the seller, and some veterans may qualify for grants offered through nonprofit agencies to help defray their closing costs.
The Veteran’s Administration is tasked with determining basic eligibility, and a variety of fixed and adjustable rate options are available. While VA loans offer a host of advantages, borrowers should be mindful of the loan funding fee, requirements that the home be used as their primary residence, and the reluctance of some sellers to deal with the mountain of paperwork involved with VA loans.
Hip to Be Square
Although the benefits of government-insured loans can be very compelling for some borrowers, the conventional mortgage is not without its own charms. The conventional loan, by definition, is one that is not government insured, and may or may not conform to baseline lending limits for loans securitized by Fannie Mae and Freddie Mac.
The key benefits of the conventional loan are its flexibility and the relatively streamlined underwriting process. Conventional loans do not require a review by the FHA or VA and tend to be processed by the lenders more quickly than government-insured loans. Borrowers with good credit and stable income can benefit from very competitive rates and will have a wide array of fixed and variable-rate loan options to choose from.
Conventional loans do come with some limitations, borrowers are often required to make a down payment of 20% of the home’s sale price to avoid paying annual private mortgage insurance premiums, which range from 0.5% to 1% of the loan amount. In addition, conventional loans require a higher FICO credit score to qualify for competitive rates, with scores of 750 or above needed to secure the most favorable rates. And, unlike FHA or VA loans, borrowers are generally responsible for all loan origination fees.
Conforming or Jumbo
A conforming loan is one that falls within the lending baseline limits that are established annually by the Federal Housing Financing Agency and used by Fannie Mae and Freddie Mac- the federal agencies tasked with expanding the secondary market for mortgages by facilitating their sale as mortgage-backed securities. This limit is adjusted each year and statutory provision set higher baseline limits in high-cost areas such as Alaska, Hawaii, Guam and the U.S. Virgin Islands. The 2018 baseline limit for a one-unit property is $453,100, rising to $679,650 in designated high-cost areas.
Conforming loan limits are set by each county, and may be increased by as much as 150% over the prevailing baseline limit. High-cost cities such as New York, San Francisco, and Los Angeles have conforming limits that are capped at 150% of the baseline limit, or $679,650 in 2018, while statutorily designated high-cost areas may see conforming limits as high as 150% of the high-cost baseline limit of $679,650.
Benefits of conforming loans include somewhat easier qualification standards than larger non-conforming loans, competitive interest rates and, in some cases, lower down payments.
Jumbo loans, in contrast, are larger loans that do not conform to baseline limits and are not purchased by Fannie Mae or Freddie Mac. As a result, they are retained by the lender. Jumbo loans generally require a 20% down payment and may involve more rigorous underwriting and less wiggle room for those with less than stellar credit. Interest rates are competitive and can actually be lower than conforming rates in certain loan categories because the costs associated with the securitization of conforming loans do not apply to these larger loans.
Fixed Rate or Adjustable Rate
A final consideration is whether to use a fixed-rate mortgage or opt for an adjustable rate loan. As the name suggests, the former offers an interest rate that is set for the life of the loan, while the latter resets its interest rate at set intervals. Fixed rate loans are attractive to borrowers because of their certainty but generally come with a higher rate of interest.
Fixed rate loans comprise the majority of the loans originated and offer repayment terms ranging from ten years to thirty years. The thirty-year fixed loan is a staple of the mortgage industry, despite the fact that the average borrower remains in their home less than ten years. The certainty of the fixed loan is a great choice for those with stable careers, good credit and expect to remain in their home for a long time.
Adjustable rate mortgage loans (ARM) begin with a set interest rate that remains locked for a specified period of time and then adjusts at specific intervals. This is referred to as the adjustment period. For example, 5/1 ARM has a set interest rate for the first five years and is subject to an annual adjustment after the fixed period expires.
Adjustable rate loans are typically comprised of an index rate and a margin. The index is the measure of general interest rates and is often set using the London Interbank Offer Rate (LIBOR), or the Cost of Funds (COFI) index. If the underlying index increases while the loan is subject to an adjustment the loan rate will generally increase. In the event that the underlying index decreases, that decline may be passed on to the borrower through a lower interest rate, though this varies by the lender so be sure to read the terms and conditions. The margin is the extra amount added by the lender and remains stable for the life of the loan.
In an effort to protect consumers, most adjustable rate loans include limitations on the amount of interest that a lender can impose on a borrower through the loan’s adjustment mechanisms. ·
- Periodic adjustment caps limit the interest rate adjustment made during any adjustment period.·
- Lifetime maximum caps limit the interest rate increase over the life of the loan.
As an example, a 7/1 ARM with 2/2/5 caps has a fixed rate of interest for the first seven years of the loan and is subject to an annual adjustment once the fixed period expires. The first 2 indicates that the loan’s interest rate may change by as much as two percent in the year after the fixed period expires. The second 2 indicates that the interest rate may change by as much as two percent each year thereafter, with the 5 limiting the total increase in the loan’s interest rate to five percent.
Adjustable rate loans generally offer a lower rate and may be a good option for those that do not expect to remain in their home for a long time, or for those with sufficient liquidity to repay the loan if rates increase. ARM loans may be ideal in periods when interest rates are in decline and not expected to increase, and when the spread between the fixed and adjustable rate is considerable. Because adjustable rate mortgages generally have a lower interest rate at the onset of the loan- and some loans may be structured so that only the interest is repaid over a set period of time (i.e., “interest only”)- the adjustable rate loan allows borrowers to qualify for a larger loan. The ability to purchase a more expensive property has an obvious appeal, but care should be exercised to ensure that the loan remains affordable should interest rates increase.
Before settling on a loan, it’s important to revisit your budget, tax situation and overall financial planning goals to make sure that the loan you select is appropriate for your needs. Consider meeting with your professional advisors and put them in touch with your mortgage banker or broker to help you sort out the options. In addition, the Federal Trade Commission contains a plethora of additional resources and helpful consumer protection tips that can be accessed free of charge. A mortgage is an enormous commitment with wide-ranging implications for your financial plan. The effort involved in selecting the right loan for you can be time well spent.
John Male CFP®, RICP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
9 East 40th Street, 5th Floor
New York, NY 10016
T: (212) 221-7067 Ext. 113
F: (585) 625-0830