You’re sick of renting and you think it’s time to buy a house. If you’re like most people, you’re not in the position to pay cash. Fortunately, there are several different financing options for buying a home to fit varying needs and specific situations.
What to Consider Before Buying a Home
Before we dive into all the home financing options, here are some general questions for you to consider:
How long do you plan to live in the home?
If you’re not planning to live in the home for several years, the general consensus is you shouldn’t buy. It takes a considerable amount of cash to complete a real estate transaction, known as closing costs, so it wouldn’t be financially prudent to walk away from the home any time soon after closing.
What is your credit score?
Your credit score has a significant impact on the loan terms you are offered for the various financing options.
If your score is below average, you can expect to pay higher interest rates. A below average or poor credit score will typically disqualify you from obtaining a conventional mortgage and may even prevent you from securing any of the financing options for buying a home.
It’s best to build your credit score as high as possible before applying for a home loan so you have the best financing options available to you for purchasing your new place.
This is a big one. You don’t want your mortgage payment to create financial stress, so it’s best to ensure it falls comfortably within your monthly budget. Having some wiggle room is very important. You want to make sure you can continue to pay your mortgage even if financial hiccups arise.
Need a new roof? Lose your job? To help weather these storms, it’s advised you have a cash cushion, or emergency fund, on hand.
Extra tip: Once you’ve closed on your home, consider creating a fund specifically to cover home maintenance and repair costs. Also, think about what jobs around the house you can do yourself to save money.
Your lender also wants to ensure you can make your monthly payments. When evaluating your loan application, they will look at all of your other liabilities and calculate your debt to income ratio, or DTI. This ratio tells them how much of your income is going to service debt, including the projected mortgage.
Some lenders will underwrite a loan with a 50% DTI, but most prefer it to be at 43% or less. Eliminating credit card or other types of consumer debt is always a good thing—but it’s particularly important when you’re trying to lower your DTI.
How much money do you have reserved for a down payment?
The amount you can put down is a significant factor in determining what type of financing options are available and right for you to purchase your home.
For instance, a sizeable down payment (at least 20%) is typically required for a conventional mortgage (though some conventional mortgages are allowing a lower down payment). If you can’t come up with the 20%, you’ll have to pay private mortgage insurance (PMI), which is insurance for the lender in case you default.
Not having to pay for PMI will save you thousands. A large down payment also helps to build some instant equity in the home.
Saving up for a substantial down payment can be a daunting and time-consuming endeavor for many people. For this reason, there are loan types specifically designed to have a low or no down payment. These loans can be great, especially for first time home buyers, because it puts homeownership within reach.
If you go with a low or no money down loan option, though, remember—since you’re putting less down, your monthly payments will be higher because you will be borrowing more money. You’ll also need to factor those PMI payments into your budget.
For those struggling with saving for a down payment, there are down payment assistance programs out there. The U.S. Department of Housing and Urban Development (HUD) disseminates funds to local governments and agencies to help area residents become educated about the home buying process and come up with down payments. You can read more here.
Are you comfortable with an adjustable rate mortgage—or do you prefer a fixed rate mortgage?
Historically, nearly 75% of home buyers opt for a fixed rate mortgage. Why? Because it’s stable and predictable over the life of the loan.
As the name implies, your interest rate never changes. Therefore, your monthly payments will remain relatively the same until you sell the home or pay it off. You should note, however, that increases to homeowner’s insurance, property taxes, and your private mortgage insurance will still cause the monthly mortgage payment to rise if you pay these items through an escrow account.
With an adjustable rate mortgage or ARM, your interest rate remains the same for the first period of your loan, typically five years. Then, your interest rate will become variable for the rest of the loan, with new interest rates assessments usually coming on an annual basis.
Interest rates could decrease, resulting in savings for you. However, if you take out a 30-year ARM, 25 of those years will be variable so you’ll likely face some years where there is an interest rate increase.
So why do some people opt for ARMs? ARMs can be advantageous if you’re planning to sell the home before the variable period begins. Since ARMs are inherently more risky than fixed-rate mortgages, the bank will incentivize ARM borrowers with a lower interest rate during the fixed period.
You really have to be sure of your plans, though, or else you may be stuck with a higher payment than you can afford if you stay in the home past the initial rate period. (Besides selling your home before the initial rate period is up you may be able to refinance into a fixed rate loan to avoid the riskiness of an ARM long-term.)
You can read more about ARMs here.
Extra tip: You may be able to reduce the interest rate you pay if your loan allows you to pay points. If you pay one point – or one percent of your loan amount, the lender will reduce your interest rate by an agreed upon amount. The lender may allow you to pay multiple points, thereby reducing your interest rate further.
How many years do you want to stretch your mortgage payments over?
Typically, mortgages are either 15 or 30 years, although there are other terms available in some financing options.
Shorter term mortgages will have higher monthly payments but generally will enjoy lower interest rates and a lower overall cost to borrow. Longer term mortgages are the reverse—good for the budget today, but more costly over the long haul in both interest rate and overall dollar amount.
If you can swing it, a shorter term mortgage could really help your long-term financial goals. You will have a paid off home twice as fast as many of your peers.
However, the higher payments could be more challenging to cover in hard times, leaving you more susceptible to default and foreclosure. Higher mortgage payments also leave less money available to save and invest for retirement and other financial goals.
Some folks opt to take out a 30-year note, or loan, and then make extra principal payments along the way to shorten the mortgage term length and save money on interest. If this is your plan, you’ll want to make sure your loan doesn’t have any early repayment penalties (most mortgages don’t).
Note: Beware of loans with a balloon payment. Here, you’ll pay a smaller monthly amount for most of the loan term. Then, at the end of the loan term, you’ll have to pay the remaining loan balance in one lump sum or balloon. Taking a loan with these terms is a risky gamble. You can read more here.
Will you have a co-signer/co-applicant for the mortgage?
Having another person on your mortgage application can be helpful or harmful depending on the circumstances.
Adding a second person can increase your purchasing power. The combined income and cash reserves will help make your case to the lender that you have the financial resources needed to cover the mortgage payments.
However, if your co-applicant has a lower credit score than you, your overall creditworthiness is diminished.
Also, if you co-applicant has ever defaulted on federally backed student loans, they cannot be a co-applicant for federal mortgage programs, like FHA loans.
Financing Options For Buying A Home
Now that you’ve considered some of the financing basics, here are your main home buying finance options:
To learn more about each loan type, click the links provided. All credit score information in the table is provided by Bankrate.
- Named conventional because it’s not government-backed
- 20% down payment required to avoid PMI; lower down payment loans are available.
- PMI can be dropped once 20% equity is reached
- Credit score needs to be 620 or higher; Jumbo loans (exceeding $424k), require credit score needs 720 or higher
- Loans backed by the Federal Housing Agency
- Loans geared towards those with lower credit scores and lower down payment availability
- As little as 3.5% down payment required
- Credit score needs to be 500 or higher—but at least 580 to get the 3.5% down; scores between 500-579 require 10% down
- Mortgage insurance is required on these loans regardless of down payment amount, possibly for the life of the loan (you can refinance to a non-FHA loan to drop PMI once you have 20% equity)
- Generally more expensive than conventional loans
Additional information available here.
- Loans are backed by the Department of Veterans Affairs
- Only available to those currently serving in the military, eligible veterans and surviving spouses of veterans
- As little as 0% down required
- Government doesn’t set a minimum credit score but lenders have been seen advertising for scores of 620 or better
- No mortgage insurance regardless of down payment amount, but a related fee may be assessed at closing
- With good credit and a good-sized down payment, a conventional mortgage may be cheaper
For more information, click here.
USDA aka Rural Development Loan
- Loans backed by the US Department of Agriculture
- Intended for low-middle income earners looking to buy a home in a rural area
- As little as 0% down required
- Credit score of 640 required
- With this route, mortgage insurance is required for life of the loan and a related fee assessed at closing; typically cheaper than an FHA loan
Additional information found here.
You might be wondering—well, what about Seller Financing? Seller financing can be an appealing option if you don’t like dealing with banks. However, there are many potential risks.
Since you are paying the seller directly, they may impose a higher interest rate than a bank would. You’ll also likely have to pay off the house fairly quickly, rather than spreading it out over the course of 15-30 years.
Can you afford the higher interest rate and a balloon payment at the end of the loan term? Do you trust the seller? Do they actually have the right to sell the home to you? This can be a dream arrangement or a complete nightmare.
Weighing the Financing Options for Buying a Home
You’ll need to do your homework regardless of what financing option you choose. Buying a home is a complicated transaction with many moving parts.
To set your home purchase up for financial success, you should:
- Understand your financial situation and credit score, improving it as much as possible before applying for a loan.
- Carefully vet your broker, lender, real estate agent and anyone else who will be involved. You need those with actual expertise and your best interests in mind standing in your corner.
- Read more about the home buying process and different mortgage types you think you may qualify for. You need to understand what will happen at every stage of this journey.
- Get pre-qualified/pre-approved before home shopping so you understand how much you may get approved for—you will look like a better prepared, more serious buyer. Compare your pre-qualified/pre-approved amount to your budget. Do you really need to spend that much? Now’s the time to ensure you don’t become house poor.
- Review all of the documents provided to you before closing to ensure they align with what you expected regarding the loan details and closing costs.
- At closing, be prepared with a bank check to cover the closing costs and a strong signing hand—you’ll sign your name more times on this day than ever before!
- Understand when your first payment is due and who you need to remit it to. Ask the lender if your account gets handled differently once you’re no longer a newly closed borrower.
There you have it!
This is by no means an exhaustive account of the home financing process—but it should get you thinking about how to prepare and what financing option might be right for you. Happy home buying!
Article written by Laura