How to Finance a Home Purchase
Adapted from the FDIC’s Money Smart Program
For most people, buying a home requires a loan. Home loans (or mortgages) are often the largest amounts of money people ever borrow. Depending on the kind of housing you are buying there may be different types of loans available for you.
A mortgage is a loan to buy your house, condominium, or townhouse The amount of money you borrow is called the principal. Some of the many costs associated with taking out a mortgage include:
- Interest. Interest is the money a lender charges for letting you use its money. Interest is the cost of using money, expressed as a percentage.
- Points*. Points are a tradeoff between upfront costs and the monthly payment for a mortgage. By paying points, you pay more money upfront, but you receive a lower interest rate and will likely pay less money over time. Points can be a good choice for people who know they will keep the loan for a long time. One point costs 1 percent of your mortgage amount (or $1,000 for every $100,000).
- For example, if you are taking out a $200,000 mortgage, the loan offer may require that you pay two points ($4,000) to receive a lower interest rate than you would pay without paying points. $200,000 X 2% = $4,000. The effect that paying a point has on the interest rate will vary. Paying one point does not always mean that your interest rate will be reduced by one percentage point.
- Fees. These can include lender charges for processing your application. They may have different names, such as application fees, processing fees, and underwriting fees.
- Other charges, such as an Appraisal fee to determine the value of the property.
Lenders will tell you the Annual Percentage Rate (APR) for a mortgage you are considering. The APR represents the overall cost of the loan on an annual basis. The APR includes not only the interest rate but also the points, some of the fees you are charged, and certain other charges that you have to pay to get the loan. For that reason, your APR is usually higher than your interest rate.
NOTE: APRs can help you compare loans.
The down payment is the portion of the purchase price of the home that you will pay in cash.
Example: If you wanted to buy a home for $160,000 and paid $8,000 for a down payment, you would borrow $152,000 which would be a 5 percent down payment. The higher your down payment, the less money you have to borrow.
When your down payment is less than 20 percent of the purchase price, lenders may require that you purchase private mortgage insurance (PMI)*. PMI lowers the risk to the lender of making a loan to you.
NOTE: It is important to remember that private mortgage insurance is different from homeowners’ insurance.
When you’re comparing mortgages, in addition to the APR, there are a few other considerations you’ll want to note:
- Loan amount. This is how much money the lender will loan to you.
- Type of interest rate. There are fixed interest rates and adjustable interest rates. A fixed-rate does not change throughout the life of the loan. An adjustable-rate will likely change.
- Loan term. This is the length of the loan. You’ve probably heard of 30- year loans and 15-year loans but there are also loans with other terms.
- Upfront costs that you must pay at closing. Closing is the last step when you buy a home. Closing is when the ownership of the property is transferred from the seller to you.
Types of Mortgage Loans
There are two major types of mortgage loans based on how the interest is calculated: Fixed-rate mortgages or Adjustable-rate mortgages, commonly called ARMs.
- Fixed-rate mortgage: a mortgage in which the interest rate does not change. You’ll pay the same amount each month in principal and interest for the life of the loan. Even if interest rates rise, your payment doesn’t change because your interest rate stays the same.
- Note: The term of a fixed-rate mortgage is often 15 years to 30 years, although there may be other term lengths available.
- Adjustable-rate mortgage*: a mortgage in which the interest rate adjusts according to a schedule or based on an index. Adjustable-rate mortgages may start with a lower interest rate than fixed-rate mortgages, but your interest rate and therefore your monthly payments will likely change. They could go up, sometimes by a lot.
- An adjustable-rate mortgage may be a good choice if you plan to keep the mortgage for a short time or if you can afford paying more in interest if rates increase and you are unable to refinance into a lower rate loan. The opposite is also true. If you are considering an adjustable-rate mortgage, be sure to carefully review the Consumer Handbook on Adjustable Rate Mortgages that the lender provides to you or that you can review at www. consumerfinance.gov.
Mortgages can also be classified as either conventional or government guaranteed, which is sometimes called government insured.
- Conventional mortgage: These mortgages are available to anyone, but they may be more difficult for some people to qualify for than other types of mortgages. You generally need:
- A credit history that is considered good by lenders
- Regular income
- A debt-to-income ratio within the lender’s acceptable limits (the traditional rule of thumb was 36%, but there are exceptions, and some lenders will approve loans for people with higher ratios)
- A down payment, which may range from 3% to 20% or more, depending on the lender and loan program
- Government-guaranteed loans include FHA, USDA, VA, and HUD loans. The U.S. Federal Housing Administration (FHA) helps people become homeowners. With an FHA loan, the lender may be able to offer you better terms than on a conventional loan, including a down payment as low as 3.5% of the purchase price of the home, closing costs included in the loan amount, and lower closing costs.
- FHA loans may be easier to qualify for, but there is a maximum loan limit, which varies by region. You must pay a mortgage insurance premium (MIP) like private mortgage insurance (PMI) with an FHA loan. With MIP, you pay part of this cost upfront at closing, and every month as part of your mortgage payment. When a borrower defaults, the FHA uses this insurance to cover the lender’s loss. Borrowers must pay MIP for the full life of the loan.
- The U.S. Department of Agriculture (USDA) also has a home loan guarantee program like the FHA program. These loans are called USDA Loans or Rural Development Loans. The big difference between USDA loans and FHA loans is that USDA loans only cover properties that are in designated rural areas. A down payment is not required with a USDA loan. However, they charge a 3.5% upfront fee and 0.05% annual fee for the life of the loan.
- The U.S. Department of Veterans Affairs has a home loan guarantee program. These loans are called VA loans. This type of loan is only available to: active duty members of the military, veterans (depending on their type of discharge), reservists and National Guard members, and eligible surviving spouses of members of the military or veterans. VA loans do not require down payments, but there is an upfront funding fee.
When it comes to mortgages, know your loan. Be sure to learn about your financing options for buying a home and shop around to get the best deal for you.
Click here to read more about what to consider before buying a home and use this checklist as a guide to start collecting items you’ll need throughout the home buying process.
*Disclaimer: FGB does not offer Points, PMI, or Adjustable Rate Mortgages.