Millennials Guide: How to Pick the Right Mortgage
As you gear up to buy a home, you’re probably caught up in the excitement of a kaleidoscope of choices: Fixer upper or turnkey? Small condo in the heart of the city or sprawling house in the suburbs? Traditional or contemporary? Brick or stucco? Fixed-rate or adjustable-rate mortgage?
OK, so maybe that last one isn’t exactly exhilarating. Boring as it may be, however, it’s a question you’re going to have to ask yourself – and answer – at some point during the home buying process. Which type of mortgage should you choose? Believe it or not, your decision could make or break your home investment (see Getting a Mortgage in Your 20s).
The good news: You’re not alone in your quest to land the perfect mortgage. For the second year in a row, Millennials represented the largest group of home buyers in America (32%), according to a March 2015 study from the National Association of Realtors. As members of this generation continue to flood the real estate market, they’re instigating some major changes in the mortgage industry. A 2014 Pew Research Center report found that Millennial mortgage borrowers are demanding a technology-based home loan application process, speedy online service and faster mortgage closings.
But before you close on your new home, you’ll need to do some mortgage homework. Here is information about the primary types of mortgages to help you make this critical decision.
Home loans offered by the Federal Housing Administration (FHA), known as FHA loans, are designed for home buyers who don’t have loads of money to put towards a down payment – which is why FHA loans are so appealing to cash-strapped Milllennials.
Traditional 30-year-mortgages, unlike FHA loans, require a 20% down payment unless you pay private mortgage insurance (PMI). Conventional lenders require you to pay this insurance if you make a small down payment because you are considered a high-risk borrower. PMI increases your monthly mortgage payment by 0.25% to 2% of your loan balance per year.
With an FHA loan, however, you’re only required to make a 3% down payment, all of which can come from a gift or grant. That means it’s possible to secure an FHA loan without putting down a single dollar of your own money. Plus, underwriting requirements aren’t quite as strict with these loans. In other words, if your credit history isn’t exactly perfect, an FHA loan might be your best bet.
FHA loans took a nosedive in popularity in recent years as the Federal Housing Administration continued to boost its monthly mortgage insurance costs (which resulted in higher monthly payments for homeowners). Unlike conventional loans, mortgage insurance payments on FHA loans continue throughout the life of the loan. Many borrowers found it more affordable to take out a conventional 30-year mortgage and cough up PMI until they reached 20% equity in the home.
However, the FHA is taking measures to turn things around. In January 2015, it started reducing mortgage premiums on FHA loans by an average of $900 a year. It appears its efforts are working as FHA loans are on the rise once again, particularly with first-time home buyers. In the second quarter of 2015, FHA loan originations increased 50% from the previous quarter and were up 46% from a year ago, according to RealtyTrac.
In the world of conventional home loans, the fixed-rate mortgage is the most predictable and straightforward choice for borrowers. That’s because the interest rate doesn’t change over the life of the mortgage. As a result, the principal and interest payments you make every month never change either. Although fixed-rate mortgages are generally set up as a 30-year loan, it is possible to obtain a 10- or 15-year fixed-rate mortgage.
Your interest rate is locked in on a fixed-rate mortgage when you first get the loan, and it stays the same until you sell, refinance or pay off the loan. That means if your interest rate is 4.2% when you obtain the loan, 20 years later, the rate will still be 4.2% (if you still have the mortgage).
The advantage of a fixed-rate mortgage is simple: There are no surprises. You’ll never have to deal with fluctuating monthly payments that vary with interest rate movements. Even if inflation surges out of control and mortgage rates skyrocket to 20%, your monthly payment stays the same. This allows you to keep control of your budget. A fixed-rate mortgage is generally the best choice if you think you will stay in a house for longer than five years, and it’s also a smart choice when interest rates are rising. Plus, because these simple mortgages are easy to understand, they’re ideal for first-time home buyers.
However, you’ll pay a premium for payment predictability. Fixed-rate mortgages are generally more expensive than adjustable-rate mortgages (see below). According to Bankrate.com, average 2014 mortgage rates were 4.5% for 30-year fixed-rate mortgages as compared to 3.3% for the first five years of a 5/1 ARM (the rate is fixed for five years and adjustable for the remaining 25 years of a 30-year mortgage). This amounts to monthly payments of $1,000 on a $200,000 mortgage with the 30-year fixed-rate (including principal and interest) as opposed to $875 a month for the “honeymoon” period of the 5/1 ARM.
When you consider the savings shown in the example above, you may be tempted to spring for an adjustable-rate mortgage (ARM). But ARMs carry a lot of uncertainty. Although an adjustable-rate mortgage can offer a major cost benefit early on in the loan, you could pay for it in spades down the road.
Also known as a “variable-rate mortgage” or a “floating-rate mortgage,” an ARM is a mortgage in which the interest rate changes over time. With an ARM, your initial interest rate is typically fixed for a period of time, and this “teaser” interest rate is often lower than the market rate. After a certain period of time specified in your contract (sometimes known as the “honeymoon” period referenced above), the interest rate on your loan adjusts or resets regularly, sometimes as often as every month. These adjustments will change your monthly mortgage payments, too. For example, the initial interest rate for a 2/28 ARM is fixed for a period of two years and then resets to a floating rate for the remaining 28 years of the 30-year mortgage.
When you have an ARM, your monthly mortgage payments can rise sharply over the life of the loan. In as little as a year, a 6% ARM can soar to 11% or higher if interest rates are on the rise. Many homeowners with ARMs lost their homes in the recent housing crash because their payments kept increasing. These borrowers couldn’t sell or refinance to get out of their loan, and eventually the value of their homes fell to less than the amount they owed on the mortgage. To top it off, adjustable-rate mortgages can be extremely difficult to understand, which makes them a questionable choice for first-time buyers.
On the plus side, ARMs allow you to take advantage of decreasing interest rates without having to refinance. It’s also a viable and affordable option if you’re only planning to stay in a home for a year or two.
The Bottom Line
Determining the type of mortgage that is best for you depends on a number of factors, from the size of the down payment you can afford and your monthly cash flow to the current state of the market. Although you may be tempted to scour the web for the answer, mortgage rates are constantly changing, so it pays to turn to the experts. Talk to at least two different mortgage brokers or lenders and discuss your unique situation. These professionals can offer you guidance, explain your options and help you choose the most suitable mortgage for your specific needs.
See Mortgage Basics and How to Shop for Mortgage Rates for more information. So you don't miss out on special programs if this is your first home purchase, also check out Credits for First-Time Home Buyers.