Understanding Your Mortgage Options
Once you think through your goals and determine how much you can comfortably afford to pay each month, then it’s time to choose a mortgage. With so many different mortgages available, choosing one may seem overwhelming. The good news is that when you work with a responsible Glossary Term: lender who can clearly explain your options, you can better select a mortgage that is right for your financial situation.
Here are the major mortgage types:
With a Glossary Term: fixed-rate mortgage, your Glossary Term: interest rate – and your monthly payment of Glossary Term: principal and Glossary Term: interest - will stay the same for the entire Glossary Term: term of the loan. This type of mortgage tends to be the most popular because it protects homeowners from the possibility of future monthly payment increases (a situation faced by borrowers who select an Glossary Term: adjustable-rate mortgage) and is very straightforward.
- Stability. You know exactly what you will be paying toward principal and interest every month for the entire length of the loan, which makes it easier to Glossary Term: budget.
- If interest rates go up, you are protected. Your rate (and your principal and interest payment) will stay the same.
- If interest rates go down, your rate (and principal and interest payment) will stay the same unless you Glossary Term: refinance.
When might a fixed-rate mortgage make sense?
- If you plan on owning your home for a long time (usually 7 years or more).
- If you have a monthly budget you need to stick to and prefer payment stability. (Keep in mind that your Glossary Term: property tax and Glossary Term: homeowners insurance payments can fluctuate throughout the life of your loan. But your monthly principal and interest payment will never change.)
Fixed-Period Adjustable-Rate Mortgage (ARM) or hybrid ARM
Most lenders today offer a fixed-period or “hybrid” ARM,—which is an adjustable-rate mortgage that features an initial fixed interest rate period, typically of 3, 5, 7, or 10 years. After the fixed-rate period expires, the interest rate becomes adjustable for the remainder of the loan term. Fixed-period ARMs are often named by the length of time the interest rate remains fixed.
Example: In a 5/1 ARM, the “5” stands for the five-year “introductory period,” during which the interest rate remains fixed. The “1” shows that the interest rate is subject to adjustment once per year after the introductory period and for the remainder of the loan term.
About the introductory period: The rate on this kind of loan tends to be lower during the introductory period, which could mean a lower starting monthly payment. However, when the introductory period ends, your rate will go up or down depending on changes in the financial Glossary Term: index to which your loan is associated. If considering an ARM, carefully consider your ability to handle potential increases to your rate, and consequently, your monthly principal and interest payment.
Caps: ARMs have two kinds of Glossary Term: rate caps. Glossary Term: Adjustment caps limit how much your rate can go up or down in any single adjustment period, limiting how much your loan payment can change when it adjusts. Glossary Term: Lifetime caps establish a maximum, and minimum, interest rate over the entire life of a loan. Many caps allow a significant increase in each adjustment period and over the life of the loan, so despite having a cap, the increase in the monthly payment allowable under the cap may still result in “payment shock.” Such an increase may make it difficult, or impossible, for you to pay your mortgage on time if interest rates rise. If you’re considering an ARM, find out what the caps would be and then run the numbers to see if you could still comfortably afford the monthly payments allowable under the rate caps.
- Hybrid ARMs generally offer lower rates during the introductory fixed rate period than fixed-rate mortgages.
- After the introductory period’s fixed rate expires, the rate is subject to adjustment. The rate could increase at this point, which would also increase your payments. This can make paying your mortgage on time more difficult.
- If you choose this kind of loan, be sure it includes an adjustment cap and/or lifetime interest cap. Keep in mind that many adjustment or lifetime caps would still result in Glossary Term: payment shock, which is a term used to describe a significant increase in your monthly payment. For example, if you had a 5/1 ARM with a starting interest rate of 4.0% (and interest rates rose) and your rate increased by 2 percentage points in the first two adjustment periods, by year 7, your interest rate would be 8.0% -- so your monthly payment would double from the starting monthly payment. So ask for details and plan accordingly.
When might a Hybrid ARM make sense?
- If you believe interest rates will go down in the future; however, because rates are currently low, it may be more likely that rates will increase. So it’s important that you are confident that you can afford the monthly payment if the interest rate adjusts upwards to the maximum amount possible with this mortgage.
- If you plan to sell the home before the introductory period ends. Of course, there is an element of risk in this plan, as it can be difficult to predict exactly how long it will take for a home to sell.
Interest-Only Mortgage (I/O)
Interest-only mortgages are adjustable-rate or fixed-rate loans, which contain an Glossary Term: interest-only payment option during a set period in the first years of the loan, often the first 10 years. During the interest-only period, borrowers can delay making principal payments and make monthly payments that only repay interest. After the interest-only period ends, assuming that a borrower selected this option and made only interest payments, the monthly payments would significantly increase when the required monthly payments started to include principal plus interest.
If there were no principal payments made during the interest-only payment period, the unpaid loan principal wouldn’t be reduced. That principal would now need to be paid back in the remaining years of the loan, in addition to the interest due on the total balance of the loan. So the payment shock would be quite significant when the interest-only period ends.
In general, interest-only mortgages may be a good choice for only a small number of buyers with very special circumstances. Carefully consider payment shock when considering an interest-only payment option.
- This type of mortgage may be a fit for a small sub-set of buyers with fluctuating incomes, as long as they are disciplined enough to pay more than the minimum as often as they can and/or plan to pay larger amounts in the future.
- Because your monthly payment would only repay the interest accruing on this mortgage, the only equity you would have in your home would be the amount you paid as a Glossary Term: down payment. You would not build Glossary Term: equity unless the market value of your home were to go up. And if the market value of your home were to decline, then you could lose part or all of your down payment.
- This kind of mortgage can be difficult to get because it is more of a risk for lenders.
- It’s critical to know the highest possible monthly payment you may have to make on this loan, and to be confident you could pay it, potentially for an extended period of time.
When could an I/O mortgage make sense?
- If you’re opting for lower starting payments to invest money into home renovations or remodeling, because you believe that these would significantly increase the home’s value and you could refinance or sell in the future.
- If you know you’ll be moving before the interest-only payment term expires, and you don’t need to access the equity (your down payment contribution) from the home in order to buy a new one.
- If the bulk of your income is paid in bonuses or Glossary Term: commissions, and you want to make small monthly payments and use large income distributions to periodically pay down principal.
- If you expect significant income increases in the short term, like a spouse going back to work.
Alternative mortgage options
Some eligible homebuyers may qualify for an Glossary Term: FHA
(Federal Housing Administration) or a Glossary Term: VA
(Department of Veterans Affairs) loan. These loans tend to allow a lower down payment and Glossary Term: credit score
when compared to conventional loans.
FHA loans: FHA loans are government-insured loans that could be a good fit for homebuyers with limited income and funds for a down payment. Bank of America, an FHA-approved lender, offers these loans, which are insured by the Federal Housing Administration (FHA)Footnote 1.
- This kind of loan is helpful for applicants who don’t have a 20% down payment saved.
- These loans can also help applicants who need more flexible income or Glossary Term: credit requirements. Be aware that minimum credit scores apply so not all applicants will qualify.
- There’s a maximum loan amount, which can vary depending on where the home is located.
- FHA loan programs typically require you to pay both an upfront mortgage insurance premium (UFMIP) and a monthly mortgage insurance premium (MIP). You’ll need to factor these premiums in when you set your budget.
- There tends to be a more complex approval process for an FHA loan, and often times more paperwork to fill out.
- An Glossary Term: FHA loan may help get you into a home, but it’s important to be sure the total monthly payment that comes along with the loan is one you can comfortably afford.
(Please note: Bank of America offers FHA and VA refinance loans to existing Bank of America home loan customers only.)
VA loans: VA loans are offered by VA-approved lenders like Bank of America, and are insured by the Department of Veterans AffairsFootnote 2. To qualify for a Glossary Term: VA loan, you must be a current or former member of the U.S. armed forces or the current or surviving spouse of one. If you meet these requirements, a VA loan could help you get a mortgage.
- VA loans can help reduce your down payment requirement, sometimes to zero.Footnote 3
- These loans may also help you get a lower interest rate on your loan.
- There are limits on the available loan amount.
- Although a VA loan can have low down payment requirements or interest rates, the borrower is still responsible for making the payments. So it is equally as important with this type of loan as any other to be sure the total monthly payment is one you can comfortably afford.
And finally, be sure to ask your mortgage loan officer if they offer affordable loan products or participate in housing programs offered by the city, county or state housing agency. You may be eligible for grants, flexible, lower down payment options and down payment and/or Glossary Term: closing cost assistance.Footnote 4