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 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 fixed-rate mortgage, your interest rate – and your monthly payment of principal and interest - will stay the same for the entire 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 adjustable-rate mortgage) and is very straightforward.
When might a fixed-rate mortgage make sense?
- If you plan on owning your home for a long time (generally 7 years or more).
- If you have a monthly budget you need to stick to and prefer payment stability. (Keep in mind that your property tax and 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 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 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 both a periodic adjustment cap and a lifetime interest rate cap. Periodic adjustment caps limit how much a rate can increase in any given period. Most ARMs today only adjust annually, so a periodic adjustment cap is also known as an annual adjustment cap. 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 your 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.
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.
Alternative mortgage optionsSome eligible homebuyers may qualify for an FHA (Federal Housing Administration) or a VA (Department of Veterans Affairs) loan. These loans tend to allow a lower down payment and 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.
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 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.
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 closing cost assistance.Footnote 3