What You Need to Know About Conventional Mortgages
Getting a conventional mortgage may sound simple enough, but there are more than a few twists in turns that home buyers should be aware of. Conventional loans aren't backed by the federal government, meaning if a buyer defaults on the loan, it's the lender's responsibility to pick up the slack. Because of this, lenders have a few more stipulations than they would for secured loans. Learn about the most recent changes for loans, what buyers need before applying for a loan, and what lenders are looking for in potential candidates.
The rules for conventional loans are always in flux, based on both societal and economic demands and pressures. Recently, the federal government made the rules more amenable to hopeful homeowners. Now, buyers can successfully own a home with as low as a 3 percent down payment, so long as the mortgage is a fixed rate and the loan amount is equal to or below $424,100. To qualify for this, a buyer must not have owned a home in the past three years, nor rent the property out at any time. This applies to a single-family home (one unit), condo, or co-op.
Down Payments 101
Just like any major purchase, lenders are looking for a down payment on the home before approving the mortgage. Conventional loans traditionally required people to have a down payment of 20 percent or more. While this is still what lenders hope for, it's no longer an inevitability. Before applying, buyers should gather up the last 30 days of their pay stubs, 60 days worth of their bank statements, and 2 years of their W2s (or tax returns.)
If the buyer has any social security or retirement awards, they should have these prepared as well. In addition to the down payment, most buyers will also need to cover their own origination and appraisal fees as well. An origination fee is charged by the lender to process the application, and the costs can be as high as 1 percent of the total cost of the home. Appraisal fees vary depending on the neighborhood and home chosen.
Down Payments Revisited
Despite the relaxed rules on down payments, 20 percent is still the magic number for buyers to avoid paying Private Mortgage Insurance, or PMI. PMI is a way to mitigate the financial risks for lenders and can be anywhere from .5 to 1 percent of the purchase price of the home—per year. This means that on a $200,000 home, buyers may be asked to pay an additional $2,000 on top of their monthly mortgage payments. PMI disappears as soon as an owner reaches 20 percent equity in the home, but it can be a difficult cost to swallow in the first few years of owning a home. Rates are determined as much by a person's credit history as they are by the specific lender chosen.
ARM vs. Fixed Rate Conventional Mortgages
When applying for a conventional mortgage, home buyers have the option to chose between an adjustable-rate mortgage (ARM) and a fixed-rate mortgage. Each has different pros and cons depending on the market and the individual buyer.
An adjustable-rate mortgage (ARM) is exactly what it appears to be. The interest rate, rather than being fixed for the entire term of the loan, varies up or down depending on market fluctuations. Typically, the initial rate is lower than prevailing market interest, but then monthly payments adjust based on prevailing rates. The primary advantage of an ARM is the lower initial payment, which allows borrowers to qualify for a higher mortgage amount. However, when interest rates trend upward, rising payments can be problematic. During the housing crisis of 2008, defaults on adjustable-rate mortgages climbed significantly, prompting additional regulatory oversight on such loans.
Such loans can be well-suited for borrowers who plan for shorter-term ownership, those who expect a substantial increase in earning power over time, or for someone intending to pay off a loan before maturity. However, adjustable-rate mortgages are always more complicated than fixed-rate loans, and prevailing interest rate trends weigh heavily into the decision to choose an ARM. Buyers should carefully weigh the pros and cons and thoroughly understand possible ramifications.
A fixed-rate mortgage is a mortgage that maintains the same interest rate over the life of the loan. Where an adjustable-rate mortgage will have an interest rate that fluctuates over the years, a fixed-rate mortgage is ideal when interest rates in the market are low. Homeowners can lock in a low-interest rate that saves them a hefty amount of money while they pay off their loan and build equity in their homes.
Such loans are more beneficial for homeowners intending to stay in a home for a long period of time, or for homeowners purchasing when the market is in their favor and interest rates are low. If interest rates are high, homeowners may be better off buying a home with an adjustable-rate mortgage in anticipation of having the interest rate changing when the market becomes more favorable.
Terms and Rates
The buyer will pick the terms of their mortgage, but the standard is either 15-, 20-, or 30-year mortgages. Borrowers with a low debt-to-income (DTI) ratio and credit scores of 740 or higher will be the ones to get the best rates. When it comes to DTI, lenders generally don't want to go any higher than 43 percent (though some lenders have been known to go as high as 50 percent under the right circumstances.) Essentially, they want to see a monthly income that's far higher than the monthly mortgage payments.