How To Choose The Best Mortgage For You

Homebuyers can easily feel overwhelmed by the house-hunting process no matter how many times they’ve done it. From finding the perfect home to figuring out how to pay for it, there is a lot of work involved.

If you’ve never bought a home before, know that when I say a lot, I mean a lot.

Plus, there are so many different mortgage options available to help you buy a new house, it can feel ridiculously overwhelming.

Let me break down the process step-by-step to help you figure out what your goals should be and how to find the right mortgage to achieve them.

1. Check your credit report and score

Getting an accurate understanding of your credit score is the best starting point for choosing the right mortgage. 

Your credit score is important because it impacts your interest rate. If your credit score is high, you’re more likely to qualify for a lower rate. That saves you a lot of money over time.

If your credit score is lower, your rate will be higher. That raises your monthly mortgage payment as well.

Request your free credit reports

Start by getting a free copy of your three credit reports from Equifax, Experian, and TransUnion. Normally you can request each copy once every 12 months through AnnualCreditReport.com. As of June 2021, however, you can obtain updated copies on a weekly basis.

Once you have all three reports, check them carefully for accuracy. Make sure there aren’t any incorrect negative entries or fraudulent accounts that could hurt your credit score. If there are incorrect items, dispute them before applying for a mortgage.

Check your credit score

Next, check your credit score. It’s not included in your credit report so you’ll have to go elsewhere to find it.

Check if your bank or credit card company offers a free credit score monitoring service. There are also some websites that offer free educational credit scores, or you can pay for a service to send you your score.

Remember, each lender has its own process

Note that any of these credit scores may not be the exact one used by a lender when you apply for a mortgage. Most mortgage lenders use the FICO 8 model, which places a greater negative emphasis on revolving debt.

Your lender will likely check your scores from all three credit bureaus, then use the middle number.

If you’re applying for a loan with a partner or spouse, they typically use the middle number of the applicant with the lower score. As you start working with a lender, they can pull your credit score, which will be valid for 120 days. 

2. Figure out your purchase budget

Once you know where your credit stands, you’re ready to figure out how much you can spend on a house.

There are three basic steps that help you figure out a house budget and the size of mortgage you’ll need.

Estimate your interest rate

To find out what type of interest rate to expect, you can do a couple of different things. First, you can speak directly to a mortgage lender. This comes with no obligation to use that lender, and you get the benefit of having a fairly specific rate to use.

Alternatively, you can Google “today’s mortgage rates for [good or bad] credit.” There are plenty of websites with updated rate estimates based on different credit profiles. You’ll need that number to help find your purchase budget.

Related: Today’s Best Mortgage Rates

2. Use a mortgage calculator

With an estimated interest rate in hand, start playing around with a mortgage calculator. Input data such as a purchase price, down payment, and tax estimate to see what an approximate monthly payment looks like.

This helps you find a price range for your purchase that you’re comfortable with. 

3. Check your debt-to-income ratio

Finally, it’s important to look at your debt-to-income (DTI) ratio. This is what the lender uses to determine your maximum loan amount.

Your DTI basically compares the number of debt payments you make versus your monthly pre-tax income. Different types of mortgages have different maximum DTIs. In general, expect a DTI limit of 43%, although some loan programs go up to 50%.

An example of how DTI could affect your budget

Let’s break this down into a hypothetical situation using a 43% DTI.

So, if your monthly paycheck (before taxes are taken out) comes to $5,800, you could only spend about $2,500 on debt payments — including your future mortgage.

Now, say your student loan bill is $400, your car loan is $300, and you carry a credit card balance with a minimum payment of $120.

When subtracted from that example debt allowance of $2,500, it leaves $1,680 for a mortgage payment.

The lender will likely limit you to a loan amount that doesn’t exceed that amount based on your estimated interest rate and down payment.

A lender can also give you insights into how much you’re eligible to borrow. Just remember to ask for a full estimated monthly payment, including homeowners insurance, taxes, and private mortgage insurance. You may not feel comfortable borrowing the full amount depending on the monthly payment.

3. Determine how much cash you have for a down payment

A mortgage may be a loan, but you’ll still need cash in order to get one.

The first big chunk of change you’ll need is your down payment. Each type of mortgage has its own minimum down payment requirement. The amount of cash you can put towards the purchase price impacts both the home loan you can apply for as well as how much house you can afford.

A down payment is calculated as a percentage of the purchase price. Most mortgages require 3% or more.

That said, there are some specialized home loan programs that can help you qualify with a 0% down payment. (We’ll break down each mortgage program and their specific requirements in a minute.)

You can use gifted money from family or friends

You’re also allowed to use gift money in case you have a parent or relative who wants to help you out. However, there are IRS limits on how much money you can receive before it’s considered taxable income.

Currently, the limit is $15,000 per donor, per recipient. So if you’re married, each spouse could receive up to $15,000 from each donor without paying taxes on the money. Hypothetically, two parents could separately gift up to $15,000 for each spouse, for a total of $60,000 in tax-free funds.

Consider asking a down payment assistance program for help

A final source to help you put funds towards your home purchase is a down payment assistance program.

There are many state and local government programs across the country, especially if you live in an area with above-average housing prices. Ask a knowledgeable lender and do some Internet searches to see what programs are available near you. You could either get a grant or loan to put towards your down payment. 

4. Estimate all of your upfront closing costs

A down payment isn’t the only thing you’ll have to pay when buying a house. Mortgages also come with a variety of fees that you must pay at settlement, which are called closing costs. Some of these closing costs vary depending on the type of mortgage, the lender, and third-party service providers.

Lender and third-party fees may include the following:

• Application fee.
• Lender origination fee.
• Appraisal fee.
• Title search and insurance.
• Attorney fees (not required in every state).
• Home inspection.
• Real estate transfer and mortgage taxes.

When you make a down payment of less than 20%, you may also have to pay fees depending on your loan type. Some types require an upfront mortgage insurance premium, and some are ongoing fees charged annually. 

5. Compare 15-year and 30-year mortgages

One distinction to think about as you weigh mortgage options is the length of your loan term. The two most common terms are either 15 or 30 years.

The benefit of a 15-year mortgage is that the interest rate is usually lower, and you’ll pay off the loan in half the time, both of which will save you a lot of money.

But a 30-year mortgage makes your monthly payment more affordable since you have twice as much time to pay it off.

Plus, with a low interest rate, you may be better off using the extra money to pay off high-interest debt or invest (assuming you expect your gains to outpace the difference in mortgage rates). You can also make extra payments on your principal to pay off the 30-year mortgage faster.

There’s a case for both options. A 30-year mortgage gives you more flexibility with your mortgage, but a 15-year mortgage will save you the most when just looking at the price of the home loan. 

6. Choose between fixed-rate and adjustable-rate mortgages

Another option you have with your mortgage is to choose between a fixed-rate and an adjustable-rate mortgage (or ARM). A fixed-rate is typically a little higher than an ARM. But it also comes with consistency because it never changes.

Fixed-rate mortgages provide simplicity

If you take out a 30-year mortgage with a 3.25% interest rate, then that is the rate you’ll enjoy for the next three decades — no matter what happens to rates in the coming years.

Adjustable-rate mortgages are more complex

An adjustable-rate mortgage is less straightforward. It starts with a fixed rate for a set number of years. That rate is typically much lower than a standard fixed rate. After the fixed period expires, the rate will adjust (or change) regularly.

So if you get a 7/1 ARM, you will pay the fixed rate for seven years, then the rate will adjust every year. A 5/6 ARM has a set fixed rate for five years, then a rate adjustment that occurs every six months.

The new rate is whatever the current prime rate is, plus a margin. There are limits to how much the rate can increase. And in some cases, the rate could even decrease. 

Here are some common scenarios when an ARM might be worth considering:

• You plan to move before the fixed-rate period ends.
• You expect a large income increase in the next five years.
• You consistently invest the savings each month.

On the downside, however, you may end up getting stuck with a higher rate, especially if something happens and you can’t refinance or sell the house. For instance, if your credit score goes south or you lose your job, you may not be able to switch to that fixed rate when you planned to.

7. Check local conforming loan limits

Most homeowners choose a conforming loan. That means the loan amount is under the maximum limit set by the Federal Housing Finance Agency (FHFA).

In most areas of the U.S., the conforming loan limit for 2021 is $548,250. That’s the maximum amount you can borrow — any amount over the limit must be paid in cash.

In some areas of the country with high costs of living, the FHFA offers higher limits. This goes by county. You can look up your area on the FHFA’s website to find out exactly how much you can borrow with a conforming loan.

In Hawaii, for instance, the loan limit jumps to $822,375. In San Diego County, the limit is $753,250.

What happens if you want to finance a home that’s more expensive than the conforming loan limit?

You’ll need to get a jumbo loan for a higher mortgage amount. While rates are typically not much more than a conforming loan, you’ll need to meet much stricter requirements in order to qualify. You need good credit, higher income, and significant cash reserves. A larger down payment is usually required as well. 

8. Find out requirements and costs for different types of mortgages

Now you’re ready to dive into specific mortgages to pick the best option for you. Here’s an overview of the most common home loans out there (starting with an easy-to-read table):

FHA: best for fair credit borrowers

An FHA loan is a mortgage that is backed by the Federal Housing Administration. The government doesn’t actually give out any loans, but they do guarantee repayments to the private lenders that borrowers work through.

FHA loans are popular because the credit requirements are some of the most flexible out there. In order to qualify for a down payment of just 3.5%, you’ll need a 580 credit score. But you could still get a mortgage with an even lower score. You’ll just need to bump up your down payment to 10%.

The downside to the FHA loan is that there are some extra fees in the form of a mortgage insurance premium (or MIP).

There’s an upfront fee (which may be rolled into your loan), plus an annual fee that’s spread across your monthly payments. With a down payment of at least 10%, your MIP lasts for 11 years. But with a down payment under 10%, you’ll have to pay that mortgage insurance for the entire life of the loan — until you either refinance, sell the house, or pay off the mortgage in full. That can end up being quite expensive compared to some other mortgage options.

Conventional mortgage: best for good credit borrowers

A conventional loan is not backed by the federal government, unlike an FHA loan. That means eligibility requirements are stricter. While each lender can set its own standards, the minimum credit score requirement is typically 620 and the maximum debt-to-income ratio is 50%.

You can also qualify with just a 3% down payment if you’re a first-time homebuyer or make more than 80% of the local median income. Otherwise, the minimum down payment is 5%.

Whenever your down payment is less than 20%, you must pay private mortgage insurance (or PMI). You can either pay the fee upfront at closing or incorporate it into your monthly payments.

These stricter standards may result in interest rates that are lower than an FHA loan. One benefit of a conventional loan is that there is just one PMI fee (compared to the FHA, which has both an upfront and an ongoing fee).

Additionally, the monthly PMI automatically drops off when you reach 22% equity in your home. If you think your equity has already reached 20%, you can pay for an appraisal to get the PMI dropped off even sooner.

Home Possible and HomeReady: best for low-income buyers

The Home Possible and HomeReady programs are similar options for buyers with mid to low incomes. Both programs require your income to be no more than 80% of your local area median income. For instance, say you want to buy a house in Round Rock, Texas, just outside of Austin. The median income is around $82,000, so your maximum income to qualify for these mortgages would be about $65,600.

The minimum down payment is between 3% and 5%, depending on your credit score. You’ll also pay PMI until you reach 20% equity in the home. If you’re a first-time homebuyer or don’t have a credit score, you’ll also need to complete an approved educational course. 

VA: best for military service members, veterans, and surviving spouses

A VA loan is another government-backed mortgage program designed specifically for military service members, veterans, and surviving spouses. Members of the National Guard and Reserve may also apply. You need to meet service eligibility requirements and obtain a Certificate of Eligibility (COE) to prove you qualify. When you work with a lender that has experience with VA loans, you can usually get their help in obtaining a COE.

The most noteworthy feature of a VA loan is that there’s no down payment required. You’ll still need to meet income requirements to make sure you can handle the loan payments, but you don’t need nearly as much cash to buy a house. There is, however, a funding fee ranging between 2.3% to 3.6%, depending on whether or not you’ve used a VA loan before.

USDA: best for rural residents

A home loan from the USDA is government-backed as well. It’s also a program that lets you avoid making a down payment on the property. But there are a couple of major requirements that must be met. First, the house you’re interested in must be in a rural area as designated by the U.S. Department of Agriculture. But there are suburban areas that may qualify. You can enter an address on the Eligibility Map to see if a USDA loan is possible.

Your income also needs to be under a certain threshold, which you can find here based on your county. The income limit also depends on how many people are in your household. The more family members you have, the more you’re able to earn and still qualify for the home loan.

There is a guarantee fee, which serves in place of private mortgage insurance. You’ll pay 1% of the loan amount at closing, or roll it into your loan amount. Then you’ll pay an annual guarantee fee of 0.35% that’s worked into your monthly payment.

FHA 203(k) renovation loan: best for fixer-upper properties

If you want to buy a property that needs substantial renovation, an FHA 203(k) can help finance both the purchase and the construction work. Before getting the mortgage, the property is assigned an as-is value and an after-improvement value. You may borrow up to 96.5% of the after-improvement value.

Rather than getting a lump sum of cash to put towards renovations, however, you’ll need a schedule of renovations. Then the contractor applies to withdraw funds at scheduled points in time based on completion.

An FHA 203(k) typically comes with a supplemental origination fee of 1.5%, plus a HUD consultant fee that can go up to $1,000 depending on the scope of your renovations. This mortgage is more complicated than most others, so make sure you understand the terms and conditions before moving forward.

9. Consider paying discount points

Discount points are a mortgage feature that can save you money in the long term. Here’s how they work.

Get a lower interest rate by paying an additional fee at closing

A discount point equals 1% of your mortgage. So if your loan is $230,000, then a discount point would cost $2,300. You typically receive a 0.25% discount on your interest rate.

Think about a couple of different things before deciding to pay a discount point with your mortgage. First, gauge the affordability based on your other closing costs, down payment, and other expenses associated with a move.

It’s probably not worth taking cash out of your emergency fund to save on your mortgage. But if your savings is robust, it’s time to consider the potential benefits.

Make sure the points are worth the upfront cost

The next thing to figure out is how long it will take you to recoup the discount point and whether you plan to own the home for longer than that period. Say your original interest rate offer is 3.5% on a $230,000 mortgage. The $2,300 discount point would drop your rate to 3.25%.

On a 30-year mortgage, your monthly payment with the original rate would be $1,033.

With the discounted rate, the payment drops to $1,001 for a monthly savings of $32. It would take six years to recoup that $2,300 and start saving money on the loan.

If you feel confident that you’ll live in the home for longer than six years, it may be worth it to you. But if you’re purchasing a starter home or have job uncertainty, you may not worry about the discount point. And in either case, that money could be put to better use either in a high yield savings account or in an investment account. 

10. Compare multiple loan offers from lenders

There is a lot of information to consider when choosing the best mortgage. A great way to navigate the process is to interview a few different lenders. Not only are you likely to receive different offers in terms of rates and fees, but you may also hear different perspectives on the best type of home loan and features for you.

Avoid relying on the opinion of just one lender. Instead, talk to a few to gauge what mortgages you’re eligible for and what kind of budget you should stick to. Then you can start comparing offer details, including:

• Origination fee.
• Application fee.
• Credit report fee.
• Interest rate.
• Lender discounts.
• Points.
• Closing timeline.
• Prepayment penalty.

Each lender can send you a preliminary loan offer estimate with these details so you can compare your options.

Summary

Buying a house comes with a lot of decisions to be made. Follow these steps to narrow down your choices with the mortgage and features that work best for you.

Whatever you do, don’t make a mortgage decision without weighing out all of the factors and how they could affect your financial future.

Read more:

• Best Mortgage Rates – Mortgage Rates Updated Daily
• Make Your Home Buying Experience Quick And Easy: How To Find The Best Online Mortgage Lenders