Financing Basics for First-Time Homebuyers
Getting finance is one of the most important aspects of a home buying process. If you are like most first-time homebuyers, chances are you considering opting for a mortgage for your home purchase. With the variety of home financing options at your disposal as a first-time homebuyer, finding the right mortgage for your home can save you lots of time and money in the long run.
In this article, you will learn more about the various home loan options for first-time homebuyers, their offerings, and requirements in 2020.
Types of Home Loan
There are several mortgage options available to first-time homebuyers in the US. They include the Federal Housing Administration (FHA) loan, Conventional loans, and VA loans. In this section, you will learn more about these home loans.
Conventional Loan
A conventional loan is a type of mortgage that is not backed or offered by the government. Instead, this type of loan is offered or secured by a private lender or through the two government-sponsored enterprises — Fannie Mae and Freddie Mac. They are usually fixed-rate mortgage and one of the hardest types of mortgage to qualify for due to their strict loan requirements.
For conventional loans, you will need the required credit score requirement, downpayment requirement, lower debt-to-income ratio, and the possibility of a private mortgage insurance requirement. Remember that the numbers associated with these requirements are dependent on your chosen lender. Furthermore, conventional loans are less expensive when compared to government-backed loans.
Conventional loans can be divided into conforming and non-conforming loans. Conforming loans adhere to the guidelines set by Fannie Mae and Freddie Mac. Typically, lenders purchase these types of loans and then sell them as securities on the secondary market. While you can get a conventional loan with a downpayment as low as 3%, lenders will require that you pay for mortgage insurance.
More importantly, conventional loans run for 30 years but it is possible to qualify for a 15–20 year conventional mortgage loan.
Federal Housing Administration (FHA) Loan
The Federal Housing Administration under the US Department of Housing and Urban Development provides home loans for homebuyers looking for financing. FHA loan is a government-backed loan, unlike conventional loans that are offered by private lenders.
FHA loans are one of the best mortgage options for first-time homebuyers because of their low credit requirement and downpayment. Most FHA lenders require a minimum downpayment of 3.5% and have a minimum FICO score of 580 to qualify for an FHA loan.
However, if you are opting for an FHA loan, you must have to pay for an upfront mortgage insurance premium which is typically included in your monthly mortgage payments.
VA Loans
VA loans are secured by the Department of Veteran Affairs. While the Department of Veteran Affairs is solely responsible for guaranteeing this type of loan, they do not make direct loans to veterans. VA loans are available to veterans, service members, and specific military spouses. This allows military members to purchase a home with favorable loan requirements (without the need for downpayments).
In most cases, qualifying for a VA loan is quite easy when compared to conventional loans and other government-backed loans due to its zero downpayment requirements. However, before applying for a VA loan, you will need to get an eligibility certificate from the Department of Veteran Affairs. More importantly, like other home loan programs, VA loans come with additional fees which may be up to 2.3% of the home purchase price.
Private Mortgage Insurance
Your loan to value (LTV) determines if you will need to pay for private mortgage insurance or not. Private mortgage insurance (PMI) helps to protect your lender in the event of a default by transferring a part of the loan risk to a mortgage insurer. Most mortgage lenders request for borrowers to carry mortgage insurance if their loan to value ratio is higher than 80%.
In clearer terms, PMI is required in all loans in which the borrower contributes less than 20% of the purchase price. Most mortgage insurance payments are collected monthly along with your property tax and insurance escrows. You will need to pay a fixed amount based on the loan amount until you reach a 78% loan to value before the PMI on the loan can be eliminated by your lender.
There are several ways you can avoid the payment of PMI. One is to borrow less than 80% of the property value when buying your home. The other is to make use of your second home equity financing to put down 20% or higher of the home purchase price. More importantly, the mortgage amount and your chosen mortgage program will determine the cost of insurance and how it is paid.
Equity and Income Requirements
Several factors that determine the final mortgage amount and pricing you will receive from a lender. Most lenders will evaluate your credit report from the three major credit bureaus and check your loan-to-value (LTV) ratio in relation to your debt service coverage ratio (DSCR) to determine the amount of loan you will receive and the interest rate.
A loan-to-value ratio is an index that calculates your potential loan amount against the perceived value of the home being purchased. For home purchases, lenders typically determine the LTV ratio by dividing the loan amount by the purchase price of the home. Lenders believe that the higher your downpayment, the less likely you are going to default on the loan repayment. And if your LTV is high, your lender may request that you carry mortgage insurance.
The debt service coverage ratio (DSCR) is used by lenders to determine the ability of your income to repay the home loan. In general, lenders will require a DSCR ratio that is greater than one since it shows that you are capable of repaying the loan and reduces the risk the lender takes on. More importantly, you should include all your sources of income and employment when negotiating with a home loan lender.
Fixed-Rate Mortgage vs. Floating Rate Mortgage
Another factor you should consider when getting a mortgage as a first-time homebuyer is the interest rate type. Mortgage interest rates are usually structured as a fixed-rate or floating rate. Under the fixed-rate package, the interest rate is fixed for the duration of the loan or a certain period of the loan. The major advantage of getting a fixed-rate mortgage is that you are sure of the monthly mortgage cost during the period of the loan.
A floating rate mortgage or an adjustable-rate mortgage is a great option for first-time homebuyers who anticipate an increase in their salary or income in the coming years. A floating mortgage rate allows you to obtain a lower interest rate in the first few years of the loan which may increase over the lifespan of the loan. By opting in for a lower introductory rate, you can qualify for more financing for your home purchase.
However, the floating rate mortgage may be risky because your income may not appreciate in line with the rise in interest rate. Also, changes in the market interest rate may increase dramatically thereby affecting your loan term in the long run.
How Adjustable-Rate Mortgages (ARMs) Works?
Like we mentioned above, an adjustable-rate mortgage is a type of mortgage with a varying interest rate or an interest rate that changes throughout the loan. Most ARMs typically start with a lower interest rate which increases as the loan duration continues. When you finance your home with an ARM, the bank or private lender sets the initial interest rate that is usually lower than the interest rate of a fixed-rate mortgage.
Typically, ARM initial interest rates remain the same for a specific period — usually a year, five years, or even seven years depending on the type of adjusted-rate mortgage. After this period, your lender will continue to adjust your mortgage rate until it reaches the capped rate or the number of times they can make changes to the rate. In the long run, an adjustable-rate mortgage can be more expensive than a fixed-rate mortgage.
Final Thoughts
If you are sourcing for home financing via the mortgage route as a first-time homebuyer, you will most definitely be overwhelmed with loads of mortgage options at your disposal. Before opting for one, you should find out the amount of mortgage you can afford and how it impacts your finances in the long run.