Deciding to buy a house is a big decision. It’s the largest purchase most people will make.
On top of that, it’s also the most debt many people will take on in their life. Unfortunately, there are very few classes about how to responsibly choose which type of mortgage to apply for. This type of information is also not taught in schools.
What this means is most people take on the largest debt of their life without fully understanding the types of mortgages available to them.
Let’s talk about the types of mortgages available and at the end, I’ll share why I find one type of mortgage very attractive in today’s environment.
What Types of Mortgages Are Available?
There are many types of mortgages, but I’m going to primarily focus on choosing between a 15-year fixed mortgage, a 30-year fixed mortgage, and an adjustable-rate mortgage (ARM) after briefly explaining a few other types of mortgages.
The other types of mortgages are FHA, VA, and USDA loans. The quick rundown is the following:
FHA loans are insured by the Federal Housing Administration (FHA) and offer loans to people with lower down payments and lower credit scores.
People can qualify for loans by only making a down payment of 3.5%, whereas most other loans require at least 10% and most encourage 20% to avoid private mortgage insurance (PMI). PMI is additional money you pay each month to compensate the lender for taking on a riskier loan with less equity in the home.
The downside is that borrowers pay FHA mortgage insurance, which helps protect the lender from a loss if the borrower defaults on the loan. The mortgage insurance varies from 0.45% to 1.05% of the loan amount and is added to the regular payment. The extra cost can’t be removed if you make a down payment of less than 10%. In other situations, it can be removed after 11 years.
There is also an upfront fee of 1.75% of the loan amount that can be rolled into the loan if you don’t have the cash to pay it.
VA loans are backed by the Department of Veterans Affairs (VA) and are offered only to service members, veterans, and eligible surviving spouses.
VA loans are especially attractive because interest rates tend to be lower, no down payment is required, and there is no private mortgage insurance. You can learn more here: https://www.benefits.va.gov/homeloans/. There are a few exceptions, but most people will pay a VA funding fee at loan closing, which can be rolled into the loan if you don’t have the cash to pay for it. The fee ranges from 1.4% to 3.65%.
USDA loans are backed by the USDA loan program and offered to people in an eligible rural or suburban area who have an adjusted gross income of 115% or less than the median income in the area where they are buying the house. You can look up property and income eligibility here: https://eligibility.sc.egov.usda.gov/eligibility/welcomeAction.do.
These loans are attractive because the interest rates tend to be lower and no down payment is required.
There is a 1% upfront fee of the loan amount that is rolled into the loan and a 0.35% annual fee based on the remaining principal loan balance each year for the life of the loan.
Now that we’ve talked about more unique mortgages, let’s talk about fixed-rate mortgages that most people will encounter.
You’ll usually encounter two types of fixed-rate mortgages: 15-year and 30-year. They have 10-year and 20-year mortgages, but they are less common.
These mortgages are easier to understand than adjustable-rate mortgages, which I’ll talk about next. Fixed-rate mortgages have a fixed rate and are paid for a certain length of time.
For example, if you had a 30-year 3% fixed-rate mortgage, your loan would be paid off after making monthly payments for 30 years. The lower the rate, the lower your monthly payment.
The interest rate of a 30-year fixed-rate mortgage has varied drastically over time. Look at the chart below.
The 10-year Treasury rate influences the rate on 30-year fixed mortgages. Generally, when 10-year Treasury rates go up, 30-year fixed-rate mortgage interest rates go up. There are other factors that influence what rate you could get, but it’s important to know rates move up or down depending on other interest rates.
The 15-year fixed-rate mortgage is another popular loan option. Unlike the 30-year fixed-rate mortgage, you only make payments for 15 years. What this means is that you have a higher payment under a 15-year mortgage than you do a 30-year mortgage, but it also means you’ll pay less in interest.
Fixed-rate mortgages are attractive because you know exactly how much you’ll pay each month for a set length of time. Your home insurance premium and property taxes may rise over time, increasing the overall monthly cost of the home, but at least the loan payment is fixed.
Adjustable-Rate Mortgages (ARMs)
ARMs are different from fixed-rate mortgages in that the interest rate you pay is set for a fixed amount of time and then the interest rate adjusts periodically.
They are often referred to as variable-rate or floating mortgages.
ARMs usually are presented as 5/1 ARM, 7/1 ARM, or 10/1 ARM. The first number tells you how long the rate is fixed. For example, with a 5/1 ARM, the interest rate is fixed for the first five years. The second number tells you how often the interest rate could adjust. In this case, it could adjust each year.
If you saw 5/6m, that would mean the rate is fixed for five years and could adjust every 6 months.
The upside of these mortgages is that the interest rates tend to start lower than fixed-rate mortgages, meaning the payment is less. The downside is that because the interest rate adjusts periodically, your payment could go up over time, potentially to a level you can no longer comfortably afford. ARMs are generally riskier the longer you stay in the home.
Some people choose ARMs because the interest rate is lower and allows them to buy a more expensive house.
Others find it a good option because they don’t plan to live in the home they are buying for more than 5, 7, or 10 years. For example, someone might plan to live in a house for only 6 years, so they are comfortable with a 5/1 ARM and the payment potentially going up in the 6th year before they sell the house or they choose a 7/1 ARM and plan to sell the home in the 6th year before their payment could adjust.
Conforming vs. Non-Conforming Loans
One other important thing to know is the difference between conforming and non-conforming loans.
Conforming loans “conform” to Fannie Mae and Freddie Mac guidelines, which have certain underwriting requirements, such as maximum loan value, minimum credit score, maximum debt-to-income ratio, and minimum down payment required.
Conforming loans can be sold to Fannie Mae or Freddie Mac while non-confirming loans cannot. They are either held by the lender or sold to another lender.
What often happens with a conforming loan is that once the lender closes, they sell your mortgage to Fannie Mae or Freddie Mac, which frees up their balance sheet to lend more money again.
FHA, VA, and USDA are types of non-conforming loans.
The other common type of non-conforming loan is a jumbo loan. Conforming loans have maximum loan values, which vary among countries. A jumbo loan is a loan above the conforming loan limits.
You can find conforming loan limits here: https://www.fhfa.gov/DataTools/Downloads/Pages/Conforming-Loan-Limits.aspx. Most counties have a conforming loan limit of $548,250, but more expensive areas can have higher conforming loan limits. For example, where I used to live, the conforming loan limit was $776,250.
Conforming loans usually have lower interest rates, but there have been periods of time where non-conforming loans had better interest rates because people who could afford jumbo loans were seen as less risky borrowers.
Now that you know what types of mortgages are commonly available, let’s talk about why it pays to shop around.
Why it Pays to Shop Around
Regardless of what type of loan you choose, including FHA, VA, and USDA loans, you should shop around. You’ll want to contact at least three lenders to compare rates.
Even though lenders may ask for similar documentation and the process standardized in certain situations, the interest rate you could receive can vary widely among lenders. For example, one lender might be offering a 2.5% 30-year fixed mortgage while another offers a 3.5% 30-year fixed mortgage.
For a $400,000 loan, that’s a difference in a monthly payment of $216 or $2,592 per year. Over 30 years, it’s $77,760.
Is a little extra time shopping around worth thousands of dollars per year for 30 years?
I think so.
When shopping around, pay attention to more than the interest rate. To make an apples-to-apples comparison, you’ll want to ask about closing costs and other fees. While one lender may have a lower rate, their closing costs and fees may be significantly higher, making the loan actually more expensive.
One tool I’ve found particularly helpful recently is NerdWallets mortgage rates comparison. Recently, I’ve seen it pull some of the lowest rates in the industry.
You can also work with a mortgage broker to shop around for you.
Another good resource is going to the last few pages of the “Refinance Mega Thread” in the Bogleheads forum. People will share where they are receiving low rates, which could give you ideas for shopping around.
Please keep in mind that just because you went with a lender for your previous house since they had the lowest rates does not mean they will have the lowest rates the next time you need a mortgage.
While interest rates are tied to the 10-year Treasury, they are also based on how much business a company is receiving, what types of risks the lender wants to take on, and much more.
During the pandemic, we saw some lenders raise rates because there was such a big demand for loans and not enough staff to handle the business.
Whether it’s a new house or a refinance, spend time shopping around. Over the past few years, I’ve known people who have saved anywhere from around $100 a month to over $500 a month.
Imagine that savings over a decade.
Lastly, please remember that cheaper isn’t always better. If you are purchasing a home, your lender’s ability to close on time is really important. If the lender is notorious for late closings and it’s a competitive real estate market, going with that lender might cost you the house if they can’t finish by your closing date.
Cheap doesn’t always mean bad. There are plenty of online-only lenders who have leveraged technology to minimize the time to closing, but I want to make you aware that the ability to deliver on what they say they will is very important when evaluating each lender.
Let’s talk about what type of mortgage I prefer right now.
Why I Favor the 30-Year Mortgage Right Now
I prefer the 30-year fixed-rate mortgage right now.
There are a few reasons for it:
- Rates are very low relative to historic mortgage rates.
- Rates are low compared to the historical returns in the stock market.
- The difference in rates between a 15-Year, ARM, and a 30-year is small.
- 30-year provides more flexibility if life changes.
As of this writing, the average 30-year fixed-rate mortgage was 2.994% and the 15-year was 2.247%. A 7/1 ARM was 2.743%.
Here are their monthly payments for a $400,000 mortgage:
- 30-year: $1,685
- 15-year: $2,620
- 7/1 ARM: $1,631
The difference in monthly payment between the ARM and the 30-year fixed-rate mortgage is $54. I’m willing to pay $54 per month for the first seven years to avoid the potential for an increase in my interest rate and monthly payment. The only reason I would not do this is if I knew I was going to sell the home within seven years.
It’s possible rates stay unchanged or go down, and I’d be better off in the 7/1 ARM, but I’m conservative when it comes to housing. I don’t see it as an investment. I see it as a place to live, and I want as much certainty in the cost to live there as possible.
The difference between the 15-year and 30-year is $935 per month. The total interest paid over the life of the 30-year loan is $206,643.93. The total interest paid over the life of the 15-year loan is $71,560.47.
What happens if you get the 30-year loan, but pay $2,620 per month to make it equivalent to the 15-year payment?
You pay it off in 16 years. The total interest paid over the life of the loan is $104,160.18. Now, the difference in interest between the 30-year loan with the same payment as the 15-year and the actual 15-year loan is only $32,599.71.
Over 15 years, that is $2,173.31 per year.
That’s a small price to pay for the flexibility to go back to the $1,685 per month payment if you lose your job, want to invest in a business, or simply spend more.
I’ve also known people who thought they were going to move in 5 or 7 years, but ended up loving the area and want to remain in their home. Time also flies. The first year you own your home will likely fly by and before you know it, your ARM may adjust.
This also does not take into account that the $935 less you are paying per month could be invested. There are no guarantees that the stock market will perform as it has historically, but if the stock market were to perform somewhere between 7% and 10% per year over a long period of time, you’d be better off financially investing rather than paying down debt at less than 3%.
Said simply, 7% is greater than 3%. If you are earning 7% instead of paying down debt at less than 3%, you are better off. It likely won’t happen over every time period, but over 30 years, the stock market historically has rewarded patient, long-term investors.
I find it amazing that people can borrow for 30 years for around 3%. The cost of debt is inexpensive relative to historical averages. Having a fixed-rate 30-year mortgage is also a good hedge against inflation.
While I admire people who want to pay off their mortgage as quickly as possible (confession: I’ve made extra payments on mine), the flexibility a 30-year mortgage provides is very attractive.
Summary – Final Thoughts
There are many types of mortgages available. If you qualify for a FHA, VA, or USDA loan, I’d check out whether those make sense for you.
While ARMs can make sense in a few circumstances, I’m a big fan of 30-year fixed-rate mortgages right now. As interest rates change, my opinion may change, but right now, I like the flexibility it provides.
Plus, with rates as low as they are, the reduced monthly payment relative to a 15-year mortgage could be invested and potentially earn a higher rate over time.
As with any financial decision, do your research, shop around, and choose whichever mortgage fits best for your life and values.