Homes are the biggest purchases most Americans will ever make. It can be daunting not only to think about the sticker price, but to think about paying for that asset month after month for decades to come.
A mortgage doesn’t have to feel like a burden, though. There are a variety of mortgage products designed for different needs — and if you choose the right package, you could save thousands of dollars over the life of your loan. As you start planning to buy your next property, explore all your options with your financial advisor.
Types of mortgages
By far the most common type of mortgage is a 30-year fixed-rate loan. With this mortgage, the borrower is locked into the same monthly payment for 30 years. Every payment includes a contribution toward both principal and interest, and the payment will not adjust for inflation. If you make that payment every month for 30 years, you will fully pay off your loan. The payments are structured so that more interest is paid toward the beginning of the loan, while the end of the loan is predominantly principal.
Many homebuyers feel most comfortable with a fixed-rate mortgage, even if they don’t plan to stay in their homes for 30 years, because of the stability it offers. If that sounds like you, remember that you can refinance after a few years once you develop a greater level of comfort with your mortgage payment.
Adjustable-rate mortgages, or ARMs, are loans organized into two payment periods. The first is a fixed-rate period, where the borrower pays a specified interest rate and principal payment for a certain number of years — typically three, five, seven or ten years. After that period ends, the interest rate adjusts to current market rates.
For example, current interest rates for 30-year fixed-rate mortgages are around 4%. A borrower might be able to secure an interest rate of 3.25% for a 7-year ARM. However, after those seven years, the interest rate may go up as often as the lender deems necessary to keep up with market rates at that time. The borrower only receives the introductory interest rate up front.
ARMs can be well suited to young people purchasing starter homes. If you plan to sell your home in five or six years, a 7-year ARM could save you a significant amount of money up front. You’ll make payments at a lower interest rate while in the property, then try to sell the home before the loan jumps to that higher rate. (If you plan to keep the home as an investment property, it may be safer to stick with a fixed-rate mortgage.)
You can also pay off an ARM before the rate resets. You can estimate the extra payments needed to pay off the loan before the rate adjusts — after the introductory period ends and the interest rate jumps — and begin making those payments early on. You could finish paying off your home years ahead of time and save interest.
Interest-only mortgages, like ARMs, start out with low introductory payments and then jump to much higher payments later in the life of the loan. Homebuyers start out paying only the interest on their loan, making no payments toward the principal for usually 10 years. After that period expires, the payment is adjusted to principal and interest based on the remaining loan term. For example, if you have an interest-only mortgage for 30 years, the first 10 years of payments will be interest only. After the 10 year period, the payments are recalculated to pay off the loan in 20 years. Thus, the payment in year 11 will be higher than if you had a 30-year mortgage.
Interest-only loans may not be right for most homebuyers. But the jump from small payments to large ones can be well suited for certain people.. Professionals who earn much of their income in bonus income rather than salaries can benefit from the ability to make small interest-only payments monthly and one large annual contribution toward the principal. These mortgages also work well for homebuyers who want to keep their payments as small as possible and plan to sell the home before the principal and interest payments start.
These mortgages are also not easy to qualify for. If you apply for an interest-only loan, the lender will seek to make sure you’re qualified for the change rate — that is, the interest rate you’ll be obligated to pay after the interest-only period ends.
Qualifying for a mortgage
Before you begin talking to lenders, check your credit score. A score of 740 or higher will help you secure the best interest rates. (If your credit score is lower than that, take some time to understand what makes up your credit score and take steps to raise it.) It is helpful to pay off any credit card balances before credit is pulled to provide the strongest score you can. Once a lender pulls credit, they have to use that score. If your credit is higher later in the process, they will take an average of the new score and the old score.
Next, work with your financial advisor to gather the documents you need: Income statements, tax returns, and more.
When lenders begin reviewing your applications, they’ll want to see that you have enough money in reserves to cover several months of mortgage payments if you were to lose your income. On conventional financing, or non-jumbo loans, lenders like to see two months of cash in reserves. On jumbo loans — mortgages up to $726,525, with limits determined according to home values in a given region — banks expect six to 12 months of reserves.
Buyers can use gifted funds for their down payment, but must be able to show that they have their own funds in reserve. Reserve items can include cash savings, 401(k)s, IRAs, stocks, whole life insurance policies, or any other liquid asset. Visit your brokerage’s website to find terms of withdrawal for those accounts, which you’ll also need to share with your lender. Note that borrowed funds cannot be used for a down payment.
Applying for a mortgage
As you begin talking to lenders, make sure to ask them to break down both their bank fees and third-party fees. Third-party fees, such as title fees, are more or less identical from one lender to another, because those fees are determined by private companies or local governments. But bank fees — which include fees known variously as loan origination fees, loan discount fees, underwriting fees, and more — are set by each bank.
Between interest rates and bank fees, you should have enough information to identify a small number of lenders you’re interested in working with.
Ask the one or two lenders who seem best suited to your needs for a loan estimate. This document details everything you’ll be required to pay, including one-time fees as well as well as monthly costs. The loan estimate will help you verify that what the lender told you is accurate. Banks have to pull your credit to create your loan estimate, however, so it’s only necessary to get loan estimates from your first one or two choices. It is also important to work with a lender who is responsive and is working in your best interest. They are your advocates during the process, talking to the underwriter to get your loan approved.
Make sure to review your loan estimate with your financial planner before you sign for the loan. This document will detail how much money you need to bring to closing, as well as fees you may not be aware of.
Do I need private mortgage insurance?
Lenders often require buyers who put less than 20% down to pay for private mortgage insurance (PMI). Banks want to make sure they’re protected if buyers foreclose, and buyers who put less cash down are perceived as a bigger risk.
Typically, PMI payments are less than 1% of the entire loan annually — that is, $5,000 per year on a $500,000 home. And PMI can allow you to purchase a home with as little as 3% down, rather than waiting until you’ve saved 20%. Think of PMI as a fee that allows you to buy a home sooner than you would have otherwise.
Also, after two years of on-time payments, buyers can often call their lenders and ask if they’ve built enough equity to stop paying for private mortgage insurance. Banks will appraise properties and evaluate these requests on a case-by-case basis, but often agree that buyers can continue without PMI.
Mortgages for physicians and business owners
Physicians carry higher levels of debt than many homebuyers. However, they also have higher incomes than many homebuyers. For those reasons, many banks offer “doctor loans,” which allow physicians to put less money down on a property and not carry PMI. They also relax the underwriting process. For example, a physician might be able to qualify for a loan after showing a signed employment contract, when another buyer would need to demonstrate years of steady income.
Doctor loans also provide better financing. Jumbo rates can be more competitive than conforming rates, but a doctor loan will usually provide you with better jumbo rates even if your property would traditionally be a conforming loan.
Generally, banks still prefer W-2 income to 1099 income. If you’re self-employed, try to demonstrate at least two years of steady income. If you’ve recently transitioned from working as an employee to a contractor but remain in the same line of work — as an emergency physician, for example — banks will evaluate your applications on a case-by-case basis. If you can, ask the hospital to specify a minimum number of guaranteed shifts in your contract, so banks can evaluate you based on your minimum possible income.
One big challenge for business owners applying for mortgages is, during their first years of business, many people write off as many expenses as they can and claim little to know income. From a lender’s perspective, that’s just business revenue, not personal income. Make sure you have claimed income reliably for several years when you go to apply for a mortgage.
If you’re a business owner, try to bring an audited profit and loss statement with you to your lender. Also, consider seeking out a loan officer who specializes in supporting self-employed people. If your underwriter knows what to look for in your documents, you won’t have to advocate for yourself quite so vocally.
Ultimately, your loan officer should become your best advocate. They’ll make the case to the underwriter on your behalf. Give them as much evidence as possible — thorough documentation and great credit — to use in support of your application.