As of 2023, the homeownership rate remained stable at 65.9%, which is not statistically different from the two previous years. The mortgage rates remain near 7%, making entry into the housing market challenging for buyers, and limited inventories continue to balloon house prices, further hindering buyers and the housing market.
Still, it is not all doom and gloom. Buyers can still find opportunities with the right types of mortgages. To make an informed decision, homebuyers must understand the various mortgage structures and how to qualify for them.
Types of Mortgages and Borrower Needs
Securing a mortgage is a consequential financial decision with a long-term commitment. The decision can mean the difference between comfortable monthly payments and financial strain. Borrowers must consider more than interest rates. A mortgage must complement a borrower's current financial position and support future aspirations. Understanding the differences between mortgages can help borrowers choose a loan and lender that matches their needs without diminishing future financial choices.
Fixed-Rate Mortgages
A fixed-rate mortgage is a popular option. It locks a borrower into an interest rate at the beginning of the loan and keeps it the same throughout the loan term. A fixed-rate loan creates a predictable and stable mortgage payment for borrowers, making budgeting and financial planning easier.
The fixed-rate option also protects the borrower from rising rates, shielding them from increases with a locked-in rate. While the protection can provide peace of mind, the loan type does not allow for flexibility. That means that if interest rates drop during the loan term, borrowers cannot capitalize on the potential savings like they can with other mortgage types.
A fixed-rate mortgage has a higher initial interest rate than some other mortgages. Still, it is preferable for borrowers who prioritize stability and predictability in their monthly payments. This mortgage option is usually best for individuals who plan on staying in their homes long-term or buyers on a fixed income.
Ultimately, a fixed-rate mortgage protects homebuyers from the potential volatility of the housing and lender market. Locking a buyer in to an interest rate means they no longer have to worry about rising rates and market fluctuations. While it can have its drawbacks, a fixed-rate mortgage is ideal for homeowners who are looking for a forever home.
Adjustable-Rate Mortgages
Adjustable-rate mortgages are a type of mortgage in which the initial interest rate a borrower qualifies for remains fixed for a set introductory period. Then, the rate adjusts periodically throughout the remaining loan term. Unlike a fixed-rate mortgage, an adjustable-rate mortgage can result in fluctuating mortgage payments based on changes in the underlying interest rate.
The initial fixed-rate period typically lasts three, five, seven, or 10 years, depending on the lender and initial mortgage agreement. Following the fixed-rate period, the interest rate adjusts periodically, usually once per year, based on a predetermined index, such as the Secured Overnight Financing Rate.
Thankfully, borrowers benefit from these types of mortgages with rate caps—limitations or restrictions on how much an interest rate can adjust per adjustment period, and over the lifetime of the loan. A cap of 2% per adjustment period and 6% over the life of the loan can reduce the likelihood of significant payment increases. This can help the borrower plan for worst-case scenarios.
While adjustable-rate mortgages initially offer potentially lower interest rates than fixed-rate mortgages, it is necessary to consider the potential drawbacks of the loan. The primary disadvantage of adjustable-rate loans is payment uncertainty. For people with a fixed income or tight budget, the unpredictability of the mortgage beyond the fixed-rate period is problematic. These mortgages are also complex and more challenging to understand than fixed-rate options.
Adjustable-rate mortgages are best for people who plan to sell their home before the end of the initial fixed-rate period. The strategy allows the borrower to lock in a lower interest rate than they might receive from a traditional fixed-rate mortgage. Homebuyers on a tight budget might benefit from the lower initial monthly payments, but they must weigh the pros and cons of potential increases and future affordability.
Government-Backed Mortgages
Federal agencies insure government-backed mortgages, meaning the government guarantees the loans. This reduces the risk for lenders and allows for more favorable loan terms for qualifying borrowers. Three primary agencies insure these types of mortgages:
- Federal Housing Administration
- Department of Veterans Affairs
- Department of Agriculture
Each agency defines its loan programs and eligibility requirements, but they all provide a government guarantee and have strict regulations. The guarantee is the key feature of these loans. If a borrower defaults on a government-backed loan, the government agency reimburses the lender for a portion of the outstanding loan balance. Not everyone qualifies for an insured loan. Typically, the programs use income limits or require mandatory mortgage insurance.
Still, government-backed mortgages offer more accessible qualifications, greater flexibility, and competitive interest rates. Compared to conventional programs, government-backed options require lower qualifying credit scores and smaller down payments. For example, a person may qualify for an FHA loan with a down payment as low as 3.5%.
Government-backed mortgages are excellent options for people who may not qualify for conventional loan programs or who belong to special interest groups. For example, the VA loan program is ideal for veterans, and the USDA program is perfect for rural homebuyers. Ultimately, government-backed programs can ease the pathway to homeownership, providing more favorable rates with fewer barriers to approval.
Fundamental Process for All Types of Mortgages
Regardless of the specific mortgage type a homebuyer chooses to apply for, there's a core process that they typically must go through. By understanding the fundamental process, they can better navigate the path to homeownership.
1. Pre-Qualification
Pre-qualification is the initial step in the mortgage process, where prospective buyers receive a rough estimate of how much they may qualify to borrow for a home. Compared to the full mortgage application process, pre-qualification is relatively quick and informal.
The typical process involves the buyer providing details about income, employment history, debts, and the desired loan amount. Based on the information provided, a lender estimates the maximum loan amount a borrower could qualify for and provides potential interest rates. Some lenders might perform a soft credit check, which doesn't affect credit scores, to get a more accurate picture of a borrower's financial health and provide a more precise estimate.
Pre-qualification is a beneficial tool, but it does not guarantee mortgage approval. It offers homebuyers a ballpark figure as a starting point for house hunting and can strengthen a buyer's negotiating position, but several factors can interfere with application approval.
2. Application
Different mortgage types have different application requirements. That said, every mortgage requires an official application process, which is more rigorous than the pre-qualification process.
The mortgage application is the formal step of requesting a specific amount from a chosen lender. Unlike the pre-qualification process, an official application requires more detailed documentation and a stricter evaluation of the borrower's financial history. Typically, an application requires:
- Proof of income (paystubs, W-2s, and tax returns)
- Employer verification (contact information or letter from employer)
- Asset verification (bank statements and investment account statements)
- Debt verification (credit card statements, loan statements, etc.)
- Personal identification (driver's license and social security number)
The application form gathers information about a buyer's financial history, prospective property purchase, and desired loan terms. A lender will use the information provided by a potential borrower to perform a hard credit check, which can temporarily lower a credit score but is necessary to determine creditworthiness and lender risk.
3. Underwriting
Underwriting is a crucial stage in the mortgage application process; it evaluates the borrower's financial situation to determine creditworthiness and risk. The process involves an underwriter, a qualified professional whose job it is to determine whether a borrower is a good fit for the loan they're requesting.
The underwriter scrutinizes a borrower's financial documents provided in the application process and verifies the accuracy of the information along with income stability, savings history, and any delinquencies. Part of the professional assessment will include the loan-to-value ratio, which aids in determining lender risk, and the debt-to-income ratio, which determines a borrower's ability to manage the demands of the potential mortgage.
An underwriter can make one of three possible decisions regarding an application: approve, deny, or approve with conditions. An approval is straightforward, but denials and approvals with conditions are often frustrating. A denial should come with a clear explanation for the rejection and may provide suggestions for improving approval odds in the future. An approval with conditions means a borrower might receive approval if they provide additional documents, reduce the loan amount, or secure private mortgage insurance—a type of insurance that protects the lender if the borrower defaults on their mortgage loan.
Underwriting is essential to the stability of the lending market and helps protect buyers from excessive loan amounts, but it is a grueling process, regardless of the type of mortgage applied for. A typical application and underwriting process can take several days to several weeks, depending on the complexity of the borrower's finances and the lender's workload.
4. Closing
The closing, or settlement, is the final step in the mortgage process; it is where the borrower finalizes the loan and takes ownership of their new home. Closing usually occurs at the office of a title company or escrow agent and includes several people:
- The buyer and their agent
- The seller and their agent
- A loan officer or closing agent representing the lender
- A title company representative
A closing involves several activities, including the reviewing and signing of all loan documents. The lender finalizes the loan by sending the funds to the closing agent, who then uses them to pay the seller and any taxes and other fees. A title company representative then ensures the title is clear of any liens or encumbrances before transferring it to the new owner. Finally, the keys and deed are given to the new owner. The closing usually takes one to two hours, depending on the number of people involved and the complexity of the transaction.
Example Mortgage Scenarios
An understanding of the various types of mortgages must go beyond definitions and specific pros and cons. The only way to genuinely understand how mortgages work is with specific examples:
Scenario 1: Adjustable-Rate Mortgage
Sarah has a credit score of 720 and is looking to purchase a $350,000 home. She can afford a down payment of 10% ($35,000), leaving a required loan amount of $315,000. After careful consideration, Sarah determines that an adjustable-rate mortgage is her best choice because of its short-term affordability, especially since she is expecting a promotion in the next three years.
Sarah decides on a 5/1 ARM with a 30-year term, meaning the adjustable-rate loan maintains a fixed rate for the first five years of the loan before adjusting up to once per year following the fixed period. The mortgage she is applying for offers a starting interest rate of 4%, considerably lower than fixed-rate loans at the time. The adjustment cap for the loan is 2% per year with a 6% lifetime interest cap. The initial monthly payment for Sarah's loan is approximately $1,504, and it should remain that amount for the first five years of the loan.
The danger of these types of mortgages comes in at year six for Sarah. For example, if the SOFR index increases by 3.5%, the interest rate would increase to 5.5% (SOFR + 2% margin). The payment increase could be over $400 per month. It is reasonable that Sarah's mortgage payment could reach $2,000 or more by year 10. However, if mortgage rates remain favorable, she may pay less over the lifetime of her loan than someone with a fixed-rate mortgage.
Scenario 2: Fixed-Rate Mortgage
Brian also has a good credit score of 720 and wants to purchase a $350,000 home. He has the same amount available for a down payment as Sarah, 10% ($35,000). That said, Brian prefers predictability and stability over short-term gains, so he decides to apply for a fixed-rate mortgage.
Brian plans on staying in the home for the duration of the loan. Wanting to avoid the uncertainty of fluctuating payments, he chooses a 30-year fixed-rate mortgage with an interest rate of 6%. His higher interest rate means that he will pay nearly $400 more per month than Sarah during her fixed-rate period. That said, Brian's mortgage payment remains the same at year six and beyond, regardless of interest rate fluctuations.
In the worst-case scenario, Sarah ends up with a mortgage payment of over $2,000 for the last 20 years of her loan, meaning she may pay significantly more than Brian over the life of the loan. Ultimately, an adjustable-rate mortgage is a gamble for long-term investors. Because Brian wants to stay in his new home throughout the life of the loan, the fixed-rate option is less of a financial risk.
How Lenders Determine Interest Rates
Regardless of the mortgage type, interest rates depend on a combination of market-driven factors and borrower-specific criteria. The market and economic factors driving lender decisions are prevailing interest rates, economic outlook, and competition—lenders typically base rates on the cost of borrowing money, inflation, and bond yields and risks. A more robust economy can lead to higher rates, while a weaker one may result in lower rates. Finally, mortgage lenders compete to earn business, so one lender may offer lower rates than its competitors, which is why shopping around is beneficial.
Personal finances also affect interest rates. A borrower with a lower credit score represents a risk to the lender, and to counter that risk, a lender may increase interest rates. Lenders also assess the borrower's debt-to-income ratio and loan-to-value ratios to determine creditworthiness and risk.
Interest rates can also depend on the loan term. For example, a 30-year mortgage often carries a higher interest rate than a 15-year mortgage because the longer the term, the greater the risk to the lender.
The Correct Types of Mortgages for Your Situation
Understanding mortgage types is only one part of the homebuying process. Your homebuying journey also depends on locating your dream residence and identifying the most feasible buying options. Nestfully provides direct access to comprehensive MLS listings, the same property listings used by real estate agents. You can even connect with an experienced local agent who’s just right for you.
Check out the Nestfully website and create an account to learn more.
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