Conventional Loan Mortgage Rates: Which Mortgage Type Is The Best?
A home is likely the largest purchase that you’ll make in your lifetime. Due to this, you’re unlikely to buy a home only with the cash you have on hand – this is where a mortgage comes in.
Of all the home loans available on the market, conventional mortgages are the most popular. In this guide, we’ll discuss conventional loan mortgages in-depth! We’ll define what conventional loan mortgages are, provide a comparison between the two major mortgage types, as well as share tips to save up on your mortgage. To help plan for your home purchase, we also provide tools to estimate your recommended loan amount and payments.
What Are Conventional Mortgages?
Any loans that are not sponsored or backed by the federal government are considered conventional loans. These loans are usually provided by lenders to creditworthy borrowers. These lenders range from banks, credit unions, to mortgage corporations.
Conventional loans adhere to conforming loan limits set by the Federal Housing Finance Administration (FHFA). These loans are also subject to the requirements set by Fannie Mae and Freddie Mac, two government-sponsored companies that guarantee mortgages.
Unlike government-backed loans, conventional loan borrowers aren’t provided any protection if they fail to repay the loan. The lenders similarly do not receive any federal guarantee if the borrower defaults on the loan, which means that lenders often apply stricter requirements to prospective borrowers.
However, conventional loans are usually free of any specific requirements that may be imposed by government loans, such as the requirement to be a service member to qualify for a VA loan. As long as the borrower meets the good credit score and the debt-to-income ratio standards set by the lender, anyone can qualify for a conventional loan.
Interest vs Annual Percentage Rate: Knowing The Difference
When shopping for a mortgage, you may be offered information regarding the loan’s interest rate and annual percentage rate (APR). While these two may look like the same thing, there are some key differences between them.
An interest rate represents the cost of borrowing the principal loan amount, usually represented as a percentage. The APR, however, represents the broader cost of your mortgage. This rate takes into account the loan’s interest alongside other associated costs, including your loan origination fee, lender fees, closing costs, as well as discount points.
Both mortgage rates should be disclosed by lenders to ensure that the borrower knows what they’re really paying before they submit the mortgage application. As a borrower, you can use both interest and APR to compare between loan offers and find which one represents the best value to you.
Most Common Conventional Mortgage Types
In this section, we’ll discuss the two major types of conventional mortgage loans. The two main mortgage types also have different benefits and caveats – we’ll break them down in this section below.
Fixed-rate mortgages are the most popular type of mortgage loans for first-time homebuyers in the United States. True to its name, the interest rate & APR stays the same throughout the entire life of your loan. Due to this, your monthly principal and interest payments will also stay the same until the whole amount is paid off.
These loans are fully amortizing, which means that by the time the loan ends, you’ll have paid for everything that you owe – both the principal and the interest of the loan. Generally, your early payments mostly go to paying your interest, while payments you make later in the loan’s life go to paying your loan principal.
Lenders offer varying terms of fixed-rate loans. Generally, people opt for a 30-year fixed rate, which is the longest term that most lenders provide. However, you can also opt for a 15-year loan if you want to pay your loan off faster. In addition to 15-year and 30-year fixed loans, lenders also provide 10-year and 20-year terms.
Fixed-Rate Mortgage Strengths
Stable Interest Rate And APR
The main strength of a fixed-rate mortgage is its stable interest and APR. Once you qualify for a loan at a certain rate, it won’t increase or decrease throughout the life of the loan. If you manage to lock in a loan during a time of low-interest rates, you’ll be able to save a lot of money on interest payments.
Payment Amount Stays Constant
Fixed-rate loans are much easier to predict in the long term because the mortgage payment value stays the same for the entire life of the loan. This predictability allows you to budget around your monthly mortgage payment and build up a safety net to pay for other urgent expenses without experiencing any financial surprises.
Fixed-Rate Mortgage Weaknesses
Higher Interest Rate And APR
The static interest rate on a fixed mortgage comes with an important drawback: lenders usually charge higher interest rates compared to the introductory rates of an ARM. If you qualify for a loan during a period of high mortgage rates, you’ll be paying much more money for the entire loan term.
Few Options Reducing Your Interest Rates
Another caveat of fixed interest rates is that once you qualify for the loan, it cannot be changed. If interest rates fall dramatically once you have your current mortgage, you won’t be able to take advantage of the rate drop.
However, you can work around this by applying for a refinance. When you refinance loans, you replace your current mortgage with a new one that features a lower interest rate.
The second major type of loan is an adjustable-rate mortgage (ARM). These loans are slightly more complicated compared to fixed mortgages because their rates will change periodically. Most ARMs feature a certain introductory period featuring fixed interest rates before the adjustable phase starts.
The length of an ARM’s introductory period and adjustment frequency is usually expressed in its title. For instance, a 5/1 ARM means that you’ll have a five-year period of fixed interest rates at the beginning of the loan. Once the five years have passed, your loan’s interest rate will be adjusted annually.
To prevent your mortgage rates from fluctuating wildly, lenders usually apply caps on your ARM. These caps limit the fluctuation of your interest rate and how much you need to pay per month.
Adjustable-Rate Mortgage Strengths
More Affordable Initial Rates
An ARM features highly competitive rates in its introductory fixed-rate period. If you apply for a 5/1 ARM, this means that you’ll get five years of predictable payments at an affordable amount. You can take advantage of this period of low-interest payments to save up and prepare for the less-predictable period of adjustable rates afterward.
Chance To Get Lower Rates
Because an ARM’s rate highly depends on an index, you may experience lower interest rates if the index is driven down. If your rates are adjusted to be lower, you’ll also be charged less on your monthly payment until the rate readjusts next year.
Adjustable-Rate Mortgage Weaknesses
Interest Rates May Increase
Conversely, if the index moves up, your mortgage rate may increase. While caps may stop your rates from increasing to unaffordable levels, you’ll still need to pay more expensive monthly installments. Without proper budgeting and planning, this may land you in a financial bind.
Risk Of Negative Amortization
While caps are meant to protect you from paying too much, it also poses a risk to you. If the mortgage rate increase causes your monthly payment value to go over the cap, you may be paying less than you should be paying per month. By paying less than what you owe per month, you’ll experience negative amortization, which means that your loan balance will increase.
What Type Of Mortgage Is Best For Me?
Different plans require different mortgages. In this section, we’ll break down three common mortgage options and the circumstances in which they’ll work best.
30-Year Fixed-Rate Mortgages
A 30-year fixed-rate mortgage is best if you’re looking to find the cheapest monthly payments. Because the loan payments are spread over 30 years, you’ll be able to save in the short term and have enough in your budget to pay for other expenses without stretching your finances too thin.
You’ll get the best value out of a 30-year fixed-rate loan if you plan to stay in the house for the long term, especially if you’ve locked in low rates when you qualify for the loan.
15-Year Fixed-Rate Mortgages
Similar to a 30-year fixed loan, a 15-year fixed-rate loan also features consistent monthly payments. However, because the loan term is halved, you’ll be paying higher monthly installments if you opt for a 15-year loan. Therefore, taking on this shorter term will allow you to pay off the loan quicker and pay less on interest. Lenders also typically impose lower rates on a 15-year loan.
Because of an ARM’s volatility, these loans are best used if you want to stay in the house for the short term. You can enjoy the cheaper rates during the introductory period, and then sell the house or refinance the loan before the rates start to adjust.
Alternatives To Conventional Loans
While conventional loans are the most popular choice for home financing, there are several government-backed loan options that you can consider. These loans typically feature more affordable rates, lower credit score requirements, as well as lower down payments.
These loans are insured by the Federal Housing Administration and are primarily aimed at lower-income borrowers who may have less-than-good credit scores.
FHA loans require a lower down payment and credit score requirement compared to a conventional loan. A homebuyer with a credit score of 580 and above can provide as little as a 3.5% down payment to qualify for these loans.
Because the FHA insures these mortgages, they can only be issued by FHA-approved lenders. Borrowers are also required to pay for mortgage insurance. The main purpose of mortgage insurance is to protect the lenders in case the borrower fails to make their payments.
Administered by the Department of Veteran Affairs, these loans are provided exclusively to current and former service members as well as their spouses. Because the government protects lenders in case the home buyer defaults on their loan, lenders are willing to offer more favorable terms as well as waive down payment entirely.
Many lenders offer VA loans, and there are specialized lenders that primarily offer this type of mortgage. These loans usually have a stricter standard for property safety, and they’re only available if you’re buying a primary residence. The low down payment requirement is also balanced out by the funding fee, which replaces private mortgage insurance (PMI) and protects lenders in case you fail to make loan payments.
Another government-backed option that you can consider is a USDA loan. This loan type is supported by the Department of Agriculture and is geared for homebuyers who want to find real estate in rural or suburban regions. With no down payment and low interest, you can use these loans to either buy a new home or pay for home improvement.
Because this type of loan is meant for people who cannot otherwise qualify for a home loan, USDA loans are typically provided to people who do not have safe and sanitary housing as well as those living below the low-income limit in their area.
Saving Money On Your Mortgage
Because mortgages are a long-term commitment, it pays to save as much as you can. Here, we provide three tips that you can try to save money on your home loan.
Pay A Larger Down Payment
While most mortgages require you to pay 20% or even less in some cases, you can still pay more than the required minimum account. By paying a higher down payment, you’ll reduce your loan-to-value ratio, which means that your monthly payments and interest will be lower.
In addition to lowering your rates, you’ll be able to avoid the mortgage insurance requirement. Because mortgage insurance only protects the lender if you default on your loan, it’s best to avoid paying the cost entirely, if possible, by increasing your down.
Compare Loan Offers From Mortgage Lenders
Lenders are required to provide standardized documents containing the interest rate and annual percentage rate (APR) of the loans they offer. By comparing these documents, you can see which lender provides the most affordable loan.
However, there are other factors you need to consider in addition to interest and APR. You’ll need to pay attention to the closing costs set by the lender as well as any prepayment penalties if you decide to refinance your loan before its term ends.
Consider Refinancing Your Loan
Refinancing your loan entails taking out a new mortgage to pay off your existing one. Depending on your mortgage type, you’ll be able to benefit from a refinance differently.
With a fixed mortgage, you can refinance if you see that the market rates are dropping and you want to take advantage of the rate drop. If you have an ARM, you can decide to refinance if you’re at the end of your introductory fixed-interest period and wish to switch to a fully fixed-rate mortgage.
Conventional loans are popular because borrowers can choose between the two types of loans to fit their needs. Both fixed-rate and adjustable-rate loans have their own strengths that can help you save more money on your mortgage. You can also consider refinancing and pay a larger down payment.
If you’re looking for the best-valued conventional loan, Wesley Mortgage, LLC is here to help! Our team of financial professionals can advise you on which type of conventional loan fits your budget on circumstances. Contact us today for more information!