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Choosing the Right Mortgage Loan as a First-Time Home Buyer

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Before approaching lenders, many first time home buyers do not realize the wide variety of loan options available to them. While conventional and government-backed mortgages are the two main categories, there are quite a few home loans and programs under each umbrella. Natalie Campisi explains in her article “Who qualifies as a first-time homebuyer may surprise and empower you” for Bankrate. Campisi writes that “there are more than 2,500 grants and loans programs nationally.” From USDA loans to Fannie Mae HomeReady loans, there are many loans and programs specifically designed with first-time home buyers in mind. Boasting lower interest rates, down payments and credit score requirements, the best mortgage loans for first-time home buyers have few barriers to entry. In this article, we outline the best mortgage options for first-time home buyers. We also explain which term lengths, interest rate types and down payment amounts are right for new homeowners. Follow below to learn everything you need to know about choosing the right mortgage loan as a first-time home buyer. 

What Exactly is a Mortgage Loan?

what exactly is a mortgage loan for first time home buyers

For first-time buyers, the US home mortgage industry is a brand-new frontier. From closing costs to jumbo loans, there are a lot of housing market terms first-time home buyers might not be familiar with. For those just getting started, a mortgage is a home loan that usually covers the majority of a property’s purchase price. The Rocket Mortgage guide “What Is A Mortgage? Loan Basics For Beginners” explains. Mortgages are “agreements between you (the borrower) and a mortgage lender to buy or refinance a home without having all the cash upfront.” The agreement you sign allows the mortgage lender to legally “repossess a property if you fail to meet the terms of your mortgage.” 

Some buyers worry about taking on such a massive amount of debt. However, they should know that most homeowners will take out a mortgage loan when purchasing a house. According to data from the US Census Bureau, an overwhelming 62% of American homeowners currently carry a mortgage. For first-time buyers, this rate is even higher as few are able to purchase their new homes outright.

What Do Lenders Look at When Considering Mortgage Applicants?

Like other loans, you must meet certain criteria before the lender approves your application. Most lenders will look at your credit score, debt-to-income ratio, employment history and how much cash you have on hand for a down payment. Some mortgage lenders have more stringent requirements than others. Before approving your home loan, a mortgage lender will also usually order a home inspection, title search and appraisal. If the home you wish to buy fails to meet expectations or your credit changes significantly, the underwriter could revoke your loan.

What Are the Different Types of Mortgage Loans?

As mentioned above, most mortgage loans are either government-backed or private and either fixed-rate or adjustable-rate.

Conventional and Jumbo Loans

Mortgages originated by private lenders like credit unions, banks and investors include conventional and jumbo loans. Conventional loans are either conforming or non-conforming. A conventional loan will “conform” to standards established by the FHFA to protect both mortgage applicants and creditors. A conventional mortgage that conforms to FHFA standards is usually limited to a certain loan amount. As one might imagine, non-conforming conventional loans do not “conform” to the FHFA’s standards. Buyers with less than stellar credit history or those who want to buy bigger, more expensive properties might apply for non-conforming conventional mortgages. 

Another type of loan that does not conform to FHFA standards is the jumbo mortgage. Jumbo loans are for buyers considering expensive properties in volatile housing markets, making them quite a bit riskier for lenders. Of all the mortgage types outlined in this article, jumbo and conventional loans usually have the strictest lending requirements. From high credit scores to large down payment amounts, conventional and jumbo loans are typically more difficult for first-time buyers to secure.

Government-Backed Loans

Because they have lower down-payment and credit requirements, many first-time home buyers opt for government-insured mortgages. The US government does not actually issue these loans. It does guarantee mortgages – particularly for buyers with lower incomes and less mature credit histories. Miranda Marquit explains in her article “5 types of mortgage loans for homebuyers” for Bankrate.com. Marquit writes that “three government agencies back mortgages: the Federal Housing Administration (FHA loans), the U.S. Department of Agriculture (USDA loans) and the U.S. Department of Veterans Affairs (VA loans).” FHA loans, USDA loans and VA loans are all backed by the federal government, but each have different perks and standards for homeowners. For example, FHA loans require buyers to carry private mortgage insurance and submit a small down payment, but VA loans do not.

Fixed-Rate and Adjustable Rate Mortgages

Lastly, home loans are either adjustable rate or fixed rate mortgages. In a fixed-rate mortgage, the interest rate you pay is constant. The amount of interest you pay from one month to the next might vary. However, the interest rate is the same from the first payment until the last. Homeowners often opt for a fixed-rate mortgage when interest rates are low and when they want to know exactly how much they will pay. In an adjustable rate mortgage, the interest rate – and therefore the monthly mortgage payments – of a loan is subject to change. 

James McWhinney explains in his article “Fixed-Rate vs. Adjustable-Rate Mortgages: What’s the Difference?” for Investopedia. According to McWhinney, adjustable rate mortgages – or ARM’s – “are significantly more complicated than fixed-rate loans.” With an ARM, the initial interest rate “is set below the market rate…and then the rate rises as time goes on.” This lower initial rate is what makes ARM’s attractive when market interest rates are relatively high. In 2022, mortgage interest rates are near record lows. The period during which the interest rate applied to your ARM remains constant “can vary significantly—anywhere from one month to 10 years.” McWhinney notes that once the initial term has expired, “the loan resets, meaning there is a new interest rate based on current market rates.” Most ARM contracts will include a cap on the rate. This means that they guarantee that the interest rate will not exceed a certain amount “during the life of the loan.” 

The Trouble With ARM’s

First-time home buyers are often discouraged from accepting an ARM loan because monthly mortgage payments can be unpredictable. This could mean low monthly payments one year and higher monthly payments the next. As McWhinney notes, “your monthly payment may change frequently over the life of the loan.” Worse yet, “if you take on a large loan, you could be in trouble when interest rates rise.” For example, some adjustable rate mortgages “are structured so that interest rates can nearly double in just a few years.”

Mortgage brokers used to issue ARM’s all the time. However, there is now greater scrutiny surrounding adjustable-rate mortgages because of the “the subprime mortgage meltdown of 2008.” When buyers were no longer able to cover sky-high monthly payments, foreclosures and short sales flooded the market. Since then, the Federal Housing Finance Agency has revised its position on ARM’s and provided new guidance for lenders on different types of mortgages. Learn all about the FHFA’s latest initiatives here.

What Do You Pay As Part of a Mortgage?

Most homeowners will pay down their principal, interest related to that principal, taxes and insurance when making monthly payments on their mortgage. In her article “How to Choose the Best Mortgage for You” for Investopedia, mortgage analyst Deborah Kearns explains the first two terms. According to Kearns, the principal “refers to the loan amount…[while] interest is an additional amount that lenders charge you for the privilege of borrowing money.” Interest payments are calculated as a certain percentage of your loan’s principal and is paid in monthly installments throughout the lifetime of your mortgage. Mortgage interest rates are either fixed or variable, depending on the terms of your contract. What percentage in interest and principal you pay the lender each month depends on your amortization schedule. 

Writing for The Balance in his article “​​What is Amortization?,” Justin Pritchard, CFP explains. Pritchard writes that “your total payment remains equal each period.” However, “you’ll be paying off the loan’s interest and principal in different amounts each month.” When you first start paying off your mortgage, “interest costs are at their highest.” Towards the end of your loan term, “more of each payment goes towards your principal, and you pay proportionately less in interest each month.” As part of your monthly mortgage payment, you might also make private mortgage insurance payments or pay guarantee fees each month. Whether you owe PMI or guarantee fees depends on the type of loan you choose as a first-time buyer.

Decisions First-Time Home Buyers Must Make Before They Apply for a Mortgage

Decisions First-Time Home Buyers Must Make Before They Apply for a Mortgage

Down Payment Amount

In the past, conventional wisdom dictated that buyers should submit at least 20% of the home’s purchase price as their down payment. Today, most home loans – especially those insured by the federal government – require much less than a 20% down payment. Some require a 3.5% down payment while others allow homeowners to put zero money down when applying for a mortgage. According to the National Association of Realtors, the average down payment was 12% in 2020. For first-time buyers, this average is much less – around 7%. First-time home buyers might feel trapped between what they think they should pay (the traditional 20%) and what they can afford. In their article “How Big Should Your Down Payment Be?” for Forbes, Amy Fontinelle and Mike Cetera offer advice to first-time buyers. 

They begin by noting that the amount you put down is a highly personal decision. This decision is always dependent upon “what’s best for your finances.” Many loans require just 3% down. However, “you might want to put down more than that because you have to pay interest to borrow money.” A larger down payment means a lower monthly mortgage payment. However, you do not want to put so much down that you have no money left for future emergencies or necessary repairs. You must also be able to cover closing costs – most of which buyers are responsible for. Cetera and Fontinelle advise paying between 3% and 20% when putting down less would require the buyer to carry private mortgage insurance. Buyers should keep in mind that some lenders require you to carry PMI even if you submit a larger down payment.

Monthly Mortgage Payment

Finance experts usually recommend homeowners spend no more than a quarter or one third of their gross monthly income on mortgage payments. Gross income is your typical salary plus any other earnings like commissions, bonuses, alimony or freelance income. Writing for Investopedia, James McWhinney explains how to calculate an affordable monthly mortgage payment. McWhinney writes that buyers should base their target monthly mortgage payment on the front-end ratio (expected income) and back-end ratio (existing expenses). According to McWhinney, “the front-end ratio based on PITI should not exceed 28% of your gross income.”

The back-end ratio or debt-to-income ratio calculates how much of your gross income must be used to pay off existing debts. These could include “credit card payments, child support, and other outstanding loans.” Mortgage lenders usually require a DTI less than 43% of your gross income. If half of your income already goes to other debts, it could be difficult to secure a mortgage. In general, buyers should consider their current lifestyle, existing debts and the cost of maintaining a home before determining an appropriate monthly mortgage payment.

Mortgage Term or Lifetime

Next, homeowners must decide on the term of their mortgage loan. Most mortgages are amortized across a ten, fifteen or thirty-year period. The vast majority of homeowners opting for either a fifteen or thirty-year term. Homeowners who want affordable, low monthly payments usually opt for a 30-year mortgage. Those who wish to cut down on the total amount they pay choose a 15-year loan. Writing for Forbes in her article “15-Year Vs. 30-Year Mortgage Calculator: How To Decide,” Rachel Witkowski outlines the pros and cons of each. In both term lengths, “you pay a set principal and interest amount every month.” This is divided over a span of either 15 or 30 years – unless you “sell the home and pay off the mortgage sooner.” Witowksi writes that “a 15-year mortgage tends to have a lower interest rate…[but] the monthly payments are higher on a 15-year mortgage because you are paying the principal off faster.” 15-year mortgages are popular when interest rates are high. 

When interest rates are low – like now – a 30-year mortgage might make more sense. This is because you can “lock in that low rate for a longer term and use your extra cash to invest in something else.” In general, fifteen year mortgages are better “if you have more monthly cash on hand and want to pay off your home faster.” On the other hand, “a 30-year mortgage might be better for someone who has a more limited budget.” Of course, you can always refinance in the future.

Interest Rate Type

As outlined above, buyers must also decide if they want to pay a fixed interest rate or an adjustable interest rate. In 2022 — when interest rates are already incredibly low — it makes little sense for first-time buyers to choose variable interest rates. Opting for a variable interest rate could result in a higher monthly payment down the road.

How to Choose the Best Mortgage as a First Time Home Buyer

How to Choose the Best Mortgage as a First Time Home Buyer

Now that we know a little bit about each type of mortgage, let’s take a look at the best loans for first-time home buyers. The best mortgage loans for first-time buyers in 2022 require minimal down payments, limited PMI payments and lower credit scores. At the same time, these home loans must offer buyers competitive interest rates. As such, first-time buyers are best served by FHA loans, USDA loans, VA loans and Conventional 97 loans. Other programs like Fannie Mae HomeReady, Freddie Mac Home Possible and Good Neighbor Next Door are also ideal for first-time home buyers. Find a brief description of each of these loans and the ways in which they benefit first-time buyers below!

Why FHA, USDA and VA Loans Are Great for First-Time Buyers

In “Borrowers with not-so-perfect credit may be eligible for FHA home loans” for The Washington Post, Michele Lerner explains. Quoting California mortgage broker Joe Shalaby, Lerner writes that “‘FHA loans are attractive for first-time buyers because they’re easier to qualify for.’” In fact, buyers can qualify for an FHA loan with a FICO score as low as 580 points. Plus, they only need down payment of just 3.5% and can have a relatively high debt-to-income ratio. Buyers who put down 10% or more can have a credit score as low as 500 points. Another benefit of an FHA loan over a conventional loan is the “increased ability to have co-borrowers on the loan.” This is ideal for young buyers who wish to purchase a house jointly with friends, partners or parents. The only downside to FHA loans is that they require PMI that cannot be canceled. Buyers might also consider FHA 203(k) loans if they plan to purchase a fixer-upper. In doing so, they can bundle renovation costs with their initial mortgage loan.

USDA loans and VA loans offer buyers who qualify similar but often more favorable terms. In her article “5 Tips for Finding the Best Mortgage Lenders for First-Time Buyers” for NerdWallet, Beth Buczynski identifies these benefits. Bucynski writes that both “USDA and VA loans can often be obtained with zero down payment.” Interest rates are competitive and “minimum credit scores…are generally lower than for conventional loans.” Intended for lower-income buyers in rural parts of the US, USDA loans have the cheapest PMI rates of any lender. Designed for members of the military and/or veterans, VA loans do not require any ongoing mortgage insurance at all. They also subsidize closing costs. 

How Conventional 97 Loans Benefit First-Time Buyers

A Conventional 97 loan also allows buyers to submit as little as 3% for their down payment. The “97” in a Conventional 97 loan refers to the total amount of the home’s purchase price covered by your mortgage. In her article “The best first-time home buyer loans in 2022” for The Mortgage Reports, Aly J. Yale elaborates. Conventional 97 loans do require PMI and a higher minimum credit score of 620 points. However, buyers can cancel their mortgage insurance after gaining 20% equity in their home. Best of all, “conventional loans don’t require an upfront insurance fee, which can save you money on your closing costs.”

Why Fannie Mae HomeReady Loans and Freddie Mac Home Possible Loans Work for First-Time Buyers

You probably have not heard of Fannie Mae HomeReady or Freddie Mac Home Possible loans if you are new to the housing market. In her article “HomeReady And Home Possible Income Limits: Do You Qualify For These Loans?” for Rocket Mortgage, Victoria Araj explains. To begin, Araj writes that “HomeReady and Home Possible are both great mortgage options geared toward lower-income, lower-credit score borrowers.” A HomeReady mortgage is a home loan “financed through the Federal National Mortgage Association (Fannie Mae).” This type of mortgage is intended to “help borrowers with low to moderate income by reducing the standard down payment and mortgage insurance requirements.” 

Home Possible loans are backed by Freddie Mac and offer similar terms to buyers with lower incomes. However, Home Possible loans require higher credit scores than HomeReady loans. The required down payment for both HomeReady and Home Possible loans is less than an FHA loan at 3%. One of the greatest perks is that they allow you to apply “gifts from friends and family toward your down payment.” You can also cancel your mortgage insurance payments once the total paid has exceeded the amount of a traditional down payment. Buyers might also consider a HomeStyle loan from Fannie Mae. This loan allows buyers to bundle their construction or renovation loan with their mortgage under favorable terms.

Good Neighbor Next Door and Other Programs that Help First-Time Home Buyers

There are a few other programs designed to help certain types of buyers. Chances are, your home state offers a first-time buyer program with assistance geared towards residents like you. These programs offer everything from competitive interest rates to down payment assistance. In California, participating lenders in first-time home buyer programs include CalHFA Lenders. MassHousing Lenders and New Hampshire Housing Lenders assist buyers in Massachusetts and New Hampshire respectively. 

In his article “8 First-Time Home Buyer Loans and Programs” for NerdWallet, Hal M. Bundrick, CFP identifies the final program on our list. Good Neighbor Next Door offers discounted FHA-insured mortgages to educators and first responders like members of “law enforcement, firefighters and emergency medical technicians.” This program is sponsored by the United States Department of Housing and Urban Development. It “allows 50% discounts on the list price of homes located in revitalization areas.” The only catch is that buyers must “commit to living in the property for at least 36 months.”

The Bottom Line

the bottom line about first time home buyer mortgage loans in today\'s market

While some conventional loans are attainable for first-time buyers, the best mortgage options are usually those with few barriers to entry. In most cases, this means government-insured home loans or payment assistance programs. FHA loans, USDA loans, VA loans and those offered through Good Neighbor Next Door help buyers purchase their first home with little money down. Buyers can apply for these loans even if they have low credit scores or high debt-to-income ratios. Some programs even subsidize the cost of the home and/or the closing costs due at signing.