A house is probably one of the biggest purchases you’ll ever make. And—despite what “normal” broke people might tell you—paying for one in cash is not just possible, it’s the smartest way to go.

But if you decide saving up that much money isn’t reasonable for your timeline, you’ll probably take out a mortgage. That can be a smart move, as long as you pick a home and a mortgage that set you up for success.

Choosing a mortgage isn’t as simple as it sounds. That’s because there are many types of mortgages available and they’re made up of different components—from the interest rate to the length of the loan to the lender.

Let’s take a look at the pros and cons of the options out there, so you can make an informed decision when it comes to your mortgage.

Fixed vs. Adjustable Interest Rates

When you choose a mortgage, one of the first things you do is determine how your interest rate is treated. You can lock the rate, make it adjustable, or do a combination of both. For example, if you get a 30-year mortgage with a 5/1 adjustable-rate mortgage, your interest rate will lock for five years, then adjust annually for the remaining 25 years.

Fixed-Rate Mortgages

• Pros: The interest rate stays the same for the entire time it takes you to pay off the loan, so the size of your monthly payment stays the same, which makes it easier to plan your budget.
• Cons: Compared to a mortgage with an adjustable interest rate, a fixed interest rate might be higher—at first.

Adjustable-Rate Mortgages (ARMs)

• Pros: ARMs offer a lower interest rate (and monthly payment) for the first few years.
• Cons: Sure, the initial low interest rate is appealing, but in exchange for that lower rate up front, the risk of higher interest rates down the road is transferred from the lender to you. Many people find this type of mortgage appealing because they can qualify for a more expensive home. But, as many homeowners learned in the economic downturn, when your rate increases or you lose your job, the payment can quickly become too much for you to afford.

Bottom line: ARMs are one of the worst types of mortgages out there. Keep more of your money and go with a fixed-rate mortgage instead.

Types of Mortgage Terms

Your mortgage term refers to the length of your loan in years. It’s an agreement with your lender on the maximum amount of time it’ll take you to pay off the loan in full. Common terms range from 15, 30, to even 50 years.

15-Year Mortgages

• Pros: A 15-year term keeps you on track to pay off the house fast, and usually has a lower interest rate and costs less total interest compared to longer term loans.
• Cons: A 15-year term comes with a higher monthly payment compared to a 30-year or longer term.

30-Year Mortgages

• Pros: You’ll have lower monthly payments with a 30-year term, compared to a 15-year.
• Cons: You’ll have a higher interest rate, which means you’ll stay in debt longer and pay way more in interest than you would’ve with a 15-year (or less) term.

50-Year Mortgages

• Pros: You’ll pay dramatically lower monthly payments with a 50-year term, compared to shorter term mortgages.
• Cons: Your interest rate will be even higher than with a 30-year term, which means you’ll pay the most in total interest out of the terms listed here.

Bottom line: Opting for a 30-year (or longer) mortgage feeds into the idea that you should base major financial decisions on how much they’ll cost you per month. That’s flawed thinking. If you want to get ahead with your money, you’ve got to take the total cost into consideration. (We’ll compare costs of different mortgage options a little later.)

A 30-year mortgage means 15 more years of debt and thousands of dollars more in interest. No thanks—go for the 15-year term, pay less in interest, and add extra payments to pay it off even faster.

Conventional vs. Unconventional Mortgages

A conventional loan is a deal between you and a lender that meets Fannie Mae’s underwriting guidelines (more on that later). An unconventional loan—like a subprime mortgage—breaks those guidelines. Unconventional loans also include government-insured programs (FHA, VA, USDA) that set their own underwriting guidelines. If the loan meets these agencies’ guidelines, they agree to buy the house if the lender forecloses on the home, so the lender won’t lose money if you don’t make payments.

Conventional Loans

• Pros: When you calculate interest and fees, your total cost is lower than an unconventional loan.
• Cons: Conventional loans aren’t backed by the government, so lenders can charge a higher interest rate or require a higher down payment (typically at least 5%) compared to unconventional loans. This type of loan also requires you to pay private mortgage insurance (PMI) if your down payment is less than 20% of the home’s value. PMI protects the lender if you default on your loan—but it doesn’t go toward paying off your home.

Subprime Mortgages

• Pros: The perceived pro is that lenders will give you money to buy a house, even if you have bad credit and no money. Subprime mortgages were designed to help people who experience setbacks—like divorce, unemployment, and medical emergencies—get a house.
• Cons: Lenders know there’s a big risk in lending money to people who have no money—go figure. So these mortgages come with crummy terms like high interest rates and stiff prepayment penalties.

FHA Loans

• Pros: With Federal Housing Administration (FHA) loans, you can get a mortgage with as little as a 3.5% down payment.
• Cons: You’re required to pay a mortgage insurance premium (MIP)—a fee similar to PMI, except that you have to pay it for the life of the loan. The only way to remove MIP is if you have more than a 10% down payment—but even then, you’ll still have to pay it for a duration of 11 years! MIP can tack on an extra $100 a month per $100,000 borrowed. If you’ve borrowed $200,000, that’s an extra $200 on top of your regular mortgage payment each month. No thanks!

VA Loans

• Pros: With Department of Veterans Affairs (VA) loans, military veterans can buy a home with virtually no down payment or mortgage insurance.
• Cons: When you purchase a home with zero money down and things change in the housing market, you could end up owing more than the market value of your home. VA loans also come with a funding fee. This fee can range anywhere from 1.25% to 3.3% of your loan, depending on your military status, down payment amount, and whether it’s your first time financing a home with a VA loan. That’s anywhere from $2,500 to $6,600 for a $200,000 loan.

USDA/RHS Loans

• Pros: The United States Department of Agriculture (USDA) offers a loan program, managed by the Rural Housing Service (RHS), to people who live in rural areas and show a financial need based on a low or modest income. With this loan, you can purchase a house with no down payment at below-market interest rates.
• Cons: You can’t refinance your loan to improve your interest rate, and the prepayment penalties are horrendous. USDA subsidized loans are designed to get people who really aren’t ready to buy a house into one. If that’s the only way you qualify, then you can’t afford a home right now.

Bottom line: Avoid the higher fees and hidden restrictions of unconventional loans. Go with a conventional loan and pay a lower total cost.

Conforming vs. Non-Conforming Mortgages

Your mortgage will either be considered a conforming or non-conforming loan, depending on how much money a lender will give you. A conforming loan is one that meets the standard underwriting guidelines (the approval process) of your specific mortgage program.

For example, guidelines for unconventional loans are determined by the FHA or VA, while government-sponsored companies like Fannie Mae or Freddie Mac provide the guidelines for conventional loans.

These companies buy loans from your lender so the lender can fund more mortgages. But they’ll only buy loans that are within the size limits established by their guidelines. If your loan size exceeds their limits and doesn’t conform to their guidelines—as is the case with a jumbo loan—it’s considered a non-conforming loan.

Conforming Loans

• Pros: With conforming loans, you’ll pay a lower interest rate compared to non-conforming loans. Recent 15-year rates are averaging under 4% on conforming and over 4% on jumbo loans.⁽¹⁾
• Cons: As mentioned already, FHA and VA loans come with extra fees and high interest rates—so your best bet is a Fannie Mae conforming loan.

Jumbo Loans (Non-Conforming)

• Pros: Jumbo loans exceed loan amount limits set by Fannie Mae and Freddie Mac, which means you can get a higher priced home.
• Cons: They require excellent credit and larger down payments, and they have higher interest rates than conforming loans.

Bottom line: A conforming Fannie Mae loan will be your cheapest option here, if you put 20% down to avoid PMI.

Reverse Mortgages

With most mortgages, you own more of your house over time. But there’s a type of mortgage that does the opposite—the reverse mortgage.

• Pros: With reverse mortgages, senior homeowners can supplement their limited income by borrowing against their home equity (the value of your home minus your current loan balance). They’ll receive tax-free, monthly payments or a lump sum from the lender.
• Cons: With this type of mortgage, you sell off your equity—the part you own—for cash. It sounds ridiculous because it is. You’re putting a paid-for home at risk—and inviting in more debt with the high fees that come along with a reverse mortgage. With a traditional mortgage, the amount you borrowed and have to repay (principal) goes down over the life of the loan. But with a reverse mortgage, the amount you actually own goes down as your interest accumulates.

Now that you know the types of mortgages and some pros and cons of each, hopefully you can see why there’s only one we recommend: the 15-year fixed-rate conventional loan. If you’re ready to start the preapproval process, find a lender you can trust. But if you need more proof on why that’s the best type of mortgage, take a look at the math.

Mortgage Cost Comparisons

Let’s compare total cost on some of the most popular types of mortgages—and see why the 15-year fixed-rate mortgage is the way to go.

In each scenario, we’ve assumed a $200,000 home purchase at a typical interest rate for each mortgage option. You can follow along using our mortgage calculator. (For simplicity, we left out property tax, homeowner’s insurance, and HOA fees on each example.)

30-Year ARM

Let’s say you come to the table with a down payment of 20% to avoid PMI and you finance the remaining $160,000 with a 5/1 adjustable-rate mortgage at an initial interest rate of 3.25%.

You’d start out paying $696 a month for principal and interest. After the first five years, we’ll say the rate bumps up by just a quarter percent each year. By the last year, your payment is up to $990, and you’d pay $147,962 in interest over the life of the loan.

30-Year FHA

With a minimum down payment of just 3.5% on a 30-year loan at 3.75% interest, your monthly payment would total $1,031. That includes $894 for principal and interest, plus $137 for MIP each month. You’d also pay $3,378 in upfront MIP at closing and $128,774 in interest over the life of the loan.

30-Year VA

Let’s say you put no money down on a 30-year mortgage at 3.5% interest. For this example, we’ll assume your VA funding fee is $4,300 and you finance it into your loan because you don’t have any extra cash on hand. That means your monthly payment would be $917 and your total interest paid would come to $125,963.

30-Year Fixed-Rate Conventional

If you put 5% down and finance the rest with a 30-year fixed-rate mortgage at 3.875% interest, you’ll pay $893 a month in principal and interest, plus PMI, which we’ll calculate at 0.5% (or $79/month) for this example. Your total interest paid would come to $131,642 by the time your mortgage is done, and your PMI would automatically drop off after a little over 8.5 years.

15-Year Fixed-Rate Conventional

If you put 20% down on a 15-year fixed-rate mortgage at 3.125% interest, your monthly payment would be $1,115 and you’d pay $40,624 in total interest. That saves you anywhere from $85,000 to $107,000 in interest charges alone! Imagine what you could accomplish with that kind of money in your pocket!

Bottom Line: 15-Year Fixed-Rate Conventional Loan Saves the Most Money

If we stack these five mortgage options against each other, it’s easy to see where the costs add up. For instance, the 30-year 5/1 ARM accrues the most interest of the bunch, while the 30-year FHA packs the highest fees.

Get a Smart Mortgage

Now that you know the math, don’t get a home with a mortgage that’ll crush your financial dreams. To help get the process started, connect with our friends at Churchill Mortgage. They’re a trusted lender who actually believes in debt-free homeownership. After that, be sure and connect with a top notch real estate agent who will keep your best interests in mind and focus on serving you first in your search for the perfect home.

Source: daveramsey.com ~ Image: daveramsey.com