Most house purchasers look at many houses before they make a decision, weighing multiple features of one against the other. In contrast, the decision about which of numerous mortgage options to select often is made hastily with little thought. Yet borrowers have to live with their mortgage indefinitely, often for as long as they have the house.
Here are some general observations about the options available in 2018 and how individual borrowers can find the one that is best for them.
In one respect, the problem is a little simpler in 2018 than it was before the financial crisis because the riskiest options and loan types are no longer available. These include interest-only and negative-amortization options, the 40-year term and adjustable-rate mortgages with initial interest rates that hold for very short periods. Some of these options may be available in the subprime market or on jumbo loans, which are those too large for purchase by Fannie Mae or Freddie Mac.
Nonetheless, the U.S. remains an outlier in its wide range of options offered borrowers. These include fixed-rate mortgages (FRMs) with terms of 10, 15, 20, 25 and 30 years, and 30-year adjustable-rate mortgages (ARMs) with initial rate periods of 5, 7 and 10 years. Most of these options are available on both FHA loans, which are insured by the government, and conventional loans eligible for purchase by Fannie Mae and Freddie Mac.
The general decision rule. To choose among the options, home buyers should select the type of mortgage that results in the lowest total cost over the entire period they have the mortgage, subject to the conditions that the initial payment is affordable and that the risk of future payment increases is tolerable. While few borrowers know exactly how long they will have their mortgage, an estimate of the cost based on their best guess of their tenure is far better than basing the decision on the interest rate or the initial monthly payment, which can easily lead a borrower astray.
Selection between conventional and FHA. Borrowers who qualify for both FHA and conventional loans are often presumed to be better off with conventional, but that is not necessarily the case. I found that over any time horizon, borrowers had lower costs on FHA if their credit score was 700 or less with a 5 percent down payment, and 660 or less with a down payment of 10 percent. In all other cases, the conventional loan had lower costs.
General guidance on mortgage type selection is better than no guidance, but the exceptions noted above point to the limitations. There is no substitute for direct access to a cost calculator by the individual borrower. To use mine, borrowers enter the required information about their transaction, and the program calculates total cost over the period they specify for every type of mortgage, at the best mortgage prices posted that day by the lenders who deliver prices to my site. For ARMs, the program also shows the total cost and monthly payment on a worst-case interest rate scenario. In sum, it shows everything the borrower needs to know to make the best choice.