How to Choose the Right Mortgage and Secure Your Financial Future

Becoming a homeowner is arguably one of the most crucial decisions anyone will make. It is one of the most substantial commitments in terms of time and likely the most significant financial decision most people will have. Buy the right home with the best mortgage, and you'll probably be on your way to financial security; take on a bad mortgage, and you could quickly find yourself in a financial predicament. Choosing the right mortgage is essential to ensuring your financial success.

Of course, with so many lenders and mortgage options, figuring out the best mortgage for your situation can be daunting. Here are five tips to help you choose the mortgage that will put you in the best financial position.

1. The Right Mortgage Depends on Your Down Payment

The right mortgage for your situation depends heavily on your expected down payment.

Broadly, there are four primary mortgage types: conventional, FHA, VA, and USDA. Each one has different down payment requirements.

It's typically easiest to secure a conventional loan with 20% down. However, getting one for as little as 3% down is possible. For example, if you're buying a $500,000 home, lenders make it relatively easy to get a loan if you have $100,000 as a down payment. Getting one for as little as $15,000 down is possible if you meet more stringent requirements. You should expect to face more scrutiny in the underwriting process if you're putting less than 20% down.

Jumbo loans, or loans that exceed the conforming loan limits defined by the FHFA, almost always require at least 10% down, and lenders strongly prefer 25% or even 30%. If you're buying a home in an expensive area, expect to need a down payment between 10% and 30% of the home's value for a conventional loan.

FHA mortgages are loans backed by the Federal Housing Authority. They require as little as 3.5% down. Upper limits on these loans vary from county to county, depending on the overall cost of housing. The upper limit in the Bay Area is over $1 million, while the upper limit in the middle of Colorado might be $500,000. The FHA updates these limits every year, adjusting them for inflation.

VA loans are only available for veterans or active-duty military members. USDA loans are only available for agricultural properties. It is possible to get either of these mortgages with no money down.

When looking at mortgages, consider these four options to see which ones you could obtain. If you have 1% down, you know that USDA and VA loans are your only options if you qualify for them. However, if you have 20%, all loan types are possibilities. Usually, the more you have as a down payment, the better your mortgage options.

2. Avoid PMI If Possible

Once you have narrowed down your possible mortgage options, you'll need to consider private mortgage insurance, or PMI, for short.

Lenders require PMI when you have less than 20% down. The idea behind private mortgage insurance is that if you default on the loan, the insurance will pay for the bank's potential losses.

PMI is expensive, averaging between 0.5% to 1.5% of the original loan amount per year. If you borrow $500,000 on a $525,000 home, as is permissible with conventional and FHA loans, you'll be looking at anywhere between $2,500 and $7,500 per year in PMI. That's between $200 and $600 monthly on top of your principal, interest, property taxes, and insurance.

With conventional loans, you'll usually pay PMI until you have 20% equity in the property, at which point the bank will drop this insurance. Some mortgage agreements state that PMI exists for the life of the loan, so you would have to refinance to remove it.

USDA and VA loans don't have PMI. FHA loans have PMI for the duration of the loan. If you choose an FHA mortgage, you must refinance later to remove this monthly charge.

If you can avoid PMI, that's often the best option. Taking the mortgage and paying PMI may make sense if you only have 5% down and you're buying a home with the potential for significant appreciation. However, if you're at 18% down, saving that extra 2% to have 20% and avoid the additional charge is often the better decision.

3. Know Your Credit Score

Your credit score is one of your tickets to the right mortgage for your financial future. Remember that many mortgages are 15-year or 30-year terms, but lenders will offer you an interest rate based on your credit score today. Unless you refinance, that interest rate will stick with you for the life of the loan.

Conventional loans often require a minimum credit score of 620. However, applying with a low score will result in a suboptimal rate. Below 680 typically results in an interest rate at least 0.5% higher than the best. Between 680 and 740 usually yields an interest rate slightly above the best. A credit score above 740 usually means you'll have the lowest interest rate on your mortgage.

FHA loans have a minimum credit score requirement of 580 to put down 3%. Credit scores between 500 and 580 require 10% down and have higher rates. VA loans have no minimum score requirements, while USDA loans require at least 640.

Consider the following two scenarios. Alice applies for a mortgage with a 650 credit score and receives a loan for 5% over 30 years. Bob applies for a mortgage with a 720 score and gets approval for a loan with the same duration but at 4% interest. Both loans are for $500,000.

In this hypothetical scenario, Alice will pay $466,330 in interest over 30 years. Bob will only pay $359,373, a difference of over $100,000. Alice will pay over 20% of the original property's value more in interest than Bob.

If you have a credit score below 680 with relatively easy fixes, you may wish to boost your score before securing a mortgage. For example, if your low score is due to high balances on your cards, you may want to lower those balances over the next few months before applying for a mortgage.

Taking two or three months to fix your credit score could save you thousands in interest and set you up for financial success.

4. Consider Your Long-Term Goals

Your long-term goals can help you choose the right mortgage. In particular, you'll want to envision where you see yourself living in the next five, 10, or even 30 years. Is this a place you're buying as your "forever home," or are you buying for the next three to five years to start building some equity?

Most homeowners choose fixed-rate 15-year or 30-year mortgages because of their predictability in monthly payments. There are adjustable-rate mortgages (ARM), though, with the same amortization period but a lower interest rate. With these loans, you have to refinance them every few years.

If you plan on staying in this house for a long time, choosing an ARM is dangerous as you could find yourself in a bind where you need to renew your mortgage, and interest rates have shot up, dramatically increasing your monthly payment.

However, if you only plan on remaining in the property for a few years, an ARM may make more sense as you save on interest. With less money going out monthly, you can keep more towards the home you want for the next 30 years.

If you believe this home will be what you live in for a long time, lock in that 15-year or 30-year fixed-rate mortgage so you have a fixed monthly payment. An ARM rarely makes sense in that scenario. However, if this is a short-term purchase, consider an adjustable-rate mortgage. It affords you a lower interest rate and the ability to save more toward the home you want.

5. Compare Rates Across Lenders

Once you know the type of mortgage you want, you can start comparing rates across lenders. Many lenders not only have different interest rates, but they can also have different rules for calculating your debt-to-income (DTI) ratio. One lender may be unable to give you a loan with more than 43% DTI, while another may be more lenient and underwrite with as high as 50%. Lenders each have their unique processes.

The easiest way to better understand what rate you'll receive is to request pre-approval from your preferred lender. During this process, you'll state your income, and the lender will pull your credit report to get a list of your current debts. Based on this information, the bank will decide whether they would issue a mortgage, and they also include the interest rate.

Pulling your credit score too often will slightly lower it, but if you go through the pre-approval process with two or three lenders, you'll likely find that one offers the lowest rate. Choosing that lender can save you thousands in interest over the loan's term.

Choosing the Right Mortgage Will Secure Your Financial Future

Selecting the right mortgage is crucial to your financial well-being. If you choose a mortgage that costs too much or has unfavorable terms considering your broader goals, you could regret the decision altogether. Make sure the mortgage you want makes sense, given your down payment, credit score, and general goals. If possible, avoiding PMI and comparing lenders makes sense so you don't get stuck with a mortgage that costs too much interest.

Considering these tips, you can choose the best mortgage to secure your financial future and help you reach your broader life goals.