Which combination of factors would result in the lowest monthly mortgage payment? Great question! Let me first break down the factors that impact your monthly payment, then we’ll talk about the kinds of borrowers who tend to get the lowest (and highest) mortgage payments.
The factors that influence your payment
There are several factors that can potentially impact your monthly mortgage payment. Among them are loan term, loan purpose (purchase, rate/term refinance, “cash out” refinance), interest rate, interest-only, escrows/impounds, mortgage insurance, and funding fees. Let’s cover each factor in more detail.
The three main types of mortgages in the United States today are conventional, FHA, and VA.
Conventional loans are non-government-insured and usually underwritten to Fannie Mae and Freddie Mac lending standards (though they don’t have to be). When you hear mortgage rates quoted in news reports, you’re usually hearing about conventional mortgage rates.
FHA and VA loans are funded by private banks, but backed by the federal government. FHA loans are insured by the Federal Housing Administration (FHA) and VA loans are backed by the Veterans Administration.
Conventional, FHA, and VA mortgages tend to price out differently, which means their rates and costs vary. They also have different requirements when it comes to mortgage insurance (more on that in a moment).
Conventional loans tend to have some of the best interest rates on the market. They usually make the most sense for non-veteran borrowers with excellent credit and financial profiles.
FHA loans tend to make the most sense for non-veteran borrowers with limited income and/or fair credit. Contrary to popular belief, FHA loans are not the automatic choice for first-time homebuyers. Many first-time buyers go with conventional loans and many experienced homebuyers go with FHA loans. It just depends on a particular borrower’s qualifications.
VA mortgages usually make the most sense for veterans who have fair to excellent credit and financial profiles. VA streamline refinances in particular tend to have the most aggressive interest rates on the market.
The purpose of the mortgage can impact the interest rate, which of course impacts the payment. Purchases and so-called rate/term refinances tend to get the lowest rates and lowest costs.
“Cash out” refinances are considered riskier from a lending standpoint, so they tend to come with higher rates and costs.
One of the most important factors that impacts your monthly mortgage payment is the loan term. Generally speaking, the longer the loan term, the lower the monthly mortgage payment.
Most mortgage lenders in the United States offer up to a 30-year term, but some lenders have offered as long as a 40-year term in years past. At one time, borrowers in Japan could even get a 100-year mortgage! How insane is that?
If you want the lowest possible payment, then you’ll likely opt for the longest loan term possible. In most cases, that will be a 30-year term.
This is an obvious one, right? Generally speaking, the lower the rate, the lower the payment. When you have a lower interest rate, less interest has to be paid with each monthly mortgage payment. This reduces your overall mortgage payment.
The more you borrow, the bigger your payment will be. ‘Nuff said on that, right?
Interest-only mortgages are rarer today than in the past. When your loan is “interest-only”, it means you’re only required to pay the accrued interest every month. Because you’re not paying toward the principal, your payment is lower than what it would be if it included both principal and interest.
Escrows (or impounds)
When lenders “escrow” (or “impound”) your property taxes and homeowner’s insurance, they add them to your monthly mortgage payment. Basically, the lender takes the total annual dollar amount of your property taxes and homeowner’s insurance, divides it by 12, and adds the resulting amount to your monthly mortgage payment. Every time you make a mortgage payment, the part of the payment for the taxes and insurance gets diverted into an escrow account. When the taxes and insurance come due, the lender makes the payment on your behalf.
Lenders like escrows because it reduces their risk in the mortgage. They know the property taxes are being paid, which eliminates the risk of a property tax foreclosure by the county. The lender knows the insurance is getting paid, which helps protect them in the event of a fire or natural disaster.
Obviously, the cost of your property taxes and homeowner’s insurance will have an impact on your monthly mortgage payment if you have escrows.
If you’re in a flood zone, the lender may require you to also carry flood insurance, which can significantly increase your homeowner’s insurance costs.
Depending on the loan-to-value and whether your loan is FHA or conventional, you may or may not have to pay mortgage insurance. Mortgage insurance is an extra premium added to your monthly payment to insure the lender against loss if you stop making your payments.
For conventional loans, mortgage insurance is only required if the loan-to-value is greater than 80% of the home value (for refinances) or sales price (for purchases).
For FHA loans, mortgage insurance is required regardless of loan-to-value. In other words, all FHA mortgages currently require mortgage insurance.
Mortgage insurance does not apply to VA loans, regardless of loan-to-value.
To see how mortgage insurance works, let’s look at an example. Let’s say you’re putting down 10% on a new home and financing with a conventional loan. Because you’re putting down 10%, the loan-to-value is 90% (100% minus your 10% down payment). Because the loan-to-value is higher than 80%, mortgage insurance will be applied to the loan.
So, how do you avoid mortgage insurance? If you’re a veteran, you avoid it by using VA financing.
If you’re not a veteran, you avoid mortgage insurance by keeping your credit scores strong (usually at least 700 to 720 or better) and saving up at least a 20% down payment.
If your credit scores are below 700 and you’re not a veteran, your best option may be FHA financing. FHA financing is usually better for borrowers with fair credit (scores between 620 and 699), but the downside is the mandatory mortgage insurance. FHA mortgage insurance tends to be expensive compared to conventional mortgage insurance, particularly on large loan amounts.
Funding fees typically only apply to VA mortgages, but they can be expensive. Funding fees are usually rolled into the new loan amount (whether you’re refinancing or purchasing), which increases your loan balance by thousands (or tens of thousands on large loan amounts). Naturally, a higher loan amount means a larger monthly mortgage payment.
If you’re a disabled veteran, you’re likely exempt from the VA funding fee.
Which combination of factors results in the lowest (and highest) monthly mortgage payment?
So, which combination of factors results in the lowest payment? In our experience, the lowest possible mortgage payments in today’s market goes to borrowers who fit the following profile:
- Disabled veteran (and funding fee exempt)
- Purchase or rate/term “streamline” VA refinance (which, remember, doesn’t require mortgage insurance)
- Modest loan amount
- Modest taxes and insurance (and no flood insurance)
Again, streamline VA refinances tend to get some of the most aggressive rates on the market – even for borrowers with marginal credit.
The only possible way to get an even lower payment than the borrower above would be to go with interest-only, which isn’t available on the vast majority of the most common mortgage products.
On the flipside, the worst payments go to borrowers who fit the following profile:
- Purchase mortgage with minimum down payment in an expensive housing market
- Marginal financial and credit profile
- High taxes and insurance (even worse if in a flood zone)
Non-veteran borrowers with marginal credit and finances often go with FHA loans, which have expensive mortgage insurance premiums. Such borrowers often put down the minimum, which means they end up with huge loan amounts and massive mortgage payments. I’ve seen large FHA loans where the mortgage insurance alone is over $500 per month. Ouch!
If you want to keep your mortgage payment low
Obviously, we’re not all veterans. If you are, I recommend looking first at a VA loan. You’ll probably get some of the best financing terms available.
If you’re not a veteran, then the best way to keep your mortgage payment as low as possible is to keep your credit strong and save up at least a 20% down payment. You’ll want to go with a conventional 30-year fixed that doesn’t have mortgage insurance.
Regardless of the loan type, another good way to keep your payment down is to buy in a modestly-priced area. A cheaper house means a smaller loan and lower tax and insurance costs.
You’ll also want to avoid flood zones. Flood insurance can be insanely expensive and is best avoided where possible. I’ve worked with homeowners who were paying as much as $10,000 per year for their flood insurance. Yikes!