Buying a home is a great feeling, but understanding the financing part of it can feel a bit overwhelming. Don't worry about it. Choosing one of the different types of mortgage loans isn’t all that confusing if you do a little homework. Once you’ve done some due diligence and figured out a budget and down payment amount, you’ve worked on your credit, you will have a better idea of which loan works best for what you are trying to accomplish.
The following are some of the most common types of mortgages:
1. Conventional mortgages
A conventional mortgage is a home loan that’s not insured by a government entity. There are two types of conventional loans: conforming and non-conforming loans.
A conforming loan simply means the loan amount falls within maximum limits set by the secondary mortgage market (i.e.. Fannie Mae or Freddie Mac), and any other government-sponsored enterprises (GSEs) that secure most U.S. mortgages. The types of mortgage loans that don’t comply with these guidelines are considered non-conforming loans. Jumbo loans, which we'll discuss later, are the most common type of non-conforming loan.
For the most part, lenders require you to pay private mortgage insurance on conventional loans if your down payment is 20% or less than the purchase price of the property.
Pros of conventional mortgages
Overall borrowing costs are usually less than other types of mortgages, even with slightly higher interest rates
Can be used for a primary home, second home or investment property
Once you’ve gained 20 percent equity, you can ask your lender to cancel PMI
You may only need as little as 3% down payment for loans backed by Fannie Mae or Freddie Mac
Cons of conventional mortgages
There is requirement of a minimum FICO score of 620 or higher
Your debt-to-income ratio needs to be 45 percent to 50 percent
You'll have to pay PMI if your down payment is less than 20% of the purchase price
You'll need to provide a lot of documentation in order for the lender to verify income, assets, down payment, and employment
Who is the best candidate for this type of loan?
Usually, borrowers with strong credit, a stable income and employment history, and a significant down payment are the ideal candidates for this type of loan.
2. Government-insured mortgages
The U.S. government plays a role in assisting Americans become homeowners. Three government agencies back mortgages: the U.S. Department of Agriculture (USDA loans), the U.S. Department of Veterans Affairs (VA loans), and Federal Housing Administration (FHA loans)
FHA loans – FHA loans help make homeownership possible for people who don’t have a large down payment saved up and don’t have the best credit. Borrowers need at least a FICO score of 580 to get the FHA maximum of 96.5% financing with a 3.5% down payment; however, a lower FICO score may be acceptable if you put at least 10% down. FHA loans require two mortgage insurance premiums: one is an upfront payment, and the other is an annual payment and is paid for the life of the loan if you put less than 10% down. This will likely increase the overall cost of your mortgage.
USDA loans – USDA loans help moderate- to low-income borrowers buy homes in rural areas. You have to purchase a home in a USDA-eligible area and meet certain income limits to qualify. Some USDA loans require a $0 down payment for eligible borrowers.
VA loans – VA loans provide flexible, low-interest mortgages for active duty and veterans members of the U.S. military and their families. There is a $0 down payment required and no requirement for PMI. In addition, there is a cap on closing costs which also could be paid by the seller of the property. In a VA loan, the funding fee is charged as a percentage of the loan amount which would offset the program’s cost to taxpayers. This fee and any additional closing costs, can be integrated with most VA loans or paid upfront at closing.
Pros of government-insured loans
Those that don’t qualify for a conventional loan have a better chance for financing a home
Credit requirements are less stringent
The required down payment is less than that of a conventional loan
They are available for first-time and repeat buyers
Cons of government-insured loans
There are mandatory mortgage insurance premiums that can't be canceled on some mortgage loans
The overall borrowing costs are a lot higher
In order to prove eligibility, expect to provide more documentation, depending on the loan type
Who should get one?
Government-insured loans are best if you have low cash savings, okay credit, and can’t qualify for a conventional loan. VA loans tend to offer the best terms and most flexibility for military borrowers.
3. Adjustable-rate mortgages
Adjustable-rate mortgages (ARMs) have fluctuating interest rates that can go up or down depending on market conditions. A lot of ARM products have a fixed interest rate for a couple of years prior to the loan changing to a variable interest rate for the remainder of the term. It would probably be best to look for an ARM with a cap the amount your interest rate or monthly mortgage rate can increase so you don’t end up in a financial bind when the loan resets.
Pros of adjustable-rate mortgages
You may save a decent amount on interest payments
You’ll enjoy a lower fixed rate in the first couple of years of homeownership
Cons of adjustable-rate mortgages
Later on in your mortgage amortization schedule, as a result of the increased interest amount, your monthly mortgage payments could become unaffordable, resulting in a loan default
After a while home values may decline, making it harder to sell your home or refinance before the loan resets
Who should get one?
Assess your level of comfort when it comes to risk before getting an ARM. If you don’t plan to stay in your home for a long time, an ARM could save you big on interest payments.
4. Fixed-rate mortgages
Unlike the ARM, a fixed-rate mortgages maintains the same interest rate over the life of the loan, which means the monthly mortgage payment will remain the same throughout the life of the loan. Fixed loans typically come in terms of 15, 20, or 30 years.
Pros of fixed-rate mortgages
Your monthly principal and interest payments stay the same throughout the life of the loan
Your monthly expenses are more predictable and you can budget accordingly and more precisely
Cons of fixed-rate mortgages
You’ll almost definitely pay more interest with a longer-term loan
The amount of time it takes to build equity in your home is increased
Fixed interest rates are typically higher than rates on ARMs
Who should get one?
If you plan to stay in your home for a minimum of 7-10 years, a fixed-rate mortgage offers stability with your monthly payments.
5. Jumbo mortgages
Jumbo mortgages are conventional types of mortgages that have non-conforming loan limits. This means the home price is more than the federal loan limit. For 2020, the maximum conforming loan limit for single-family homes in a majority of the U.S. is $510,400. In certain high-cost areas, the limit is $765,600. Jumbo loans are commonly used in higher-cost locations, and qualifications generally require more in-depth documentation.
Pros of jumbo mortgages
If you want to buy a home in an expensive area, you can borrow more money
Interest rates are just a good as with other conventional loans
Cons of jumbo mortgages
They require a higher down payment of at least 10 to 20%
You'll need a good FICO score of 700 and up, though some lenders will accept a minimum score of 660
Your debt-to-income ratio needs to be less than 45%
You may need to prove that you have significant assets (generally 10% of the loan amount) in cash or savings accounts
Who should get one?
Jumbo loans make sense for more well off buyers the want to buy a high-end home. Jumbo borrowers should have the best credit, a high income and a large down payment.
You can use a mortgage calculator to determine how much you can afford to spend on a home.
Other types of home loans
In addition to these common kinds of mortgages, there are other types you may find when searching for a loan including:
Construction loans: A construction loan can be a good choice if you want to build a home. You can determine if you should get a separate construction loan for the project and then a separate mortgage to pay it off, or combine the two together. You more than likely need a higher down payment for a construction loan and proof that you can afford to pay it back.
Interest-only mortgages: With an interest-only mortgage, the borrower pays only the interest on the loan for a certain amount of time. Upon completion of that time period, between five and seven years, the monthly payments increase as you start paying your principal. You won’t build equity as quickly with this type of loan because you’re only paying interest initially. These loans are best for those who know they can sell or refinance, or for those who can reasonably expect to afford the higher monthly payment later on in the loan term.
Balloon mortgages: This type of mortgage requires a large payment at the end of the loan term. For the most part, you’ll make payments based on a 30-year term, but only for a short time, such as seven years. You’ll have to make a large payment on the outstanding balance at the end of that time which will be a substantial amount.
You should consider your financial situation carefully before moving forward with mortgage loan. Consider your circumstances and needs, and do your due diligence so you know which types of mortgage loans will help you reach your goals.