Homeownership can be both rewarding and a great financial decision for your future. But as anyone who has dipped their toes into the home-buying process knows, the pressure to find and secure the “right” mortgage loan can feel overwhelming, especially if you’re a first-time home buyer.
During the early stages of the home-buying process—perhaps while you’re researching neighborhoods and schools, shopping around for properties, and nailing down the details of your budget—it would serve you well to do some research into the types of mortgages available. That way, you’ll feel prepared when the time comes to put down an offer on the perfect home.
The process of applying for a mortgage loan can be complicated, and one of the first steps for a homebuyer is to decide which type of loan will best serve his or her needs.
Some mortgage applicants are first-time homebuyers, seeking to buy a home as a primary residence, while others are seasoned residential homebuyers, with experience purchasing homes primarily for investment purposes in the form of rent revenue and asset appreciation.
As you’ve likely noticed, there are quite a few mortgage loan types available to borrowers. Brace yourself, because the process definitely requires you harness your best inner comparison shopper.
You’ll need to consider the ins and outs of each option alongside your personal and financial needs. To help make the decision a bit easier, we’ve compared the advantages and disadvantages of each mortgage type below.
Fixed Rate Loans vs. Adjustable Rate Loans
Fixed rate mortgage loans are exactly what they sound like: the interest rate is fixed for the entire life of the loan, locking a borrower into a set interest rate. The length of fixed rate loans can vary, but two of the most common time frames are 15 and 30 years.
A 30-year fixed-rate loan is the most common, though you can save a lot in interest if you opt for a 15-year loan. Monthly payments on a 15-year loan will be much higher than for a 30-year mortgage, so it’s probably wise to commit only if you’re confident that it works in your budget—even in the event of a financial emergency.
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One advantage of this type of loan is that the monthly payment is fixed for the entire term, which can make budgeting predictable and therefore easier. However, one downside is that if you take out a loan when interest rates are high, you’re locked into that higher rate for the entire term of the loan—unless you refinance.
If you have a high fixed rate mortgage loan in a low interest rate environment, you may be able to refinance your mortgage when interest rates drop. Of course, there is no guarantee you will qualify to refinance in the future, nor that rates will necessarily drop or stay low.
Adjustable rate mortgage (ARM) loans have an interest rate that changes throughout the life of the loan as interest rates fluctuate. ARMs generally have an initial fixed-rate period of between 5 and 10 years, during which the interest rate is fixed.
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ARMs are often expressed in two numbers (like 5/1 or 2/28), although those numbers don’t follow one particular formula (they could represent years, months, number of annual payments, etc.). For example, a 5/1 ARM has five years of fixed payments and one adjustment to the interest rate in each year thereafter.
After the fixed-rate period of an ARM, the interest rate switches to variable. The variable rate is typically set based on a benchmark index rate that varies based on market conditions. During the fixed-rate period, the interest rate is usually lower than the interest rate on a traditional fixed-rate loan.
It’s easy to be drawn to the lower initial rate offered on an ARM, but it very well could end up costing more in interest than a fixed-rate loan over the lifespan of your mortgage. An ARM might work best for someone who plans to pay off their mortgage in five years or less, or is committed to refinancing prior to the ARM’s rate increase.
Rate increases in the future could be dramatic, although there are limits to the annual and life-of-loan adjustments, typically leaving adjustable-rate mortgage-holders with much higher monthly payments than if they had committed to a fixed-rate mortgage.
Deciding to go with an ARM or fixed rate mortgage may be a different process for every homebuyer, so be sure to consider your personal situation along into your research.
Conventional Loans vs. Government Insured Loans
A conventional loan is a mortgage loan originated by a bank or private lender, and is not backed or insured by the government. Banks and lenders typically look at credit scores and debt-to-income ratio, among other factors which will vary by lender, in evaluating conventional loan applications. Down payments (up-front cash) are usually required when taking out a conventional mortgage.
Conventional mortgage loans are one of the most popular types of mortgage used today. Conventional loans may have stricter requirements than government-backed home loans, which can make them slightly more difficult to qualify for than a government-backed loan. However, some borrowers may obtain conventional loans for a second home or investment property because most government-backed mortgages can only be used to purchase primary residences.
Minimum down payments for conventional mortgage loans are typically around 5%, but many borrowers choose to pay more in cash up-front in order to decrease the size of the remaining mortgage. Conventional fixed-rate mortgage loans typically require a minimum of a 620 FICO® credit score and a down payment between 5% and 20% (first-time homebuyers may be able to put down as little as 3% .
If you put less than 20% down, however, private mortgage insurance is required—but you have options. PMI can be paid monthly or can be an upfront premium that can be paid by you or the lender. Monthly PMI needs to stay in place until your loan-to-value ratio reaches 78%. (The loan-to-value ratio is the amount of the mortgage you are applying for relative to the appraised value of the home. The more money you put down, the lower your loan-to-value ratio is, and vice-versa.)
Pros: A variety of property types would qualify for a conventional mortgage. Private mortgage insurance can make it possible for borrowers to qualify for a conventional loan if they choose to put a down payment of less than 20%.
Cons: Conventional loans tend to have stricter requirements for qualification and may require a higher down payment than government loans.
For home buyers looking for more flexible lending standards, government-backed loans such as Federal Housing Administration (FHA) loans and Department of Veterans Affairs (VA) loans for veterans can be appealing options.
Federal Housing Authority (FHA) Loans
FHA loans are not directly issued from the government; certain lenders can issue FHA loans on behalf of the government and the Federal Housing Administration insures the loans. With flexible lending standards, qualifying for an FHA loan is often less difficult than qualifying for a conventional mortgage.
As such, FHA mortgages can be a great choice for people with less than stellar credit scores or a high debt-to-income ratio. With at least a 580 FICO® credit score, you might qualify with a a 3.5% down payment . For more important details, check out the FHA’s lending limits in your state. Generally, FHA mortgages come with an additional insurance charge called a “mortgage insurance premium.”
Pros: Because FHA loans are ubiquitous and have lower down payment and credit score requirements, they are one of the most accessible mortgage loans. FHA loans give potential homeowners a chance to buy without a big down payment. Additionally, FHA loans allow a non-occupant co-signer (as long as they’re a relative) to help borrowers qualify.
Cons: Historically, the requirements for FHA mortgage insurance have varied over the years. Currently, an FHA loan requires both an up-front mortgage insurance premium (which can be financed into your loan amount) and monthly mortgage insurance. The monthly mortgage insurance generally stays in place until the loan-to-value ratio reaches 78%.
The U.S. Department of Veteran Affairs provides loan services to members and veterans of the U.S. military and their families. If you are eligible , you could qualify for a home loan that requires no down payment or monthly mortgage insurance.
VA mortgages are designed to help veterans purchase homes with no down payment. VA loans are provided by banks and private lenders. Similar to FHA loans, the government doesn’t directly issue these loans, instead they are processed by banks or private lenders and guaranteed by the VA.
While VA loans are attractive because they typically require no down payment, they don’t have a maximum limit, depending on eligibility. Veterans, active-duty service members, and surviving spouses are eligible for VA mortgage loans.
Pros: You don’t have to put any money down or deal with monthly PMI payments, which could save borrowers thousands per year.
Cons: These loans are great to get people in homes, but are only available to veterans.
FHA 203k Rehab Loans
FHA 203k loans are home renovation loans for “fixer-upper” properties, helping homeowners finance both the purchase of a house and the cost of its rehabilitation through a single mortgage. Current homeowners can also qualify for an FHA 203k loan to finance the rehabilitation of their existing home.
Many of the rules that make an FHA loan relatively convenient for lower-income borrowers apply here, such as requiring just 3.5% down. An FHA 203k loan does not require the space to be currently livable and it has credit score requirements similar to regular FHA loans, however some lenders may require a minimum credit score of 620 to qualify.
Many types of renovations can be covered under an FHA 203k loan: structural repairs or alterations, modernization, elimination of health and safety hazards, replacing roofs and floors, and making energy conservation improvements, to name a few.
Pros: They can be used to buy a home and fund renovations on a property that wouldn’t qualify for a regular FHA loan. And they only require a 3.5% down payment.
Cons: These loans require you to qualify for the value of the property plus the costs of any planned renovations.
Conforming Loans vs. Non-Conforming Loans
Both conforming and non-conforming mortgages are types of conventional mortgages. A conforming loan meets certain guidelines established by the Federal Housing Finance Agency (FHFA) and Fannie Mae and Freddie Mac, but they are not insured by the government. The amount a buyer can borrow is limited, and that limit changes annually, based on federal guidelines.
As of 2020, the conforming loan limit is $510,400 in most of the U.S. and goes up to $765,600 in certain higher-cost areas, and is adjusted annually. Conforming loans offer better interest rates and lower fees than non-conforming loans.
Pros: Conforming loans may have lower interest rates and fees than non-conforming loans.
Cons: Limits on the amount that can be borrowed.
Non-conforming loans are loans that fall above the conforming loan limit set by the FHFA. There are several different types of non-conforming loans. The most common is a jumbo loan.
A jumbo loan is a loan that exceeds the conforming loan limit. Due to the size of the loan, the requirements to qualify are more stringent. Most jumbo loans require a minimum FICO® credit score above 700 or 720 and a down payment of 10%, although specific requirements will generally vary by lender.
Interest rates can also be higher for jumbo loans because they are considered more risky to the lender. Other types of non-conforming loans exist for borrowers with credit scores on the lower end, or borrowers with a high debt-to-income ratio.
Those looking to fund an expensive property purchase will likely have little choice but to use a jumbo loan. If that’s you, it might require taking some time to get your credit score in good shape.
Pros: Jumbo loans can help qualified borrowers purchase expensive properties.
Cons: Qualifying for a jumbo loan may have stricter requirements or additional fees.
Each homebuyer is unique, so taking the time to fully understand the process of selecting the right mortgage for your needs is a critical first step.
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