The 5 Main Types of Mortgages: Which Is Best?
For most families, buying a home is one of the biggest purchases they’ll ever make. So, to say you need to have an idea of how the process works and what options are available to you is an understatement. After all, when you buy a home, you will be forced to live with your decisions, so you want to make the best choices possible for you and your family.
Making the best decision matters throughout every state of the home buying process, from choosing which home to buy to choosing what type of mortgage you want to use to finance it. It is this latter point that we will discuss here. There are five primary types of mortgages to pick from. Here’s what to expect from each in terms of their guidelines, so you can do your due diligence and choose the one that best meets your needs.
#1: Conventional Loans
Conventional loans are mortgages that are not secured by the federal government. As a result, these types of loans can come in a wide range of sizes and types, so they can suit the needs of a lot of different buyers.
Conventional loans come in two formats – conforming and non-conforming. True to its name, a conforming loan follows the set of standards put in place by the Federal Housing Finance Agency (FHFA). This includes credit, debt, and loan size. Non-conforming loans, on the other hand, do not meet FHFA standards. Instead, these types of conventional loans are more suited to borrowers with unusual credit profiles and/or those looking to purchase homes priced well above the FHFA size standard.
Advantages of Conventional Loans:
- Can be used to purchase a primary home, a second home, or an investment property
- Interest rates tend to be lower than other types of mortgages
- Buyer can avoid paying private mortgage insurance (PMI) by putting 20% or more down
- Loans backed by Fannie Mae or Freddie Mac can be acquired with little as 3% down
- Sellers can contribute to closing costs
Disadvantages of Conventional Loans:
- A credit score of 620 or higher is required by most lenders
- Requires a higher down payment than most government-backed loans
- A debt-to-income (DTI) ratio of no more than 43 percent (50 percent in some special instances) is required by most lenders
- PMI is added to the monthly payment if the down payment is less than 20% of the sale price
#2: Fixed-Rate Loans
A fixed-rate mortgage loan is one that keeps the same interest rate over the life of the loan. This means that your monthly mortgage payment will be the same from your first payment to your last. Fixed loans are available in a wide range of terms, typically between 8 and 30 years, however loans with 15 year and 30 year terms tend to be the two most common.
These types of loans are popular because they are easiest to budget for thanks to their consistent payment amounts, but should interest rates fall, you would have to refinance your loan to get the lower rate.
#3: Government-Backed Loans
A government-backed loan is one that the federal government guarantees, and this guarantee makes homeownership more accessible to more Americans. These types of mortgages are backed by one of three government agencies: the Federal Housing Administration (FHA), the U.S. Department of Agriculture (USDA), and the U.S. Department of Veterans Affairs (VA).
FHA loans are popular among first time home buyers because they come with competitive interest rates, and they don’t require large down payments or pristine credit. Most applicants can get approved with at least a credit score of 580 and a 3.5% down payment. However, FHA loans can still be acquired with a score as low as 500 if the borrower puts at least 10% down. As with conventional loans, an FHA loan allows the home seller to contribute to closing costs, but this type of loan requires two mortgage insurance premiums, and this can ultimately increase the overall cost of the mortgage.
USDA loans are designed to help moderate- to low-income borrowers buy homes in rural, USDA-eligible areas. These loans do not require a down payment for eligible borrowers, but there are extra fees included that most conventional loans don’t have, such as an annual fee and an upfront fee of 1% of the loan amount (which can typically be financed into the loan).
VA loans are flexible, low-interest mortgages that are only available to members of the U.S. military (active duty and veterans) and their families. These loans can be acquired with no down payment, no mortgage insurance, and no credit score requirement (although borrowers will need to meet lender credit guidelines). Closing costs are also generally capped and can be paid by the seller, if preferred. However, VA loans charge a percentage of the loan amount as a “funding fee,” and this can be paid upfront at closing or rolled into the loan along with the other closing costs.
#4: Adjustable-Rate Mortgage (ARM) Loans
Whereas fixed-rate loans offer the convenience of stable monthly payments, adjustable-rate loans feature fluctuating interest rates that change to reflect the current market conditions. These types of loans tend to start off with a fixed interest rate for a few years before the loan is adjusted to a variable rate for the remainder of the term.
Here is an example of how this type of mortgage works. If you purchase a 7-year/6-month ARM, this means that your interest rate will stay the same for the first seven years. After that, the interest rate on the loan will be adjusted every six months until the loan is paid in full. Because of this, it is important to read the fine print on the loan agreement documents, so you know how much your rate can increase and how much you could wind up paying for your home after the introductory period expires.
#5: Jumbo Loans
Jumbo home loans fall outside of the FHFA’s borrowing limits. These types of loans are more common in areas where real estate prices are substantially above the norm, such as Los Angeles, San Francisco, New York City, and the state of Hawaii. For many looking to live in these areas, a jumbo loan may be the only option available to finance their home purchase.
As you might expect, jumbo loans have higher than usual requirements. For instance, borrowers usually need a credit score of at least 700, a down payment between 10% and 20%, a DTI lower than 45%, and significant assets in cash or savings accounts to qualify.
Choosing the Right Mortgage for You
Now that you have a better understanding of what these five primary mortgage types are, you should be better able to choose the one that will best help you reach your homeowning goals. As always, discuss all your available options with your lender. Your lender will review all your documents and help you pick the best mortgage product for your home purchase.
