The process of applying for a mortgage loan can be overwhelming. Whether you are a first-time home buyer or a seasoned investor, you should be familiar with the different types of mortgage loans available to determine what type of loan will best serve your needs. Homes come in many different styles and price ranges, and so do the ways you can finance them. While it may be easy to decide what type of home you want, figuring out what kind of mortgage works best for you requires a little more research. A great lender can walk you through all your options, but you can start by understanding these main categories.
Fixed Rate Mortgages
Just as it sounds, the interest rate remains fixed throughout the life of the loan. Market rates may rise or fall, but your interest rate will not change. A 30-year fixed-rate loan is the most commonly used mortgage for the average home buyer. Most people feel comfortable with this structure because they know what to expect. The cost of insurance and taxes may fluctuate, but with a fixed interest rate you can expect your monthly payments to be fairly stable. This type of loan is usually best for people who plan to stay in the home for a long time.
The shorter the loan term, the lower the interest rate will be. Of course, your monthly payments will be more with a 15-year term than a 30-year term, but the interest rate will be lower. Some borrowers choose to take out a 30-year loan, but pay it as if it were a 15-year loan. This saves them money in the long run. You can always pay more than you owe, but you can’t pay less.
Also, if the market interest rates drop significantly, you can refinance to get that better rate.
Adjustable Rate Mortgage (ARM)
With an adjustable rate, what you pay in interest can fluctuate throughout the term of the loan. Initially you get a lower interest rate than with a fixed rate, but it won’t necessarily stay that way. After a period of 3, 5, 7 or 10 years, the rate will adjust to the current market rates which mean you could pay more or less. Adjustable rates can make borrowers uneasy with the fear that they will end up paying way more as the market changes, but they don’t need to be too worried. Adjustment intervals are predetermined and there are minimum and maximum caps to limit the amount of the adjustment so borrowers won’t be hit with huge monthly fluctuations.
The lower initial rate might be appealing to you especially if you do not plan to stay in the home very long or if you plan to refinance in the near future. You might also qualify for a higher loan amount due to the lower interest rate. If you choose an ARM, make sure you look at the frequency of adjustments and the upper limit of the caps to be sure you can afford the payments. Relying on refinancing can sometimes be a bit risky.
Conventional Loan or Government-Backed Loan
Aside from determining if a fixed rate or adjustable rate is the route to take, you must decide if you want to use a government insured loan or a conventional loan.
A conventional home loan is a mortgage originated by a bank or private lender, and is not backed or insured by the government. When evaluating conventional loan applications, banks look at credit scores and debt to income ratio. Private mortgage insurance (PMI) is generally required when the down payment is less than 20%. Minimum down payments are typically 5%, but many borrowers put up to 20% down to decrease the size of the remaining mortgage giving them more equity and avoiding having to pay the PMI.
The three main government-backed mortgage types are explained below.
FHA loans are mortgages insured by the Federal Housing Administration which is managed by the Department of Housing and Urban Development (HUD). Qualifying for an FHA loan is often less difficult than qualifying for a conventional mortgage. This program is great for many types of buyers, especially first time home buyers or those who do not have enough to pay a large down payment or who have less than great credit. An FHA loan allows you to make a down payment as low as 3.5% of the purchase price with a credit score of 580 or higher.
There are a few caveats…
Interest rates are typically fixed for a 15 or 30-year term and you’ll have to pay for mortgage premium insurance (MPI), which will increase the size of your payments. Also, properties must meet certain standards and loans are limited to certain amount.
The U.S. Department of Veterans Affairs (VA) offers home loans to qualifying veterans, active military and military families. Similar to the FHA program, VA loans are guaranteed by the federal government meaning the VA will reimburse the lender for any losses that may result from borrower default. The primary advantage of this type of loan it that buyers who qualify can receive 100% financing for the purchase of a home. That means no down payment whatsoever. However, the VA has strict requirements on the type of property you can purchase. It must be your primary residence and must meet certain requirements (no fixer uppers). There is also a funding fee applied to the borrowers mortgage.
The United States Department of Agriculture (USDA) offers a loan program for borrowers who meet certain income requirements. This type of mortgage is designed to help people with low or moderate income buy, repair or renovate a home in rural and sometimes suburban areas. Income must be no higher than 115% of the adjusted area median income (AMI) which varies by county. Buyers who are eligible for a USDA loan can purchase a home with no down payment and get below-market mortgage rates. They will, like the FHA loan, be required to purchase mortgage insurance.
Conforming or Non-Conforming Loan
A conforming loan meets certain guidelines established Fannie Mae and Freddie Mac based on the size of the loan. Conforming loans fall within their maximum size limits and therefore “conform” to predetermined criteria. The conforming loan limit in 2016 was $417,000, with certain adjustments for those who live in high-cost real estate markets. Conforming loans offer better interest rates and lower fees than non-conforming loans.
The most common non-conforming loan is called a jumbo loan. A jumbo loan exceeds the conforming loan limit of Fannie Mae and Freddie Mac. Due to the size of the loan, the requirements to qualify are more stringent. Interest rates can also be higher for jumbo loans because they are considered riskier to the lender. Jumbo borrowers typically must have excellent credit and pay a large down payment. Other types of non-conforming loans exist for borrowers with poor credit, borrowers who have recently filed for bankruptcy or borrowers with a high debt-to-income ratio.