Can’t afford to pay for a new home with a pile of cash? You’re in good company. Most of us don’t have six figures or more lying around for the taking. Finding your dream home in a competitive housing market may seem like the ultimate prize, but it’s only half the battle.
Once you enter the home-buying process, you need to decide which type of mortgage will work best for your financial situation. Given the different types of mortgage loans to choose from, you’ll want to make this decision with careful consideration.
What is a mortgage?
A mortgage is essentially a loan you take out to borrow the money to purchase your house. Lenders such as banks, credit unions, and other financial institutions offer mortgage loans.
Typically, you put some money down on the home you want to buy, then borrow the remainder with a mortgage. Just like other loans, mortgages have interest rates, a repayment term, and a minimum monthly payment.
With mortgage loans, lenders will tell you how much you qualify for when you apply. This directly impacts the type of home you can buy. Lenders look at factors like your credit history, existing debt, and income to determine how much you can borrow for a mortgage.
Before you start shopping for a mortgage, find out how much you need saved to buy a house.
Types of mortgage loans: conventional loans
A conventional mortgage loan is not part of any government program. It’s a common type of home loan that accounts for nearly 80% of new home sales in the U.S. Conventional mortgages can have a fixed or adjustable interest rate with a 30, 20, or 15-year term.
Conforming vs. non-conforming loans
There are two types of conventional mortgages: conforming and non-conforming. Conforming loans have rules set by Fannie Mae or Freddie Mac, which are government-sponsored agencies that buy mortgages from lenders and sell them to investors.
Conforming conventional loans have maximum borrowing limits ranging from $647,200 in some counties to $970,800 in higher cost-of-living counties.
Individual lenders set loan limits and terms for non-conforming conventional mortgages instead of Fannie Mae or Freddie Mac. This means eligibility, pricing, and other features could be less strict, but it could also make you subject to higher fees and riskier terms.
With non-conforming loans, the Consumer Financial Protection Bureau advises you to consult with multiple lenders to shop around and make sure you truly understand the terms and requirements.
Pros of conventional loans
- Higher loan limits
- Finance a primary residence, vacation home, or rental property
- No private mortgage insurance (PMI) if you put at least 20% down
- Optional shorter repayment terms to help you save on interest
Cons of conventional loans
- Borrowers with a credit score lower than 620 may not qualify
- Minimum down payment of 3%
- Stricter eligibility requirements overall
Who should get a conventional loan?
Consider getting a conventional loan if you have good credit, a lower debt-to-income ratio (DTI), and can meet the minimum down payment requirements. Conventional mortgage loans are also an option if you’re looking to buy a second property or can afford to put more money down and want to avoid paying PMI.
Types of mortgage loans: fixed-rate loans
A fixed-rate mortgage has the same interest rate for the duration of the repayment period. If you get a mortgage with a 5% fixed interest rate at a 30-year term, your rate will remain at 5% until the 30-year term ends.
If you sell your home in the meantime or refinance, you would be giving up the fixed mortgage rate.
Pros of fixed-rate loans
- Protects you from rising interest rates
- Mortgage payments will be more consistent
- Easier to budget and plan your finances
Cons of fixed-rate loans
- Interest rate may be higher than the market rate initially
- You’d have to refinance to lower your rate
Who should get a fixed-rate loan?
You should get a fixed-rate loan if you’re looking for more stability with your monthly mortgage payment. A fixed-rate mortgage makes it easier to budget for your house payment. Also, if interest rates are low, you can lock in a great rate and save yourself some money over time.
On the flip side, if your rates decrease once you have your fixed-rate mortgage, you may feel trapped with a higher APR than the market currently offers. You should be willing to take on this risk if you’re leaning toward getting a fixed-rate loan.
Make sure you understand how mortgage rates work so you can compare different mortgage loan types with confidence.
Types of mortgage loans: adjustable-rate loans
An adjustable-rate mortgage (ARM) is a loan where the interest rate changes during the life of the loan. Initially, your rate may be lower than other types of mortgages, and this initial phase will last anywhere from one month to five years. Most ARMs have an adjustment period where your rate will change based one of these schedules:
- Three years
- Five years
Your mortgage payment can vary more throughout your loan term.
Most lenders have rate caps so that your interest rate may not exceed a certain amount. Rate caps are based on an index that lenders follow along with the rate terms. If the index rate goes up, your mortgage payment can increase, but if it goes down, your payment might decrease.
Pros of adjustable-rate loans
- Possibly get a lower interest rate initially
- Won’t be locked into a rate if the market and index rates go down
Cons of adjustable-rate loans
- More complex to understand and manage than a fixed rate loan
- Mortgage payments could increase by a lot
- Could end up paying more than you borrowed (even if you make on-time payments every month)
Who should get an adjustable-rate loan?
You should get an adjustable-rate loan if you’re comfortable with your mortgage payment fluctuating over time. An adjustable-rate loan could seem appealing if you have some wiggle room in your budget and want to take advantage of potentially lower interest rates now or in the future. Just be mindful of the drawbacks.
Types of mortgage loans: jumbo loans
Jumbo mortgage loans finance homes for larger amounts that exceed the Federal Housing Finance Agency. The current loan limit for conforming mortgages acquired by Freddie Mac and Fannie Mae is subject to change each year. The conforming loan limit is currently set at $647,200, but this can vary slightly by state or county. For counties with a higher cost of living, the FHFA set the maximum loan limit to $970,800.
Jumbo loans have stricter requirements, so you must have excellent credit and a lower debt-to-income ratio. You may also need to prove you have liquid assets and enough cash on hand to cover your payments for a few months. Jumbo mortgage loans can also have higher interest rates than conventional loans.
Pros of jumbo loans
- Higher loan limits
- Wide range of properties to consider
Cons of jumbo loans
- Stricter credit and DTI requirements
- Higher interest rates
- Not guaranteed by Fannie Mae and Freddie Mac
Who should get a jumbo loan?
Consider a jumbo loan if you live in an area where home prices are much higher than the national average. With a jumbo loan, you can finance a home that costs more than $1 million if needed. Make sure you meet the credit and DTI requirements and have enough cash reserves to qualify for the mortgage.
Types of mortgage loans: government-insured loans
A government-issued loan is a loan that a federal government agency backs. The lender is protected if the buyer cannot repay the loan. Government-issued loans also make it easier for homebuyers to qualify for a mortgage since they have more lenient requirements, including a lower down payment.
Private lenders also offer these loans so that you can choose to get a government-issued loan from a bank, credit union, or mortgage lender. Three types of government-issued loans exist: FHA, VA, and USDA.
What is an FHA loan?
The Federal Housing Administration backs FHA loans. These loans are intended for borrowers with a limited credit history or low savings. You can qualify with a credit score as low as 580 and put as little as 3% down on your home. You may still be able to get an FHA mortgage with a credit score lower than 580, but you may have to make a larger down payment.
You can only use an FHA loan for your primary residence, so this would not be an option for vacation homes or investment properties. When putting less than 20% down on a home, you’d be responsible for private mortgage insurance (PMI), which protects the lender if the house ever has to be foreclosed.
PMI is broken up and added to your monthly mortgage payment. PMI costs range between 0.22% to 2.25% of your mortgage. You’d have to pay PMI throughout your loan term with an FHA loan. Other types of mortgages, like conventional loans, allow you to get rid of PMI once you reach a certain amount of home equity.
What is a VA loan?
The U.S. Department of Veteran Affairs backs VA loans. You must be an active-duty service member or a veteran to be eligible. Surviving spouses can also qualify. VA mortgage loans have low interest rates, limited closing costs, and no down payment requirements. There are no loan limits so long as the lender believes you can afford the amount you want to borrow.
There is also no PMI with a VA loan. You can get a VA home loan as many times as you like since it’s a lifetime benefit.
Sometimes, there is a program funding fee that represents a percentage of the total loan cost. However, Congress introduced a program that can help waive this if you meet certain qualifications.
What is a USDA loan?
The United States Department of Agriculture backs USDA loans. To qualify, you must buy a home in a rural area. The USDA has a map of eligible regions as well as income guidelines which vary by state.
With a USDA loan, the home must be your primary residence, and there are no minimum credit score or down payment requirements. Interest rates vary depending on the private lender you choose. USDA loans are only offered at 30-year repayment terms. A USDA loan is an ideal mortgage option for people who want to live in a rural area but may struggle to meet the requirements for a conventional mortgage.
Who should get a government-insured loan?
Government-insured loans are options for people who are looking to buy a home but may not be able to meet the requirements for other types of mortgages. These options allow for more lenient credit requirements and no money down.
You have several options when it comes to choosing the type of mortgage you need. Narrow your choices by reviewing your financial situation and comparing the pros and cons of these mortgage loans. Ask questions like:
- What is my credit score? Do I plan to improve it?
- How much am I able to put down?
- Where do I want to buy a home? What’s my budget?
Of course, choosing a type of mortgage is just one important aspect of the home-buying process. Before you plunge into the housing market, find out if now is a good time to buy a house.