When it comes to financing the largest purchase you’ll ever make in your life — your home — it’s essential that you approach it as an informed consumer. Not educating yourself during the mortgage process could mean ending up with a more expensive loan than necessary and could cost you tens of thousands of dollars.
To avoid that, make sure you have an understanding of all your financing options. In this guide, we’ll go over the different types of mortgage loans to help you find the one that best meets your needs.
Mortgages are classified based on a few overarching criteria.
- Government-backed or conventional. All mortgages fall into one of the two categories.
- Fixed-rate or adjustable rate. This refers to how the interest rate on the mortgage is structured.
- Jumbo or conforming. The amount of the loan dictates whether it is a conforming or jumbo loan.
Tendayi Kapfidze, chief economist for LendingTree, the parent company of MagnifyMoney, said multiple factors dictate which loan product is best for an individual. You’ll need to consider the size of your down payment, the price of the home, your credit history, your risk tolerance and your eligibility for specific loan programs. “Once you have some preferences on those, then you shop around and see what kind of deals you’re getting,” Kapfidze said.
Let’s take a look at the various loan options.
Government-backed vs. conventional home loans
Loans are defined one way by whether they’re a government loan or not. The government offers three loan programs: FHA, VA and USDA. A conventional mortgage is any loan that is not a part of one of these programs.
Government-backed loans target and serve consumers who may be underserved by traditional financing. Because lenders potentially take on greater risk by extending credit to these borrowers, the government provides protection to lending institutions by insuring the loans. The cost of insuring or guaranteeing the loan is passed on to the buyer through fees built into the mortgage.
Federal loans tend to be more expensive than conventional loans, but they are easier to qualify for. You may need a lower credit score to qualify, and you may be able to put down a smaller down payment.
Let’s review the three types of government loans.
FHA loans are insured by the Federal Housing Administration. These loans let you purchase a home with a down payment as low as 3.5% and a credit score as low as 500, depending on the size of the down payment.
You’ll be limited in the amount you can borrow, based on the market rate for homes in a specific area. With FHA financing, homebuyers usually pay mortgage insurance premiums through an upfront charge of 1.75 of the loan amount, which can be rolled into the mortgage. Additionally, you’ll pay an annual mortgage insurance premium that is built into the monthly payment.
You can finance properties of between one and four units as well as mobile and manufactured homes that meet FHA program requirements. You apply for FHA loans through FHA-approved private lenders.
Advantages of an FHA loan:
- Low down payment
- Lenient credit requirements
- Low closing costs
FHA loans are best for:
- First-time homebuyers who don’t have home equity already built up that could go toward a down payment
- Buyers with lower credit scores
- Buyers with low down payments
The Department of Veterans Affairs backs mortgages for veterans, service members and eligible surviving spouses. Borrowers can purchase homes with no money down and lenient credit requirements.
There is no purchase price limit with a VA loan. However, there are limits on how much you can finance without putting money down.
Applicants will need to meet the VA’s residual income guidelines, which establish how much income you must have left over after covering all debts and living expenses.
VA loans do not require the borrower to pay mortgage insurance, but you will pay an upfront funding fee, which is a percentage of the loan amount. You can apply for VA loans through approved private lenders.
Advantages of a VA loan:
- No down payment (unless a lender requires one)
- No minimum credit score (unless a lender requires one)
- No mortgage insurance required
- No maximum loan amount
- No maximum debt-to-income ratio (DTI) (unless set by the lender)
VA loans are best for:
- Veterans, service members and eligible surviving spouses
- First-time homebuyers
- Buyers with low or no credit score
- Buyers with little or no down payment
Buyers in rural areas can seek financing through the United States Department of Agriculture.These programs are income-sensitive, and you must purchase a property in an eligible rural area.
The USDA has two loan programs:
Guaranteed loan program. In this program, loans are offered by local lenders and guaranteed by the USDA. Your income must fall within the income limits established for low- or moderate-income households, determined by the location of the home and your family size.
These loans carry an upfront loan guarantee fee and may also include an annual fee, both of which are at the borrower’s expense. The lenders set the interest rate for these loans, but rates are capped by the USDA.
Direct loan program. In this program, you can finance a home directly with the USDA. Your income must fall within the established guidelines for very low or low-income households. And the property itself must meet specific criteria. For example, homes must be 2,000 square feet or less in most cases.
Additionally, this program limits the purchase price based on location. Interest rates are lower in the direct loan program than the guaranteed loan program, and there is no mortgage insurance or guarantee fee. Some applicants may qualify for a payment subsidy, which can lower the effective interest rate to as low as 1%.
Advantages of a USDA loan:
- No down payment required
- Flexible credit requirements
- Closing costs can be financed
- Longer loan terms can reduce the monthly payment
USDA loans are best for:
- First-time homebuyers
- Low-income borrowers
- Rural residents
- Buyers with low or no credit score
- Buyers with little or no down payment
As mentioned previously, any loan that is not a part of a government program is a conventional loan. These loans are issued by private lenders and are not backed or insured by the federal government.
Conventional loans require higher down payments than government-backed loans — typically, a minimum of 5% — although some lenders offer programs with down payments as low as 3%. Borrowers who put down less than 20% will need to pay for private mortgage insurance, or PMI, which is added to the loan payment.
Credit requirements are a bit tighter with conventional financing and vary by lender. Borrowers with higher scores will qualify for better rates.
Advantages of a conventional loan:
- Lower fees than government loans
Conventional loans are best for:
- Applicants with good to excellent credit
- Applicants putting down 5% or more
Fixed-rate vs. adjustable-rate mortgages (ARMs)
Mortgages are also classified by the structure of their interest rate. Loans have either a fixed rate or an adjustable rate.
The interest rate and monthly payment on a fixed-rate mortgage remain the same throughout the life of the loan. That means your payments are predictable, and you’re protected from interest rate hikes. Conversely, it also means you cannot take advantage of any interest rate drops unless you refinance the loan.
Advantages of a fixed-rate mortgage:
- Easier to plan for
- Protects you from rate increases
Disadvantages of a fixed-rate mortgage:
- Cannot take advantage of interest rate decreases
- Higher rates than adjustable-rate mortgages
Fixed-rate mortgages are best for:
- Most buyers
- Borrowers who are risk-averse
- Borrowers who cannot afford an increase in their payment
Unlike fixed-rate loans, the interest rate on adjustable-rate mortgages adjusts throughout the loan. The rate is tied to an index that the lender uses. As the index goes up or down, the mortgage rate and the monthly payment increase or decrease.
Interest rates on ARMs are usually lower than fixed-rate loans initially, but as the market fluctuates, the rate could increase significantly.
Adjustable-rate mortgages can differ in how they are structured. But generally, these loans have a period when the rate is fixed, which can range from one month to 10 years. The most common fixed terms are three, five, seven and 10 years.
Once the fixed period ends, the interest rate will adjust at predetermined intervals — monthly, quarterly, annually or every three or five years. The most common adjustment period is one year, which means the interest rate and payment will change once per year until the end of the loan.
When comparing ARMs, you’ll notice that they are written with two numbers such as 3/1, 5/1 or 10/1. The first number represents the fixed period while the second number represents how often the rate will adjust.
For example, a 3/1 ARM will have a fixed rate for three years and will adjust annually after the fixed period ends. A 5/1, 7/1 and 10/1 ARM will have fixed periods of five, seven and 10 years respectively, followed by annual adjustments.
The initial low rates of ARMs can be appealing for some buyers, but those rates will likely increase. “If you do consider an ARM, make sure you’re very comfortable with the possibility of your payment going up,” Kapfidze advised.
Advantages of an ARM:
- Lower rates initially
- Interest rates and payment could decrease
Disadvantages of an ARM:
- Very risky and unpredictable
- Interest rate and payment can increase significantly
Conforming vs. jumbo loans
Conventional loans are defined by another classification: conforming or jumbo.
Conforming mortgage loan
Conventional loans have maximum price limits in place set by the government as well as other guidelines established by Fannie Mae and Freddie Mac, the government-sponsored companies that insure a majority of conventional loans.
Limits are based on geographical area, with higher loan amounts allowed in counties that are considered “high cost.” Conforming loans are those that fall within the loan limits. In most of the United States, the limit for one-unit properties is $484,350 in 2019.
Jumbo mortgage loan
Borrowers who want to purchase above the conforming loan limits will need to take out a jumbo loan.
Qualification requirements are usually stricter for jumbo loans, with borrowers needing higher down payments and a strong credit profile.
Determining the right mortgage for you
Now that you have a better understanding of the types of loans, you can compare various options to see what is best for you. Again, give thought to the size of your down payment, the price of the home you wish to buy, your credit history and your risk tolerance.
Additionally, Kapfidze said one of the most important factors to consider is your bottom line. Before shopping for a loan, he advises that consumers should ask themselves how much they are able and willing to pay for a mortgage. The best way to answer that is to come up with a monthly budget projecting the prospective mortgage payment and expenses related to the home, including taxes, insurance, maintenance, repairs and utilities.
“Get a complete all-in monthly housing cost that you’re comfortable with,” Kapfidze said. He added that once you have that number, you can review the loan options that line up with your budget.
Doing this before you begin shopping is crucial, as it’s easy to get swept up in the emotion of buying a home. He also said consumers should talk to several lenders. “There’s always a lender out there that will work with your situation, you just have to find them,” he said. “The more lenders you talk to, the more chances you’ll have of finding that lender that fits your particular circumstances.”