Homeownership is a powerful financial investment that can help your family build wealth and equity for generations to come. But the decision to buy a home isn’t taken lightly, especially when it comes to borrowing a six-figure mortgage that you may be repaying for decades.
Choosing the right type of home loan can save you thousands of dollars over time. With so many mortgage products available, it’s important to fully understand your options before you take out a home loan. Get familiar with the different types of mortgages below, so you can set yourself up for long-term financial wellness.
— Conventional vs. Government-Backed Loans.
— Fixed-Rate vs. Adjustable-Rate Mortgages.
— Other Mortgage Products.
— How to Choose the Right Mortgage for You.
[Read: Best Mortgage Lenders]
Conventional vs. Government-Backed Loans
The vast majority of mortgages are either conventional loans or government-insured loans. Conventional mortgages are not part of a specific government program, whereas government-backed loans are insured by agencies like the Federal Housing Administration or the Department of Veterans Affairs.
Conventional loans are typically more difficult to qualify for, but they may come with lower mortgage rates and added flexibility. However, there are some instances where a government-insured loan can be the best mortgage choice for you. Here’s a breakdown of the different types of government-backed loans.
— Pros: low down payment and lenient credit score requirements.
— Cons: upfront mortgage insurance premium (MIP) and ongoing monthly mortgage insurance.
FHA loans offer a path to homeownership for borrowers with a less-established credit history and little savings for a down payment. These mortgages have more forgiving financial requirements than conventional loans — you may be able to qualify with a credit score of 580 or lower and as little as 3.5% down.
As a result of their lenient eligibility criteria, FHA loans require mortgage insurance that’s paid through an upfront fee, as well as over time in monthly installments. The mortgage insurance fee due at closing is 1.75% of the total loan amount, and it may be rolled into the loan.
Monthly FHA mortgage insurance payments are between 0.15% and 0.75% of the loan amount. While some borrowers may be able to reduce their mortgage insurance premiums once their loan-to-value ratio hits 20%, MIPs are required for the duration of their mortgage.
— Pros: no down payment or mortgage insurance required, competitive mortgage rates.
— Cons: must be an eligible active-duty or retired military service member to qualify.
VA loans are no-down-payment mortgages available to qualifying veterans and military personnel. Since these loans are insured by the Department of Veterans Affairs, lenders don’t require borrowers to pay mortgage insurance, and VA loans often come with lower interest rates than other types of home loans.
Instead, VA mortgages come with a one-time VA funding fee ranging from 1.25% to 3.3% of the total loan amount, depending on the amount of your down payment as well as how many times you’ve used a VA loan in the past.
To qualify for a VA loan, you must provide your lender with a Certificate of Eligibility, or COE, to prove you’ve met the military service requirements to participate in this program. The lender will also consider your credit score and debt-to-income ratio to determine your eligibility for a VA loan.
— Pros: no down payment required, flexible credit score requirements.
— Cons: mortgage insurance required, limited to homes located in rural areas.
USDA home loans are reserved for homebuyers in designated rural areas with a population of less than 35,000. They are either directly funded or backed by the U.S. Department of Agriculture, and they require as little as 0% down.
USDA direct loans are given to low-income borrowers based on the median area income, offering interest rate subsidies that can greatly reduce the cost of borrowing. USDA-guaranteed loans are funded by a private lender, while the USDA insures 90% of the mortgage amount against default. Both options allow borrowers to bypass a down payment requirement, but some types of USDA-backed loans from private lenders require mortgage insurance.
Fixed-Rate vs. Adjustable-Rate Mortgages
Another factor homebuyers should consider is the type of interest rate a mortgage carries. The vast majority of mortgages are fixed-rate, which means your interest rate and monthly principal and interest payment stay the same throughout the length of the loan.
Alternatively, adjustable-rate mortgages have an interest rate that can change over time, making them inherently more risky if you plan on living in your home long term. The most common type of adjustable-rate mortgage is a hybrid ARM, in which your rate is fixed for a set period — typically three, five, seven or 10 years — before it can change.
When compared with fixed-rate mortgages, ARMs usually come with lower initial interest rates. This can make them a viable option if you plan on selling or refinancing before the rate adjusts. Some lenders also include adjustment caps that limit the amount your interest rate or monthly payment can rise over a set period of time.
Other Mortgage Products
Besides the common types of mortgages outlined above, there are a few alternative home loan options that provide a less traditional path to homeownership. If you need to borrow beyond the conforming loan limit or you want to change the way your mortgage interest is paid, here’s what you need to know.
Jumbo mortgages are conventional loans that exceed the conforming loan limit set by the Federal Housing Finance Agency. For 2023, the national baseline limit increased to $726,200, a jump of nearly $80,000 from 2022 due to rapid home price appreciation. In some counties with a high cost of living, the limit is higher — up to $1,089,300.
Compared with a conforming loan, jumbo loans can be harder to qualify for due to the large borrowing amount. Jumbo loan lenders have stricter requirements for a borrower’s down payment, debt-to-income ratio and credit score. These home loans also typically come with higher mortgage rates.
If you’re buying a home that needs urgent repairs, you may consider borrowing a rehabilitation home loan. This type of mortgage, also known as a fixer-upper loan, includes the purchase price of the home, as well as extra funds to cover the cost of certain renovations. There are several types of fixer-upper loans:
— Standard and limited FHA 203(k) loans.
— VA rehabilitation loans.
— Fannie Mae HomeStyle.
— Freddie Mac CHOICERenovation and CHOICEReno eXPress.
Renovation loans give buyers a way to fix up aging houses while building their own home equity. But the process for borrowing this type of mortgage can be complicated, between filling out paperwork and overseeing contractors. Plus, not all lenders offer a fixer-upper mortgage option.
Interest-only loans allow borrowers to pay only the mortgage interest without paying down the loan’s principal balance. While this may result in much lower mortgage payments, it also greatly limits the amount of equity a homeowner can build over time.
However, the interest-only period isn’t permanent. On a typical 30-year mortgage, the interest-only period may only last during the first 10 years of repayment, for example. That means that your monthly payments will be much higher after the interest-only period expires. And by then, your principal mortgage balance will remain the same as when you originated the loan.
Mortgage rates on I-O loans may run a bit higher than on conventional loans, since they’re inherently riskier for both the borrower and the lender. Just a small percentage of mortgages have an interest-only period.
An assumable mortgage allows a homebuyer to take over the seller’s home loan during a real estate transaction. It’s a way for the buyer to keep the loan’s original mortgage rate, which may be much lower than what’s currently available. For sellers, offering mortgage assumption can help set their listing apart from the rest.
Most types of government-backed mortgages, including FHA loans, VA loans and USDA loans, are assumable. However, mortgage assumption is relatively uncommon, since the buyer would have to cover the difference between the outstanding loan amount and the home’s purchase price (also known as the assumption gap). Plus, the buyer must meet the lender’s credit and income requirements in order to be approved for assumption, risking the chance that the sale will fall through.
How to Choose the Right Mortgage for You
— Take a look at your finances. Weigh your credit score, existing debts and household income to determine which mortgage programs you qualify for. Borrowers with fair credit and little savings could consider a government-backed loan, while those with very good credit and a low debt-to-income ratio may get better rates through a conventional loan.
— See if you qualify for benefits. VA loans and USDA loans offer competitive mortgage options for borrowers who meet the eligibility requirements. In most cases, veterans and active-duty military will get the most favorable repayment terms through the VA home loan program. And if you’re looking for a home in a rural area, a USDA loan may be more beneficial than a conventional loan.
— Think about how long you’ll live in the home. A traditional fixed-rate mortgage gives you a clearer picture of your monthly payments over a long period. So if you’re buying your forever home, an adjustable interest rate may be less predictable. But if you plan to move out of your starter home or refinance within the next few years, it may be worthwhile to consider an ARM.
— Seek advice from a mortgage professional. Your home is likely to be the largest purchase you’ll make your entire life, so it’s important that you don’t make a mortgage decision lightly. If you’re not sure which type of mortgage is best for your financial situation, get in touch with a third-party advisor.
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Update 09/19/23: The story was previously published at an earlier date and has been updated with new information.