Types of Mortgage Loans for home buyers
Generally speaking, there are four types of home loans home buyers should know about:
Both "fixed rate" and "adjustable rate mortgages" can be offered in "conventional" or "FHA" formats (we'll talk about that below).
What is a Fixed Rate Mortgage?
With a fixed rate mortgage the interest rate (one of the four components of a mortgage) does not vary.
That means your monthly principal and interest will always be the same amount. While there’s security in knowing that your monthly payment will never increase, the catch is the interest rate will be higher than the initial rate on an adjustable-rate mortgage
What is an adjustable rate mortgage (ARM)?
With an adjustable rate mortgage, the initial interest rate you start with will be lower than the rate on a Fixed Rate loan.
That interest rate will be adjusted periodically after the initial term expires (anywhere from 1 to 10 years), based on movements in market interest rates. That means your monthly mortgage payment could go up or down in the future.
Example: Abby used a $200,000 Fixed Rate loan to buy a house. Her interest rate is static, at X.X%, so her monthly payment is always $XXX.XX per month. Abby’s twin sister Gabby uses a $200,000 ARM to buy a house in the same town. For the first XX year(s), Gabby pays $XXX.XX per month. But when the rate adjusts, her payments go up/down to $XXX.XX per month, while her sister Abby’s stay the same.
Pro Tip: If you are considering an ARM, ask your loan officer what your monthly payment look like if interest rates rise 1, 3 or 5 percentage points, so you can predict how much more you may have to pay in the future.
Conventional vs. FHA mortgages
Both adjustable rate and fixed rate mortgages are available in conventional and FHA (Federal Housing Administration) formats.
The primary difference is that FHA loans are "guaranteed," that is insured against buyer default, by the federal government, and conventional mortgages are not guaranteed. There are other differences between the two (as you can see below), but those differences may not matter, depending on your circumstances.
Pro Tips:
Conventional mortgages:
Pro Tip: Borrowers who make a down payment of at least 20% do not have to pay mortgage insurance premiums. This would lower your monthly payment in two ways (lower principal (since a greater down payment is made + no monthly mortgage insurance charge).
FHA mortgages:
Pro Tip:
- Fixed Rate
- Adjustable Rate Mortgages (ARM)
- Conventional
- FHA (Federal Housing Administration)
Both "fixed rate" and "adjustable rate mortgages" can be offered in "conventional" or "FHA" formats (we'll talk about that below).
What is a Fixed Rate Mortgage?
With a fixed rate mortgage the interest rate (one of the four components of a mortgage) does not vary.
That means your monthly principal and interest will always be the same amount. While there’s security in knowing that your monthly payment will never increase, the catch is the interest rate will be higher than the initial rate on an adjustable-rate mortgage
What is an adjustable rate mortgage (ARM)?
With an adjustable rate mortgage, the initial interest rate you start with will be lower than the rate on a Fixed Rate loan.
That interest rate will be adjusted periodically after the initial term expires (anywhere from 1 to 10 years), based on movements in market interest rates. That means your monthly mortgage payment could go up or down in the future.
Example: Abby used a $200,000 Fixed Rate loan to buy a house. Her interest rate is static, at X.X%, so her monthly payment is always $XXX.XX per month. Abby’s twin sister Gabby uses a $200,000 ARM to buy a house in the same town. For the first XX year(s), Gabby pays $XXX.XX per month. But when the rate adjusts, her payments go up/down to $XXX.XX per month, while her sister Abby’s stay the same.
Pro Tip: If you are considering an ARM, ask your loan officer what your monthly payment look like if interest rates rise 1, 3 or 5 percentage points, so you can predict how much more you may have to pay in the future.
Conventional vs. FHA mortgages
Both adjustable rate and fixed rate mortgages are available in conventional and FHA (Federal Housing Administration) formats.
The primary difference is that FHA loans are "guaranteed," that is insured against buyer default, by the federal government, and conventional mortgages are not guaranteed. There are other differences between the two (as you can see below), but those differences may not matter, depending on your circumstances.
Pro Tips:
- If your credit score is lower than 620, you likely won't qualify for a conventional mortgage, so you can skip to reading about FHA loans, which will your best option.
- On the other hand, if you’re planning to buy a property that won’t be your primary residence, skip the section on FHA loans and focus on conventional loans because you can’t use FHA loans for investment properties, second/vacation homes and fix-and-flip (within 90 days) properties
- Borrowers with credit scores of 720 or higher usually find that conventional loans cost them less each month
- Home buyers with credit scores less than 720 generally find that FHA loans cost them less per month
Conventional mortgages:
- Unlike FHA loans, conventional mortgages are not guaranteed (insured against buyer default) by the federal government
- Accordingly, they are riskier for lenders, so conventional loans typically have tougher approval requirements and higher interest rates than FHA loans
- The term of a conventional mortgage is usually 15, 20 or 30 years
- available in both fixed-rate and adjustable-rate structures
- Also unlike FHA loans, conventional loans can be used to buy a vacation home, investment property or primary residence
- Conventional loans approval is more likely with a debt-to-income ratio of 43% or less (debt-to-income ratio = all your monthly debt payments divided by your gross monthly income (the amount of money you earn before taxes and other deductions are taken out))
- Conventional mortgage borrowers typically make larger down payments than FHA borrowers
- Conventional lenders have traditionally required up to 20% for a down payment, but now they can offer a 3% down payment
- In order to qualify for such a lower down payment, one must have a minimum credit score of 660 or 680, depending on how much savings you left over after closing
- Mortgage insurance on conventional loans is automatically canceled after your equity reaches 78% of the purchase price
- In addition to the down payment, borrowers are often responsible for origination fees, mortgage insurance and appraisal fees. As such, conventional loans tend to have a higher out-of-pocket cost at closing than other types of mortgage loans
- Conventional mortgages fall into two categories: “conforming” and “nonconforming” loans.
- Conforming loans follow the guidelines set by Fannie Mae and Freddie Mac, two government-controlled companies that provide money for the U.S. housing market.
- The most well-known rule has to do with the size of the loan. In 2019, the conforming loan limit for single-family homes in most of the continental U.S. is $484,350. (Higher-cost areas, such as Hawaii and Alaska, have higher limits up to $726,525 for single-family homes.)
- Nonconforming loans, often called jumbo loans, are for borrowers who don’t qualify for a conforming loan because the amount is higher than the conforming limit for the area. Other types of nonconforming loans include those made to borrowers with poor credit, high debt or recent bankruptcy, or on homes with a high loan-to-value ratio (usually up to 90% for a conforming loan).
- Lenders typically charge higher rates for nonconforming loans, and they may carry other fees or insurance requirements due to their riskier nature.
- Conventional loans allow slightly smaller down payments, have lower mortgage insurance payments for borrowers with credit scores of 720 or higher and have more liberal standards for approving properties for purchase with a mortgage. Private mortgage insurance on conventional loans may be canceled
Pro Tip: Borrowers who make a down payment of at least 20% do not have to pay mortgage insurance premiums. This would lower your monthly payment in two ways (lower principal (since a greater down payment is made + no monthly mortgage insurance charge).
FHA mortgages:
- FHA loans are guaranteed by the Federal Housing Administration
- available in both fixed-rate and adjustable-rate structures
- available in 15-year or 30-year terms
- Only primary residences are eligible for FHA loans (not investment properties and second/vacation homes).
- FHA loans exist to make buying homes more affordable for low to middle income families
- In general, government loan programs are easier to qualify for and have lower down payment requirements as well as more flexible credit requirements
- FHA loans require a minimum credit score of 580 to be eligible to make a 3.5% down payment. If your credit score is 500 to 579, you may qualify for an FHA loan with a 10% down payment.
- competitive interest rates
- Your debt-to-income ratio must be 50% or less to qualify for an FHA loan (debt-to-income ratio = all your monthly debt payments divided by your gross monthly income (the amount of money you earn before taxes and other deductions are taken out))
- FHA loans charge mortgage insurance premiums for the life of the loan, if you make a down payment of less than 10%
- FHA mortgage insurance premiums cost the same no matter your credit score
- While buyer approval is easier, FHA property appraisals are more stringent. Not only is the property assessed for value, it is inspected for safety, sound construction and adherence to local code. In other words, it’s easier for people, but harder for properties to qualify for FHA loans.
- Other types of government backed loans: if you are active duty or a military veteran, a loan backed by the VA may be the way to go. VA loans usually require no down payment. If you live in a suburban or rural area, a USDA loan might be an option.
Pro Tip:
- You can get rid of FHA mortgage insurance by refinancing to a conventional loan
