When shopping for a home, finding the house of your dreams is one challenge. Unless you’re paying in cash, the second challenge of homeownership is finding a mortgage to finance the house. So, how do you choose the right home loan for you?
Not all home loans are created the same. Understanding how each works will help you make an informed decision.
How Home Loans are Classified
Home loans are typically classified into three:
Conventional/Conforming
Conventional loans are mortgages not backed by the federal government. For this reason, they have stricter credit score and debt-to-income ratio (DTI) requirements. You can qualify for a conventional mortgage if you have good credit, stable employment and income history, and can make a 3% down payment.
Conventional loans come in two forms: conforming and non-conforming. A conforming loan meets the lending standards set by the Federal Housing Finance Agency (FHFA), Fannie Mae, and Freddie Mac. On the other hand, non-conforming loans don’t meet FHFA standards. Instead, they cater to individuals looking to purchase luxury properties.
Low-interest/FHA
If you’re looking for a low-interest mortgage, FHA loans are probably your best bet. Since a government agency backs these loan programs, lenders impose lenient requirements, including low rates.
Special Programs
There are mortgage loans that fall into the special programs category. These mortgage programs cater to different people, including first-time home buyers, veterans, low-to moderate-income buyers, and people with disabilities.
7 Most Common Types of Home Loans
Here are seven common types of home loans:
1. Fixed-rate Mortgage
A fixed-rate mortgage is exactly what it sounds like 一 a home loan with the same interest rate over the life of the loan. This means your monthly mortgage payments will remain unchanged over the loan term.
Fixed-rate loans typically come in terms of 15 years and 30 years. Unlike other types of home loans with variable rates, fixed-rate loans offer predictability on how much you’ll pay each month, which can help you budget and plan for the long term.
A fixed-rate mortgage may be a great option if you currently live in your “forever home.” But if your area has high interest rates, you may want to avoid fixed-rate loans. Once you lock in, you could overpay thousands of dollars in interest unless you refinance.
Pros of Fixed-rate Mortgage
- Monthly mortgage payments remain the same over the life of your loan
- Easier to budget for the long-term
Cons of Fixed-rate Mortgage
- Interest rates are often higher than adjustable-rate mortgages
2. Adjustable-rate Mortgage
An adjustable-rate mortgage (ARM) is the opposite of a fixed-rate mortgage. It’s a mortgage loan with an interest rate that fluctuates over the loan term.
Many ARM options have an introductory fixed interest for a few years before the loan changes to a variable interest rate for the remainder of the term. For example, if you choose a 5/1 ARM loan, you’ll pay a fixed interest for the first five years, typically lower than 30-year fixed rates. After the introductory period expires, your interest changes based on the market conditions.
One upside of ARMs is that they include rate caps. A rate cap is a limit on how high an interest rate can rise on adjustable-rate loans. Rate caps protect you from swiftly rising rates. For instance, your mortgage will stay within the limit when it hits the rate cap.
ARMs can be a good choice if you want to purchase a starter home before moving to your forever home. It can also be advantageous if you plan on paying more early on, as you can save thousands of dollars over time.
Pros of ARMs
- Lower interest rates for the introductory period
- You could pay less in interest over the life of the loan
Cons of ARMs
- Unstable monthly mortgage payments
- If the home’s value falls, it can be hard to refinance or sell before the loan adjusts
3. Interest-only Mortgage
With an interest-only mortgage, you make interest-only payments for a certain period, typically five, seven, or 10 years. After the introductory period ends, the loan converts to a fully amortized schedule 一 payments will include both the interest and the principal for the remainder of the loan term at a variable interest rate.
While you must pay interest first, you can pay down the principal during the loan’s introductory period. However, remember that you’ll gain zero equity in your home during this period.
After the interest-only period ends, you’ll need to repay the principal either in one balloon payment at a set date or monthly payments with interest over the remaining loan term. You can also refinance your mortgage after the interest-only period is over.
An interest-only mortgage is best suited for individuals with substantial amounts of assets. It may also benefit those who expect their income to significantly increase before principal payments become due.
Pros of Interest-only Mortgages
- The initial monthly payments on interest-only tend to be lower
- If you plan to move out before the introductory period ends, an interest-only mortgage can help you set aside some cash for other goals.
Cons of Interest-only Mortgages
- You don’t build equity during the interest-only period
- After the introductory period is over, your monthly payments will be higher
4. Jumbo Loan
A jumbo loan is a type of mortgage loan that exceeds the lending limits set by the FHFA. Because of this, jumbo mortgages are non-conforming conventional loans. The loans are common in areas with high housing costs, such as New York City, Los Angeles, and San Francisco.
Jumbo mortgages are more difficult to qualify for than other loans. You need a credit score in the 700 range and a lower debt-to-income (DTI) ratio to qualify for a jumbo loan. Besides, jumbo mortgages have high down payment requirements, typically 20%.
A jumbo loan is a good choice if you want to purchase luxury properties but don’t qualify for conventional mortgages or don’t have the cash or assets to buy the properties outright.
Pros of Jumbo Loans
- Higher lending limits
- Competitive interest rates to conforming conventional loans
- Can help you buy properties in areas with extremely high housing costs
Cons of Jumbo Loans
- Difficult to qualify
- A larger down payment is required
5. FHA Loan
An FHA loan is a mortgage loan guaranteed by the Federal Housing Administration and offered by approved FHA lenders. Since FHA loans are government-backed mortgage loans, you don’t need a stellar credit score or a huge down payment to be eligible.
You can qualify for an FHA loan with a credit score as low as 580 and a down payment of 3.5%. If your score is in the 500-579 range, you still qualify, but you must put down 10%.
FHA loans have mandatory mortgage insurance premiums: upfront mortgage insurance premium (1.75%) and annual mortgage insurance premium (0.45% to 1.05%).
FHA loans are the best option for individuals who can’t qualify for other types of home loans due to poor credit scores.
Pros of FHA Loans
- Flexible qualification requirements
- Low down payment of 3.5%
Cons of FHA Loans
- You must meet property requirements
- Low down payments require mortgage insurance
6. VA Loan
VA loans are mortgages insured by the Department of Veteran Affairs and issued by VA-approved lenders. Because a government agency backs the loan, lenders are more willing to approve a VA loan as they take on less risk.
Members of the U.S. military (active duty and veterans) and their spouses can qualify for VA loans. A VA loan allows you to buy a home with zero down payment and lower interest rates than most other types of home loans.
VA loans typically don’t require private mortgage insurance, but you’ll pay a funding fee, which is a percentage of the total loan amount.
Pros of VA Loans
- Flexible credit score requirement
- No down payment required
- No mortgage insurance
Cons of VA Loans
- Limited to active duty, veterans, and their spouses
- Borrowers must have a Certificate of Eligibility (COE)
- VA loans have funding fees
7. USDA Loan
The U.S. Department of Agriculture offers USDA loans to low-and-moderate–income buyers in rural areas who otherwise cannot qualify for a conventional mortgage.
If you’re looking to buy a home in areas designated eligible by the USDA, you must meet the income limits. These limits vary by location. USDA loans are offered by local- and online-approved lenders. However, you can get the loan directly from the USDA itself.
The USDA doesn’t have credit score requirements, but borrowers with a score of 640 or higher are said to have a streamlined process. Like FHA loans, down payments can be as low as 0%, but you must pay PMI if you put down less than 20%. USDA loans are best for anyone who can qualify.
Pros of USDA Loans
- No minimum credit score requirements
- Help low-to-moderate-income buyers buy a home
Cons of USDA Loans
- Income and geographical restrictions
- You must pay PMI if you put down less than 20%
How to Choose Which One is Right for You?
Choosing the right mortgage is a major decision that can impact your financial health. With several types of home loans, choosing a mortgage that best suits your needs can be challenging, especially if you’re a first-time homebuyer. Here are five things to look at to help you make the right choice.
Loan Type
There are various types of home loans. Depending on your needs, you may be able to qualify for these mortgages:
- Conventional mortgage (Have good credit and low DTI ratio)
- Jumbo loans (Want to buy a house that’s more expensive than the standard guidelines)
- FHA loans (Have a low credit score)
- USDA loans (Want to live in rural or suburban areas)
- VA loans (Have a military connection)
Loan Terms
Most mortgage lenders offer flexibility in loan terms. While most types of home loans have terms ranging from 15 to 30 years, you can negotiate for a shorter or longer term.
If you choose a mortgage with a shorter term, your monthly payments will be high, but you’ll pay less interest over time. Plus, you’ll build equity faster. On the other hand, long-term loans have relatively low monthly payments, but you’ll pay more in interest.
Fixed vs. Adjustable Rates
Another factor to consider when choosing a mortgage is the interest rate. Do you want a fixed or adjustable rate?
With a fixed-rate mortgage, your monthly payments will remain the same over the life of the loan. This means you can predict how much you’ll pay each month, which can help you plan and budget for the long term. On the other hand, an ARM has a variable interest rate, which fluctuates over the loan term.
Down Payment
If you’re taking on a mortgage, you must put down a certain percentage of your home’s purchase price. The minimum down payment on a house varies depending on the type of home loan you choose. In some cases, you might be eligible for a loan that doesn’t require a down payment.
Repayment
Most mortgage repayment terms last anywhere from 15-30 years. Choosing a longer repayment term means lower monthly mortgage payments but more interest over time. The shorter the repayment term, the higher your monthly payments will be, but you’ll pay less interest over the life of the mortgage.
