As debts go, the mortgage is pretty popular. In fact, 44% of U.S. consumers have one, according to 2020 data from Experian, the credit reporting agency. If you’re planning to finance a home purchase, then it’s likely you’ll be joining the mortgaged masses.
What you might not know is that there are six main types of mortgages: conventional loans, jumbo loans, and interest-only loans, and three federal government-backed mortgage programs through the Federal Housing Administration (FHA), U.S. Department of Agriculture (USDA), and Veterans Affairs (VA).
What are the features, pros and cons of each? Who qualifies for which type? And which one is the best option for you?
Let’s start with the basics.
How does a mortgage work?
As you shop for a house, unless you’re buying in cash, you’re also shopping for a mortgage. This is a loan that will enable you to pay the cost of the house over a set period of time, often 15 or 30 years. The Consumer Financial Protection Bureau recommends contacting at least three lenders to explore your options. A lender will look at your specific financial situation to determine how much money you qualify to borrow and at what interest rate.
Once you close on your house, your monthly mortgage payment will go toward your principal (the total amount you borrowed) and the interest on the loan. Part of your monthly payment may also go toward an escrow account to pay property taxes, mortgage insurance, and homeowners insurance.
Your mortgage loan is secured by your property itself, which means if you violate the loan agreement terms, the lender can claim your property.
How do you qualify for a mortgage?
- Credit score. This number, ranging from 300 to 850, tells a lender how well you manage your debts. Your lender uses your score to determine your creditworthiness. Typically, the better your credit score, the better your interest rate.
- Debt-to-income ratio (DTI). You can determine your DTI by dividing your total monthly minimum debt payments (student loans, car loans, and minimum credit card payment, for example) by your gross monthly income (before taxes and deductions are taken out). Most lenders want to see a DTI of 45% or below (some go up to 50%), which includes factoring in your prospective mortgage payment.
- Savings. Your lender wants to see that you have enough saved to cover your down payment and closing costs without going into the red.
What interest types are available?
Your mortgage loan comes with an interest rate, the cost you’ll pay to your lender to borrow the money that buys your home. You can choose between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM).
What’s the difference?
With a fixed-rate mortgage, you get:
- One interest rate for the entire life of your loan. That means if you secure a 30-year mortgage with a 3% interest rate this year, it will still be 3% when you make your final mortgage payment three decades from now.
- Reliability. Your principal and interest payments will remain the same for the life of your mortgage, making it easier to budget. (Your escrow payments may change with your tax and home insurance costs).
A drawback is that rates might drop below the one you’ve secured, leaving you with the homeowner’s equivalent of FOMO.
An adjustable-rate mortgage gives you:
- A low introductory rate to start. After a set period of time — usually five, seven or 10 years — the interest rate will adjust to the market rate.
- A lower mortgage payment for the first few years. This could be advantageous to people who plan to sell before the rate changes.
A drawback is that once the rate changes, the interest payment portion of your mortgage payment will change, too. This can be risky if you’re on a budget, especially if the interest rate increases significantly.
Now that you know what a mortgage is, how it works, how to qualify, and the difference between interest-rate arrangements, let’s take a look at mortgage types.
Most conventional loans are conforming loans, meaning they have certain requirements that qualify the loan to be backed by Fannie Mae or Freddie Mac, government-sponsored enterprises (GSEs).
Buyers must meet these requirements for a conforming, conventional loan:
- Minimum credit score: 620
- Minimum down payment: 5% (could be as low as 3% for certain borrowers)
- Max DTI: 50%
- Is mortgage insurance required? Yes, private mortgage insurance (PMI) is typically required for a down payment that is less than 20% of a purchase price.
A major benefit of this type of mortgage is that it’s a ubiquitous offering from lenders. “Because it’s widely available, it’s really easy to shop around …” says Helali.
“You can call Lender A, Lender B, Lender C … and they’re all going to have an offering for these conventional loans. So, you’d expect to see great interest rates, because they’re all going to be competing with each other.”
But for a conventional loan, the devil is in the details. Even though the minimum credit score is technically 620, buyers will likely need a 660 or higher to get a good interest rate, Helali says. And if you’re planning on making a down payment of less than 20%, your lender may want to see a credit score of at least 700.
A conventional loan is a good option for people with strong credit and money for a solid down payment. But buyers with weaker credit who need to make a smaller down payment might want to look into an FHA loan instead, Helali says.
A jumbo loan is a mortgage that exceeds $548,250, the maximum loan limit set by the Federal Housing Finance Agency for most U.S. counties. Unlike conforming conventional loans, a jumbo loan is considered non-conforming. This means Fannie Mae or Freddie Mac won’t insure it.
For lenders, jumbo loans are riskier to extend than conventional loans, so the qualification requirements will likely be steeper.
Buyers must generally meet these requirements for a jumbo loan:
- Minimum credit score: 700
- Minimum down payment: 10%
- Max DTI: 45%
- Is mortgage insurance required? The lender can decide whether or not to require mortgage insurance.
Jumbo loans are ideal for buyers who want to spend more on a house than a conventional loan allows. The catch is that lenders expect the buyers to be “ultra-qualified,” Helali says. Not only will they be looking at credit score, down payment and DTI, but they’ll also expect buyers to have ample additional reserves, just in case.
This type of loan is rare, and with good reason: it comes with risk for both the buyer and the lender. Most lenders prefer not to offer this type of loan, and if they do offer it, it’s usually only to high-net-worth buyers who already have ongoing investments with the institution. With an interest-only mortgage, you’ll pay only interest — rather than contribute toward the principal — for what’s known as the introductory period, usually five to 10 years.
Unlike the other loan types where the threshold for qualifying must conform to guidelines set by the GSEs or government programs, interest-only loans are only offered by private banks and the qualification requirements for these loans are entirely at the discretion of the lender.
“The biggest pro is that your payment is going to be a lot lower,” Helali says. He gives the example of someone buying a $500,000 house, with a $100,000 down payment. With a conventional loan, the mortgage is about $1,700 a month. But with an interest-only loan, the payment could be $1,250 a month.
But here’s the catch: These mortgages tend to be adjustable-rate, so after the introductory period, not only will you need to begin paying down your principal, but you might also have a higher interest rate. That means a higher monthly payment.
For wealthy buyers who don’t plan to live in a house long term or pay off the principal, and instead prefer to invest their extra money, this could be a good option. But for most buyers, this mortgage type won’t be an available option.
The next three mortgage types are government-backed loans.
An FHA loan is a type of mortgage that’s been around since 1934. The Federal Housing Administration, which is part of the U.S. Department of Housing and Urban Development, backs each FHA loan, giving approved lenders the ability to offer low down payments and easier credit qualification.
Buyers must generally meet these requirements for an FHA loan:
- Minimum credit score: 580
- Minimum down payment: 3.5%
- Max DTI: 43% (but can go up to 57% for certain qualified buyers)
- Is mortgage insurance required? Yes.
For buyers with low credit scores, small down payments and lower incomes, the FHA loan might be the best — and only — option. “The drawback on FHA is, regardless of how much you put down … that person is going to have mortgage insurance, whether they like it or not,” Helali says. “Mortgage insurance for FHA loans is typically the life of the loan.” (Unless you make a down payment of 10% or higher — then you’ll pay FHA mortgage insurance for 11 years.)
A USDA mortgage is backed by the U.S. Department of Agriculture and is designed for low-to-moderate income buyers who want to live in eligible rural areas. “It’s the government’s way of helping people afford homes outside the major metropolitan areas,” Helali says.
Buyers must generally meet these requirements for a USDA loan:
- Minimum credit score: No set requirement, but typically 640 or higher
- Minimum down payment: No down payment required.
- Max DTI: 41%
- Is mortgage insurance required? No, but USDA loans do require an upfront guarantee fee and an annual fee that is paid monthly for the life of the loan. Even so, total mortgage costs are typically lower than a conventional loan.
These loans may be attractive to low- to moderate-income buyers who want to live in a rural area while avoiding some of the expenses they may encounter through a conventional loan.
A VA loan, issued by a private lender and backed by the U.S. Department of Veterans Affairs, was created in 1944 to help service members returning from service in World War II to purchase homes. Today, it’s still helping veterans, service members and certain military spouses become homeowners.
Buyers must generally meet these requirements for a VA loan:
- Minimum credit score: Although the VA has no set credit score requirement, lenders typically set 620 as the minimum.
- Minimum down payment: No down payment required.
- Max DTI: 41% (though technically the VA doesn’t set a maximum DTI)
- Is mortgage insurance required? Mortgage insurance is not required, since the loans are fully backed by the VA.
The VA loan can be a great option for buyers who want to avoid a down payment, since they won’t need to pay mortgage insurance. But VA-eligible buyers do need to factor in their funding fee. This one-time payment, which can be as high as 3.6% of the loan, helps fund the VA loan program. (Not every VA loan recipient is required to pay it.)
While VA loans are often the best option for veteran homebuyers, if you find that you’ll be required to pay the higher funding fee and are in a position to make a larger down payment, say over the 20% to exclude you from paying for PMI, it’s definitely worth considering whether a conventional or jumbo loan is a better option for you, Helali says. This is where you should work with your experienced loan officer to look at all the types of mortgages available to you to find the best program to fit your needs.
Taking the next step
Should you go with a fixed-rate conventional loan with 10% down? Or an adjustable-rate one with 20% down? Or maybe a VA loan with no money down?
Once you’re ready to move forward, it’s a good idea to speak with a loan officer who can provide additional insight on deciding between, for example, a fixed or adjustable rate, Helali says.
“Each one of these has their own set of pros and cons. There’s no right or wrong way to do it,” he says.
If you have questions about which types of mortgages are right for you, our team of professionals at HomeLight Home Loans can speak with you about your specific needs and help you determine the best funding option to purchase your new home.
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