Types of Mortgages: The Break Down
By: Elizabeth Garner
When starting the home buying journey, one of the first steps you'll take is finding the right mortgage for you by meeting with a lender. A lender's job is to review your entire financial situation and evaluate the amount and type of loan you can be pre-approved for. To move forward in any real estate, assuming you will not make an all-cash offer, getting pre-approved is the first step to having that pre-approval letter ready for your REALTOR to begin the home search process. So what loans exist, and how do you qualify?
Types of mortgages
Conventional Fixed-rate – For borrowers with a good credit score (620 or higher); also great for borrowers who want the predictability of the same payments throughout the entire loan.
FHA – This is a loan run by HUD; it is an excellent option for first-time homebuyers but is available to everyone who qualifies as an option.
VA – For veteran borrowers and their families, great if you have lower credit scores and not much cash for a down payment, as this loan allows you to purchase a home with no downpayment.
USDA – The U.S. Department of Agriculture guarantees this loan. There are guidelines for income and the home's location, and if you meet those qualifications, you can benefit from a zero-down payment.
Jumbo loan – The best for borrowers with excellent credit (680+) looking to buy an expensive home. Rates can be higher with these loans; however, the limit for the loan amount is much higher than a conventional loan.
Adjustable-rate mortgage – These loans follow the path of a conventional loan for a fixed period; after that time, the rate would then adjust to fit the current market. This is best for borrowers who don't plan on owning the home for more than five years or who've prepared for higher payments in the future.
Now that you know what loans are out there let's look at each one in further detail. Each type of home mortgage has its own qualifications, benefits, and even pitfalls. Selecting the right loan will be crucial for you and your lender before starting your home search.
Conventional Fixed-Rate Loan
Conventional Fixed-Rate Loans are not backed by the federal government, which means they can have stricter requirements placed on them by the lender/mortgage company; they are broken down further into two types: conforming and non-conforming.
- Conforming Loans - These loans follow a set of standards provided by the Federal Housing Finance Agency or FHFA. They are looking at your credit, debt, and loan size to qualify you. As of 2022, the limit average for this type of loan is $647,200 in most areas and as much as $970,800 in more expensive areas.
- Non-Conforming Loans - These fall under the category of not meeting the FHFA standard; your lender might offer you this option if your credit is lower or if you have experienced financial catastrophes like bankruptcy.
- This loan can be used for a primary home, second home, or investment property.
- The cost of borrowing tends to be lower with this loan type, even if the interest rate might be slightly higher.
- Once you have reached 20% in equity, you can ask your lender to cancel the PMI (private mortgage insurance) or refinance to remove it.
- This loan allows you to make smaller down payments, as little as 3%, when backed by Fannie Mae or Freddie Mac (created by Congress to provide liquidity, stability, and affordability to the mortgage market)
- With this loan, sellers can also contribute to closing costs -- saving you money.
- This loan does require a minimum FICO (credit) score of 620 or higher (remember, there are non-conforming options if you fall under that score).
- Generally, you are looking at a higher down payment than some government loans.
- Your DTI (debt-to-income) ratio needs to be no more than 43%(sometimes it can be as high as 50%)
- Generally, PMI (private mortgage insurance) will be added to your loan if your downpayment is less than 20% of the sales price.
- Your income, assets, employment, and down payment will require verification with substantial documentation.
Government-Insured Loans (FHA, VA, USDA)
While the U.S. Government isn't a lender, they play an important role in helping Americans become homeowners. The three government agencies that back mortgages are the Federal Housing Administration (FHA loans), the U.S. Department of Veterans Affairs (VA loans), and the U.S. Department of Agriculture (USDA loans).
- FHA Loans - These are backed by FHA (Federal Housing Administration), and this loan helps make homeownership possible when your FICO (credit) score falls at or below 580. If you meet the minimum requirement of a 580 score, you can qualify with a maximum of 96.5% financing with a 3.5% downpayment. If your score falls below the 580 thresholds, you can still be eligible; however, you need to put down at least 10%. The FHA loan also requires two types of mortgage insurance premiums that can increase the overall cost of the loan. The sellers can also contribute to closing costs with this type of loan, saving you some money.
- VA Loans - This loan type is provided to members of the U.S. Military (active duty or veterans) & their families. It offers a flexible, low-interest mortgage that doesn't require a downpayment, mortgage insurance, or a minimum FICO (credit) score. VA loans do charge a funding fee that you can choose to pay upfront at closing, or you can have it folded into the cost of the loan with the other closing costs. In addition to that, closing costs are generally capped, and the seller can pay those closing costs.
- USDA Loans - The USDA loan helps low-income borrowers purchase homes in rural areas. The home you are buying must be in an eligible USDA area and require you to meet specific income limits to qualify. In some cases, the USDA loan doesn't require a down payment for those qualifying low-income borrowers. A few extra fees include an upfront fee of 1% of the loan amount and an annual fee of 0.35% (as of 2021) of the loan amount. These fees can generally be financed with the loan.
- These loans can be a great option when you don't qualify for a conventional loan.
- The credit requirements are more relaxed.
- You don't need a large down payment.
- These loans are options for first-time buyers and repeat buyers.
- VA loans do not require down payments or mortgage insurance.
- FHA loans require mortgage insurance premiums that cannot be canceled until refinancing to a conventional mortgage loan.
- FHA Loan limits are lower than conventional loans in most areas, limiting the potential inventory you have to choose from.
- Under all of these GI Loans, you must live on the property; however, you may be able to finance a multi-unit building and rent out the other units.
- There is the potential of the borrowing cost being higher.
- To prove eligibility, you will need to provide ample documentation depending on which loan type you go with.
Jumbo Loans are named accordingly. These loans are for higher-cost homes, such as luxury properties. They fall outside the FHFA limits and are more common in higher-cost areas like New York City, Hawaii, and Los Angeles.
- These loans have higher limits (the limits may vary from area to area) and can be used to borrow more money to purchase more expensive homes.
- Interest rates are competitive with other conventional loans.
- Typically a 10-20% down payment is needed.
- You would need a FICO (credit) score of at least 680+
- Your DTI (debt-to-income) ratio must be below 45%
- Proof of significant assets (in cash or savings) must be provided.
- More in-depth documentation is required to qualify.
Adjustable-rate mortgages follow the ups and downs of the rate based on the market. This means your monthly payments will be varied; however, they will be fixed for a period based on the loan. For example, you might see a five-year/ six-month ARM. This means you will have a fixed rate for the first five years of the loan and after your rate will adjust up or down every six month. If you are considering an ARM, read the fine print carefully to know how much your rate can go up and how much you could pay once the fixed-rate introductory period ends.
- Possible lower rates in the 1st few years of ownership.
- ARMs can save you money on interest payments.
- Once the variable rate begins, it can result in high payments that are no longer affordable and has the potential of loan default.
- Refinancing or selling before the loan resets could be more challenging if home values decrease.
Now that we've covered the types of loans available to you (there are others, but this list is the most common we see in home sales), your next step is to find the right lender for you. There are many options from banks, credit unions, mortgage lenders, and even some online-only mortgage companies. With such a wide range to choose from, you must choose the lender with the best terms to fit your financial needs.
If you're in the market for a lender, please follow any of the links below to make a connection:
Photo Credit: Precondo CA & Tierra Mallorca on Unsplash
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