As a prospective home buyer, it’s just as important to research types of mortgage as the neighborhoods you want to live in. Applying for a home loan can be complicated, and deciding which type of mortgage best suits your needs early on will help direct you to the type of home you can afford.
There are a number of home loans to choose from when you buy property, so it’s important to fully understand the advantages and disadvantages of each type before you make a decision.
Depending on the type of mortgage you choose, you’ll have different requirements that influence your rate, the length of the loan, and your lender. Selecting the right mortgage for your situation can lower your down payment and decrease the overall interest payment over the life of your loan.
Related: What is a Mortgage?
Types of mortgage
- Conventional loan – Best for borrowers with a good credit score.
- Fixed-rate mortgage – Best for borrowers who want the predictability of the same payments throughout the entire loan.
- Adjustable-rate mortgage – Best for borrowers who do not plan to stay in the home for a long time, and are comfortable with the risk of larger payments down the road.
- Government-insured loan – Best for borrowers who have lower credit scores and not much cash for a down payment.
- Jumbo loan – Best for borrowers with excellent credit looking to buy an expensive home.
Understanding Different Types of Mortgage
1. Conventional loan
Conventional loans are not backed by the federal government, and they come in two packages: conforming and non-conforming.
Conforming loans – As the name implies, a conforming loan “conforms” to a set of standards put in place by the Federal Housing Finance Agency (FHFA). The standards include a range of factors about your credit and debt, but one of the main pieces is the size of the loan. For 2022, the conforming loan limits are $647,200 in most areas and $970,800 in more expensive areas.
Non-conforming loans – These loans do not meet FHFA standards. They might be for larger homes, or they might be offered to borrowers with subpar credit. Some non-conforming loans are designed for those who have gone through major financial catastrophes such as bankruptcy.
Pros of conventional loans
- Can be used for a primary home, second home or investment property
- Overall borrowing costs tend to be lower than other types of mortgage, even if interest rates are slightly higher
- Can ask your lender to cancel private mortgage insurance (PMI) once you’ve reached 20 percent equity, or refinance to remove it
- Can pay as little as 3 percent down on loans backed by Fannie Mae or Freddie Mac
- Sellers can contribute to closing costs
Cons of conventional loans
- Minimum FICO score of 620 or higher often required (the same applies for refinancing)
- Higher down payment than some government loans
- Must have a debt-to-income (DTI) ratio of no more than 43 percent (50 percent in some instances)
- Likely need to pay PMI if your down payment is less than 20 percent of the sales price
- Significant documentation required to verify income, assets, down payment and employment
Who should get a conventional loan?
If you have a strong credit score and can afford to make a sizable down payment, a conventional mortgage is probably your best pick. The 30-year, a fixed-rate conventional mortgage is the most popular choice for homebuyers.
2. Fixed-Rate Mortgages
A fixed-rate mortgage has the same interest rate and principal/interest payment throughout the duration of the loan. The amount you pay per month may fluctuate due to changes in property tax and insurance rates, but for the most part, fixed-rate mortgages offer you a very predictable monthly payment.
A fixed-rate mortgage might be a better choice for you if you’re currently living in your “forever home.” A fixed interest rate gives you a better idea of how much you’ll pay each month for your mortgage payment, which can help you budget and plan for the long term.
You may want to avoid fixed-rate mortgages if interest rates in your area are high. Once you lock-in, you’re stuck with your interest rate for the duration of your mortgage unless you refinance. If rates are high and you lock-in, you could overpay thousands of dollars in interest.
Pros Of Fixed-Rate Mortgages:
- Monthly payments don’t change over the life of your loan, making it easier to plan a budget.
Cons Of Fixed-Rate Mortgages:
- You may end up paying more in interest over time if the rates are high.
Home Buyers Who Might Benefit:
- Buyers that are purchasing or refinancing their forever home.
3. Adjustable-Rate Mortgages
The opposite of a fixed-rate mortgage is an adjustable-rate mortgage (ARM). ARMs are 30-year loans with interest rates that change depending on how market rates move.
You first agree to an introductory period of fixed interest when you sign onto an ARM. Your introductory period is typically 5, 7, or 10 years. If you sign on for a 5/1 ARM loan, for example, you’ll have a fixed interest rate for the first 5 years. During this introductory period, you pay a fixed interest rate that’s usually lower than 30-year fixed rates.
After your introductory period ends, your interest rate changes depending on market interest rates. Your lender will look at a predetermined index to calculate how rates are changing. Your rate will go up if the index’s market rates go up. If they go down, your rate goes down.
ARMs include rate caps that dictate how much your interest rate can change in a given period and over the lifetime of your loan. Rate caps protect you from rapidly rising interest rates.
For example, interest rates might keep rising year after year, but when your loan hits its rate cap, your rate won’t continue to climb. These rate caps also go in the opposite direction and limit the amount that your interest rate can go down as well.
ARMs can be a good choice if you plan to buy a starter home before moving to your forever home. You can easily take advantage and save money if you don’t plan to live in your home throughout the loan’s full term.
These can also be especially beneficial if you plan on paying extra toward your loan early on. ARMs can give you some extra cash to put toward your principal. Paying extra on your loan early can save you thousands of dollars later on.
Pros Of Adjustable-Rate Mortgages:
- Gives lower interest rates for the initial introductory period.
Cons Of Adjustable-Rate Mortgages:
- If the rate increases, it can dramatically increase your monthly payments.
- Home Buyers Who Might Benefit:
- Those who are purchasing a starter home and don’t expect to live there for the loan’s full term.
4. Government-insured loan
The U.S. government isn’t a mortgage lender, but it does play a role in helping more Americans become homeowners. Three government agencies back mortgages: the Federal Housing Administration (FHA loans), the U.S. Department of Agriculture (USDA loans), and the U.S. Department of Veterans Affairs (VA loans).
- FHA loans – Backed by the FHA, these types of mortgage loans help make homeownership possible for borrowers who don’t have a large down payment saved up or don’t have pristine credit. Borrowers need a minimum FICO score of 580 to get the FHA maximum of 96.5 percent financing with a 3.5 percent down payment; however, a score of 500 is accepted if you put at least 10 percent down. FHA loans require two mortgage insurance premiums: one is paid upfront, and the other is paid annually for the life of the loan if you put less than 10 percent down, which can increase the overall cost of your mortgage. Lastly, with an FHA loan, the home seller is allowed to contribute to closing costs.
- USDA loans – USDA loans help moderate- to low-income borrowers buy homes in rural areas. You must purchase a home in a USDA-eligible area and meet certain income limits to qualify. Some USDA loans do not require a down payment for eligible borrowers with low incomes. There are extra fees, though, including an upfront fee of 1 percent of the loan amount (which can typically be financed with the loan) and an annual fee.
- VA loans – VA loans provide flexible, low-interest mortgages for members of the U.S. military (active duty and veterans) and their families. VA loans do not require a down payment or mortgage insurance, and closing costs are generally capped and may be paid by the seller. A funding fee is charged on VA loans as a percentage of the loan amount to help offset the program’s cost to taxpayers. This fee, as well as other closing costs, can be rolled into most VA loans or paid upfront at closing. Many lenders offer the lowest rates possible on VA loans, and some are willing to accept lower credit scores.
Pros of government-insured loans
- Help you finance a home when you don’t qualify for a conventional loan
- Credit requirements more relaxed
- Don’t need a large down payment
- Available to repeat and first-time buyers
- No mortgage insurance and no down payment required for VA loans
Cons of government-insured loans
- Mandatory mortgage insurance premiums on FHA loans that cannot be canceled unless refinancing into a conventional mortgage
- Loan limits on FHA loans are lower than conventional mortgages in most areas, limiting potential inventory to choose from
- Borrower must live in the property (although you may be able to finance a multi-unit building and rent out other units)
- Could have higher overall borrowing costs
- Expect to provide more documentation, depending on the loan type, to prove eligibility
Who should get a government-insured loan?
If you cannot qualify for a conventional loan due to a lower credit score or limited savings for a down payment, FHA-backed and USDA-backed loans are a great option. For military service members, veterans, and eligible spouses, VA-backed loans can be a good option — often better than a conventional loan.
5. Jumbo Loans
A jumbo loan is one that’s worth more than conforming to loan standards in your area. You usually need a jumbo loan if you want to buy a high-value property. For example, you can get up to $2.5 million in a jumbo loan. The conforming loan limit in most parts of the country is $548,250.
Jumbo loan interest rates are usually similar to conforming interest rates, but they’re more difficult to qualify for than other types of loans. You’ll need to have a higher credit score and a lower DTI to qualify for a jumbo loan.
Pros Of Jumbo Loans:
- Their interest rates are similar to conforming loan interest rates.
- You can borrow more for a more expensive home.
Cons Of Jumbo Loans:
- It’s difficult to qualify for, typically requiring a credit score of 700 or higher, significant assets and a low DTI ratio.
- You’ll need a large down payment, typically between 10 – 20%.
Home Buyers Who Might Benefit:
- Those who need a loan larger than $548,250 for a high-end home, have a good credit score and low DTI.
Other types of home loans
In addition to these common kinds of mortgages, there are other types you may find when shopping around for a loan:
If you want to build a home, a construction loan can be a good choice. You can decide whether to get a separate construction loan for the project and then a separate mortgage to pay it off, or wrap the two together (known as a construction-to-permanent loan). You typically need a higher down payment for a construction loan and proof that you can afford it.
With an interest-only mortgage, the borrower pays only the interest on the loan for a set period of time. After that time is over, usually between five and seven years, your monthly payment increases as you begin paying your principal.
With this type of loan, you won’t build equity as quickly, since you’re initially only paying interest. These loans are best for those who know they can sell or refinance, or for those who can reasonably expect to afford the higher monthly payment later.
A piggyback loan also referred to as an 80/10/10 loan actually involves two loans: one for 80 percent of the home price and another for 10 percent. Then, you make a down payment of 10 percent. These are designed to help the borrower avoid paying for mortgage insurance.
While eliminating those PMI payments might sound appealing, keep in mind that piggyback loans require two sets of closing costs and two loans accruing interest. You’ll need to crunch the numbers to find out if you’re really saving enough money to justify this unconventional arrangement.
Another type of home loan you might come across is a balloon mortgage, which requires a large payment at the end of the loan term. Generally, you’ll make payments based on a 30-year term, but only for a short time, such as seven years.
At the end of that time, you’ll make a large payment on the outstanding balance, which can be unmanageable if you’re not prepared. You can use Bankrate’s balloon mortgage calculator to see if this kind of loan makes sense for you.