Types of Mortgage Loans
Buying a home just might be the biggest purchase of your life. It’s an important decision involving big dollars, and you want to get it just right. The location, the layout, the look — you want everything to be as perfect as possible. But what about your loan?
As you search for your new home, take some time to find the right home loan for you as well. Consider the pros and cons of the five most common types of home loans to help you find a home and a home loan you can love.
Fixed-Rate Loan
A fixed-rate loan has the same interest rate throughout the life of the loan, which means your monthly mortgage payment will stay more or less the same for the entirety of your loan term.
Pros: Fixed-rate loans typically come in 15- to 30-year terms, and your rate won’t ever change. They’re a great option for those who want to stay in their home long-term and those who like to plan out their monthly payments, right down to the last dollar.
Cons: If market rates ever dip below your fixed interest amount, you may want to refinance your fixed-rate mortgage to lower your monthly payment. This process may save you money in the long run, but can cost extra in closing fees and other expenses upfront.
Conventional Loan
The most common type of home loan, a conventional loan, often comes with stricter lending requirements, including a higher qualifying credit score than other types of home loans.
Pros: A conventional loan usually comes with a fixed rate and you can choose your loan term, typically between 10 and 30 years. It’s a great choice for most borrowers because a conventional loan can be used to purchase just about any type of home—a primary residence, a vacation home, or an investment property.
Cons: With conventional loans, you may want to save up for a larger down payment, as much as 20% of the purchase price of the home, to avoid paying monthly mortgage insurance on top of your conventional loan amount.
Adjustable-Rate Loan
An adjustable-rate loan, sometimes referred to as an ARM, is usually a 30-year loan with variable interest that may go up or down, depending on market conditions.
Pros: Some adjustable-rate loans come with a fixed interest rate for the first 5 to 10 years and is often lower than conventional loan rates. An adjustable-rate loan can be a good option for borrowers with lower credit, who may not qualify for a conventional loan. It’s also a good option for homeowners who may move before their introductory period expiries.
Cons: Following a fixed interest rate introductory period, the rate on an adjustable-rate loan is subject to change with the market. Even though most adjustable-rate loans come with hard caps that prevent your rate from exceeding a pre-specified percentage threshold, your monthly loan amount may change dramatically over the course of your loan term. This can potentially make homeownership much less affordable or make it harder to budget for each month.
Jumbo Loan
A jumbo loan is a home loan that typically costs much more and is often used for luxury homes and homes in competitive real estate markets. This type of loan often comes with certain loan restrictions and stricter lending requirements.
Pros: Although the principal loan amount is higher on a jumbo loan, interest rates are historically about the same as conventional loans. A jumbo loan can be a great option for those who want to purchase a more expensive home and for those who want to buy in an area with high home values.
Cons: A jumbo loan typically requires a higher qualifying credit score and a larger down payment of at least 20%. Because jumbo loans involve larger loan amounts, monthly payments are usually much more expensive than other types of home loans.
Government-Backed Loans
Government-backed loans, including FHA loans, VA loans, and USDA loans, are insured by the federal government and make home loans accessible to more borrowers.
Pros: With low down payment and relaxed credit score requirements, government-backed loans are great for borrowers who may not qualify for a conventional loan.
Cons: Because government-backed loans are insured by the federal government, depending on the type of loan, you may have to pay monthly insurance premiums. Loan limits may also be lower than with other types of home loans, possibly restricting the kind of property you can purchase.
- FHA Loan: FHA loans, insured by the Federal Housing Authority, require borrowers to pay monthly mortgage insurance. They also come with a low down payment requirement and are available to borrowers with lower credit scores.
- VA Loan: VA loans, backed by the Department of Veterans Affairs, are available to current and former members of the U.S. military and their families. There are no down payment or credit score requirements, and borrowers don’t have to pay mortgage insurance.
- USDA Loan: USDA loans, insured by the United Sates Department of Agriculture, are designed for low- to medium-income borrowers who want to buy a home in designated rural areas. There is no down payment requirement, but borrowers are required to pay mortgage insurance.
Other Types of Home Loans
Some borrowers fall outside the bounds of the traditional lending requirements covered by the five common types of home loans. But that doesn’t mean they’re on their own. Some lenders will structure loans to meet the specific needs of non-traditional homebuyers.
- Construction Loans: If you want to build your own home, you may want to look into securing a construction loan. These loans often come with shorter terms and higher interest rates.
- Interest-Only Mortgages: For borrowers who may need a little extra help affording monthly payments, interest-only mortgages provide the option to pay just the monthly interest amount at the start of the loan term — usually for the first 7 to 10 years. Although convenient, this may make the loan more expensive in the long-run.
- Piggyback Loans: Piggyback loans allow borrowers to “piggyback” their primary home loan with a secondary loan used as a down payment on the home purchase. This allows the buyer to satisfy a down payment requirement on a certain type of loan or to qualify for a loan without having to pay private mortgage insurance.
- Balloon Mortgages: Balloon mortgages allow borrowers to make small monthly payment amounts (often with little or no interest) for an initial term, after which the entire loan amount becomes due.
What to Consider Before Getting a Home Loan
At the end of the day, buying a home is all about finding the right fit for your personal, family, and financial situation. On top of finding the right home loan, you’ll want to make sure you can afford to make your monthly payments and ensure that your home fits your unique needs.
How Much Can I Afford?
Your lender will help you to understand exactly how much you can afford, but even before you consider your loan, it’s nice to know what types of homes you should be looking for. Look online for a free mortgage calculator to help you determine how much you can afford, based on your current income and debt amounts.
What Type of Home Fits My Needs?
Take some time to consider your specific home needs. How many bedrooms and bathrooms do you need? Do you have a square-footage requirement? What kind of yard, garage, and kitchen do you want? What neighborhood do you want to live in? This simple practice can give you an idea of how much your ideal home will cost and help you narrow down your list of suitable homes on the market.
What Size of Mortgage Do I Qualify For?
As you determine how much home you can afford, take into consideration your ability to afford a down payment, your credit score, and current market interest rates. These factors, in addition to your debt-to-income ration, will help you to determine the type of mortgage loan you can qualify for.
What Is My Credit Score?
Your credit score is an important factor in securing a home loan. It will determine your interest rate, type of loan, and monthly payment amount. Know your current score and how it impacts your ability to borrow money. If you can’t currently qualify for the type of loan you want, work to build or rebuild your credit and ask your lender whether you can qualify for a loan with a lower credit score requirement.
What Is My Debt-to-Income Ratio?
The last thing your lender wants to do is stretch you thin financially. Your debt-to-income ratio gives your lender an idea of how much debt you can manage and how much money you can afford to pay toward your loan every month. Take time to determine your gross monthly income and the amount you currently pay toward your debts. Typically, lenders like to see a debt-to-income ratio of no more than 36%.
What Does My Savings Look Like?
Although debt-to-income is the primary measurement for determining your loan amount and how much home you can afford, some lenders will want to see that you have enough money to cover the cost of several months of mortgage payments. Your current savings will also contribute to a down payment and may determine the type of loan you qualify for.
What to Know About the Monthly Payment
For many homeowners, the anatomy of a monthly home loan payment is a mystery. It’s not just a simple repayment of your principal loan amount, but rather a combination of several costs and home loan related payments rolled into one.
- Principal: The principal loan amount is the amount of money you borrow from your lender. If you borrow $300,000 to buy a home, you have to pay $300,000 of principal back to your bank, plus interest. A portion of each of your monthly home loan payments will go toward paying off this principal amount.
- Taxes: When you become a homeowner, you take advantage of roads, police services, and other government infrastructure in and around your residence. These services don’t come free and you now have the property taxes to prove it. In most home loans, your yearly property taxes will be included with your monthly mortgage amount.
- Interest: It costs money to borrow money. Interest is the price your bank charges to lend you money. As you repay your principal loan amount on a monthly basis, a portion of each payment will go toward interest. Because your loan amount is highest at the start of your loan, most of the interest you owe will be front-loaded onto your loan. As your loan progresses, you’ll pay less in interest and more of your monthly payment will go toward the principal.
- Insurance: Many lenders will require you to get homeowners insurance, in connection with your loan. After all, your bank has an interest in your home until your loan is repaid. Often, your homeowner’s insurance premiums, along with any mortgage insurance required by your specific loan, will be bundled with your monthly mortgage payment.
Buying a home is a big deal. Finding the right home loan is an important first step in what might be the biggest, most important purchase of your life. With a little work and the right lending partner, you’ll find a home and a home loan that’s right for you.