What Are The Different Types Of Mortgages Available? How Do I Choose The Right One For Me?
Buying a home can be an exciting process, but this can be offset with being tied to a substantial mortgage for decades. Depending on which type of mortgage you choose, you may be stuck with monthly payments for the term of the mortgage as a reminder of your poor decision-making - or even foreclosure if you fall behind.
In this article, we will take a look at the different types of mortgages that homeowners can apply for as well as provide information about which option is the best for your particular situation.
What are the Different Types of Mortgages?
The following are the most common types of mortgages available to prospective homeowners:
- Conventional mortgages
- Jumbo mortgages
- Government-issued mortgages
- Fixed-rate mortgages
- Adjustable-rate mortgages
- Conventional mortgages
Conventional mortgages are the most common type of home loans that borrowers take out to fund a new home purchase. These loans are typically issued by banks and other lenders, which means that they are not insured by the federal government. Conventional mortgages fall into two categories: conforming and non-conforming loans.
A conforming loan means that the loan amount is capped within maximum limits set by the Federal Housing Finance Agency (FHFA). On the other hand, mortgage loans that do not meet these guidelines are considered non-conforming loans (see Jumbo mortgages below).
What makes conventional mortgages a good idea is that the overall borrowing costs tend to be lower than other mortgages, which makes them useful for funding a primary home or secondary investment properties. You may be able to fund your home purchase with as low as 3% down for loans that are backed by Fannie Mae or Freddie Mac
While the barriers to entry are low, lenders of conventional mortgages generally require a substantial down payment of the mortgage is paid upfront (20% of the home’s value) to avoid private mortgage insurance (PMI), a fee that offsets the risk to lenders. Also, interest rates tend to be slightly higher than other types of loans, leading to more interest on the mortgage.
Jumbo mortgages are conventional mortgages that have non-conforming loan limits. Like their name suggests, jumbo mortgages are designed for larger home purchases that exceed loan federal loan limits. These loan limits in 2021 for single-family homes in most of the United States is $548,250, and for certain high-cost areas, the maximum is $822,375.
Because of their cost and the risk to the lender, jumbo loans generally require more documentation and upfront payments to qualify for. Down payments for qualified borrowers usually requires at least 10 - 20%, a minimum credit score of 660 (700 and above is more common to qualify), significant cash assets, and a debt-to-income ratio below 45%. That being said, interest rates tend to mirror those of conforming conventional loans.
For individuals that may not qualify for conventional loans through bad credit history or a lack of savings, the federal government offers paths to homeownership with several mortgages backed by government agencies. Some of the most popular include FHA loans (Federal Housing Administration), VA loans (U.S. Department of Veterans Affairs, and USDA loans (U.S. Department of Agriculture).
Here’s a brief overview of each mortgage type:
- FHA loans: For a 3.5% down payment of a home’s value, FHA loans make it possible for those with bad credit (as low as 580 for 3.5%; 500 is acceptable for 10% down payment).
- VA loans: For active members of the military and veterans who have served, VA loans provide low-interest mortgages that don’t require a down payment or private mortgage insurance (PMI).
- USDA loans: For those looking for property in rural areas, USDA loans help moderate- to low-income borrowers purchase homes if they meet certain qualifications (such as household income equal to or less than 115% of the area median income). Besides the VA loan, the USDA loan is one of the few loans that doesn’t require a down payment.
Fixed-rate mortgages are home loans that maintain the same interest rate over the life of the loan. This means that monthly mortgage payments always remain the same.Because of their fixed nature, these loans typically come in terms of 15 years, 20 years or 30 years where you’ll pay off the same monthly principal and interest over the course of the loan. This helps homeowners budget their expenses more precisely and avoid market fluctuations.
However, there are a few drawbacks to fixed-rate loans, as borrowers will generally pay more interest the longer their loan terms are, face higher interest rates than adjustable-rate mortgages (see below), and will take longer to build equity in the home.
Adjustable-rate mortgages (ARMs) are loans that have fluctuating interest rates. Many ARMs begin with a fixed interest rate for the first few years, then change based on market conditions after this period has elapsed. This can be a great deal for homeowners that may only want to stay in their home for a few years, then move to another locations to avoid higher interest rates.
Savvy homebuyers should look for an ARM that caps how much the interest rate or monthly mortgage rate will increase. If you don’t, you may wind up paying substantially more when the loan resets or even defaulting on the loan. Other options include refinancing the loan, but not all lenders may offer this option.