There are many different types of mortgages. Before you apply for a home loan, you need to understand how each one works. This includes conventional mortgages and government-backed loans, such as FHA or VA mortgages. It also includes both fixed- and adjustable-rate loan options.
This guide explains all of the different mortgage types so you can make an informed choice about which loan is right for you before you apply for mortgage pre-approval.
There are 13 mortgage types borrowers need to know about.
A conventional loan is a mortgage that’s not guaranteed by a government agency. They’re widely available. So you’ll have options when choosing a mortgage lender. They’re often confused with conforming loans, which are a subset of conventional mortgages. A conforming loan meets requirements to be purchased by Fannie Mae and Freddie Mac. Lenders often resell mortgages, and Fannie and Freddie buy most of the loans on the secondary market.
Here are some of the key things you need to know about conventional mortgages:
- Conventional mortgages are best for borrowers with fair or good credit. Because there’s no government guarantee, qualifying requirements are stricter. You generally need a credit score of at least 620 to qualify. Higher is preferred.
- Conventional loans require a down payment. The minimum is 3% with some lenders. It’s more common to require at least 10% down. All or part can come from a down payment gift (depending on your circumstances).
- Private mortgage insurance is typically required with a down payment below 20%. This protects the lender in case of foreclosure.
- Conventional mortgages come in different forms. You could choose a fixed-rate conventional mortgage or one with an adjustable rate, and you’ll have a wide selection of repayment timelines including 15 years, 20 years, or 30 years.
30-year fixed rate
A 30-year fixed-rate mortgage is a mortgage loan you’ll pay off over 30 years. Your rate and payment remain the same for the entire repayment time.
Here are some of the key things you need to know about 30-year fixed-rate loans.
- You can get a conventional or government-backed 30-year mortgage.
- 30-year mortgage rates are usually higher than on loans with shorter payoff timelines.
- Monthly payments are lower than on loans with shorter repayment timelines. This is true even though the 30-year loan typically has a higher interest rate than loans with shorter payoff times. It’s because you’re making payments for more time.
- You’ll pay more interest than on loans with a shorter repayment timeline. By stretching out your time to pay off your loan, your total interest costs increase.
- Qualifying requirements vary by lender. Your eligibility for a loan and the rates you’re offered depend on the type of 30-year fixed-rate loan. If you obtain a 30-year fixed-rate FHA loan, you’d be subject to the qualifying rules set by the FHA.
15-year fixed rate
A 15-year fixed-rate loan is a mortgage you’ll pay off over 15 years. Your rate and payment remain the same for the full repayment period.
Here are some of the key things to know about 15-year fixed-rate loans.
- Both conventional and government-backed 15 year mortgages are available.
- 15-year mortgage rates are usually lower than the rates on loans with longer repayment terms.
- Monthly payments are higher than on loans with longer payoff times. Since you’re reducing the number of payments you make, each one is higher.
- You’ll pay less interest than on a loan with a longer repayment period. When you pay interest for less time, total interest costs decline.
- Qualifying requirements vary by lender. You can get a 15-year conventional loan or government-backed loan. Qualifying requirements are determined by the option you chose. Because 15-year loans have higher monthly payments, they can be harder to qualify for.
FHA loans are mortgages backed by the Federal Housing Administration. Because of the government guarantee, lenders take less risk and qualifying requirements are more lax. However, there are some additional costs you won’t usually incur with conventional loans.
Here are some of the key things you need to know about an FHA loan:
- FHA loans are best for borrowers with poor or fair credit or with minimal down payments. Borrowers can qualify with a credit score as low as 500 with 10% down or 580 with 3.5% down. All of your down payment can come from a down payment gift.
- Mortgage insurance is required. There’s an upfront fee of 1.75% and an annual fee based on loan term and the ratio of your loan amount relative to home value. In some cases, mortgage insurance premiums must be paid for the life of your loan.
A VA loan is guaranteed by the Veterans Administration. The VA offers direct loans and also guarantees loans from private VA lenders. Although there are some upfront fees, VA loans are easy to qualify for and designed to be affordable.
Here are some of the things you should know about VA mortgages:
- VA loans are available only to active-duty military members and eligible veterans.
- There’s no down payment required.
- No mortgage insurance is required. This is true regardless of your down payment.
- There’s an upfront funding fee. The fee varies depending on your down payment and whether you’ve already obtained a VA loan in the past. Some borrowers don’t have to pay this, including those eligible for VA compensation for service-connected disabilities.
A USDA loan is guaranteed by the U.S. Department of Agriculture. The USDA makes direct loans, or guarantees loans made by USDA mortgage lenders. USDA loans are targeted for lower income borrowers purchasing homes typically in rural areas.
Here’s what you need to know about USDA loans:
- USDA loans are best for borrowers with limited incomes and low down payments. No down payment is required for USDA loans.
- Borrowers and properties must meet eligibility criteria for a USDA loan. There are income limits, as well as loan limits and restrictions on the type and location of property purchased.
- USDA loans come up with upfront and ongoing fees. The upfront funding fee is 1% of the loan amount and the annual fee is 0.35% of the average scheduled unpaid principal balance.
A jumbo loan is a loan for a larger amount of money. The specific threshold at which a loan becomes “jumbo” varies by location and changes periodically. A loan is “jumbo” if it’s too large to be purchased by Fannie Mae or Freddie Mac.
Here’s what you need to know about jumbo loans:
- Jumbo loans are best for borrowers with excellent financial credentials who are purchasing expensive homes. Many lenders require a credit score above 700.
- Down payment requirements are often higher. Some lenders allow you to take jumbo loans with just a 10% down payment. Many require you to put down 20% or more.
- Mortgage insurance is usually required with less than 20% down.
- Jumbo loan rates can be fixed or adjustable. You’ll have a choice of loan terms including 15-year or 30-year loans.
ARM stands for adjustable-rate mortgage. The “5/1” in the name specifies that the initial interest rate will remain fixed for the first five years and can then begin adjusting once annually.
Here’s what you need to know about a 5/1 ARM:
- ARMs make sense when their starting interest rate is below the rate on fixed-rate alternatives. It usually only pays to take a risk of your rate adjusting if the rate starts low.
- Your rate and payment could change. Your interest rate is tied to a financial index. If the index shows rates rising, your interest rate goes up. This increases the amount of your monthly payment. And it means you pay more interest over time.
A 7/1 ARM is an adjustable-rate mortgage. It keeps your interest rate stable for the first seven years. After the initial seven year period, your rate begins adjusting once annually.
Here’s what you need to know about a 7/1 ARM:
- It can make sense to take a 7/1 ARM if your initial rate is below fixed-rate alternatives. Low starting rates may justify the risk of your rate adjusting upward.
- Your rate and payment could change. After seven years, your rate will begin adjusting along with a financial index. Payments could go up if your interest rate rises.
Balloon mortgages require you to pay a large lump-sum payment after a short period of time. Typically, your monthly payment covers interest only, or is based on what it would cost to pay off your loan over 30 years. Your entire remaining mortgage balance comes due after just a few years.
Here’s what you need to know about balloon mortgages:
- Balloon mortgages are extremely high risk. You’ll initially make small monthly payments. But you’ll owe the entire balance of your loan after just a few years. This creates a significant risk of foreclosure.
- Some borrowers take out balloon mortgages if they plan to move or refinance soon. Balloon loans can be easier to qualify for due to their low monthly payments. If you don’t plan to keep the mortgage for long, they may seem smart. Just be aware of the considerable risks.
An interest-only mortgage requires you to only cover interest costs on your home loan. Your monthly payment does not reduce your loan balance. Usually, you pay interest only just for a limited time. Then payments go higher or you make a lump-sum payment.
- Interest-only mortgages are risky and expensive. You don’t make any progress on paying off your loan although you pay interest every month. After a period of time, your payments rise substantially or you owe a large lump sum.
- Some borrowers choose interest-only mortgages because they offer a low monthly payment initially. This could make it easier to get approved for them or afford your payment. But be aware your payments will be higher once your interest-only period ends than they would’ve been with a conventional loan that required you to pay interest from the start.
A 20-year mortgage is designed to be repaid within 20 years, as opposed to 15 years or 30 years.
Here are some of the key things to know about 20-year mortgages.
- Monthly payments are higher than a 30-year loan but lower than a 15-year. Shorter loan repayment periods lead to higher monthly payments.
- 20-year mortgage rates are usually lower than the rates on loans with longer terms but higher than those with shorter payoff timelines.
- Total interest costs are lower than on a 30-year loan but higher than a 15-year. When you pay interest for a longer period, your total costs are higher.
A refinance is a mortgage loan you take to repay a current mortgage. You’ll use the proceeds from the refinance loan to pay off your existing debt. You’ll then make payments to the new lender. There are different mortgage refinance types, including cash-out refinances.
Here’s what you need to know about refinance loans:
- Refinancing usually makes sense when you can reduce your current interest rate. If you can drop your interest rate, that means you’ll pay less to borrow.
- You may have the option to take a cash-out refi loan. You may be able to borrow more than the current amount you owe on your loan to tap into your home equity.
- You should consider your loan term carefully. Refinancing to a shorter loan term will save you the most on interest. But shorter repayment timelines lead to higher monthly payments. On the other hand, if you refinance to a loan that takes longer to repay, it’s possible you could end up with higher total costs even if you reduce your interest rate.
- Refinance loans come with closing costs. Some lenders offer no-closing-cost refinance loans, but usually those come with higher interest rates or the fees are tacked on to your loan balance.
View more information: https://www.fool.com/the-ascent/mortgages/mortgage-types/