When buying a new home or refinancing your existing home mortgage, one of the decisions that most homebuyers need to make is the type of mortgage loan to take out. While some buyers do pay cash for their home, this is not an option for most homebuyers. Choosing the best mortgage option for your situation is an important financial decision and can make your home purchase or refinance more affordable.
Buying a home is the largest financial purchase most of us will ever make. How you finance this purchase is a critical financial decision. Here are seven types of mortgage loans to consider.
A conventional mortgage is a mortgage loan that is not government insured. Conventional mortgages can be either conforming or nonconforming loans. A conforming loan is one that conforms to guidelines set by Freddie Mac and Fannie Mae, two government backed entities that purchase mortgages from the originating bank or other financial institutions.
A nonconforming loan is one that exceeds the FHFA (Federal Housing Finance Agency) conforming loan limits or the Freddie Mac or Fannie Mae underwriting guidelines. Nonconforming loans often carry a higher interest rate compared to a conforming loan as they carry a higher level of risk for the lender.
The pros of a conventional mortgage include:
- A conventional loan can be used to finance a primary residence, a second home or an investment property.
- The overall borrowing costs of a conventional mortgage are often lower than with other types of mortgages, even if the interest rate on the mortgage is a bit higher.
- You may be able to have your PMI insurance cancelled once you achieved a 20% equity level in the property, or the PMI can be removed by refinancing the loan.
- Your down payment can be as low as 3% for conventional loans backed by Freddie Mac or Fannie Mae.
The cons of a conventional mortgage include:
- The minimum FICO score required, generally at least 620, may be higher than for some other types of loans. The minimum applies to refinancing as well.
- A higher down payment is generally required than with a government insured loan.
- In order to qualify, your debt-to-income ratio (DTI) will need to be better (a lower DTI ratio) than with a government insured loan.
- If your down payment is less than 20%, you will generally be required to pay PMI as part of the monthly mortgage payment.
- You will need to provide extensive documentation regarding your income, assets, debt level and other financial information to qualify.
A conventional mortgage is often the best option for borrowers with a strong credit score, a stable income and a stable employment history. A down payment of at least 3% is generally required.
A fixed-rate mortgage is one where the interest rate remains fixed for the full term of the mortgage. This means that the payment amount for principal and interest will remain fixed. Your payment might vary a bit over time due to changes in local property taxes or other similar costs that are a part of your payment.
Pros of a fixed-rate mortgage include:
- Monthly payments for principal and interest remain the same throughout the life of the loan.
- The stability of the payments can make ongoing budgeting easier for borrowers.
Cons of a fixed-rate mortgage include:
- You may pay more interest over the life of the loan than with some other types of mortgages.
- It can take longer to build equity in your property than with many adjustable mortgages.
- Initial interest rates are generally higher than for adjustable rate mortgages.
Adjustable-rate mortgage (ARM)
Unlike a fixed-rate mortgage, an adjustable-rate mortgage or ARM has a fluctuating interest that is subject to periodic adjustments based on prevailing market interest rates.
With an ARM, the interest rate is fixed for an initial period. This is typically the first 5, 7 or 10 years of the loan term. After that the interest rate can fluctuate up or down depending upon the direction of interest rates. There will be a benchmark interest rate tied to the mortgage and the rate can be adjusted at set intervals based on the direction of the benchmark.
Many ARMs have a cap on the amount of this adjustment. This is an important feature to look for as you don’t want to risk a major increase in the rate, and in your monthly payment, if interest rates suddenly spike up.
Pros of an adjustable-rate mortgage include:
- The initial payment can be lower than with a fixed-rate loan, saving you a substantial amount in interest costs in the initial years of the mortgage.
Cons of an adjustable-rate mortgage include:
- If interest rates are increasing, over time your mortgage payments could become unaffordable.
- If the value of your home falls in the face of rising interest rates it could make it hard to either refinance or sell the home to get out of these higher payments.
An adjustable-rate mortgage could be a good choice for a buyer who can tolerate the potential risk and uncertainty of a variable payment, and a buyer who isn’t planning to stay in the home over the long-term.
An interest-only mortgage is what the name implies. For the first few years of the loan term, often the first 5-7 years, the borrower pays only the interest portion of the loan. There are no payments towards the principal.
Pros of an interest-only mortgage include:
- The monthly payments are initially lower, allowing you to save money towards the higher payments down the road.
- For those who are likely to move out of the house before the interest-only phase ends, this can allow them to save money for other goals or for a down payment on their next home.
- The mortgage interest may be tax-deductible depending upon your situation.
Cons of an interest-only mortgage include:
- If you are not prepared, the shock of drastically higher payments when the interest-only period ends can cause major financial issues.
- If the value of the home declines during the interest-only period you could find yourself upside down on the mortgage since you haven’t been paying anything against the principal.
- If your financial situation changes and you can’t make the payments, you could lose your home.
An interest-only mortgage is generally best for those with higher credit scores; some banks may require a minimum FICO score as high as 700. These loans are best for those who are financially prepared to make the higher payments down the road and who may want to divert some money elsewhere, perhaps into investments, during the interest-only period.
A jumbo mortgage is one whose balance is higher than the conforming loan limits. For 2021, this range is $356,362 to $685,400 for an FHA loan. The Fannie Mae and Freddie Mac limit is $548,250, the limit is higher in some areas of the country.
Pros of a jumbo mortgage include:
- You can borrow more to buy a property in a higher cost area.
- The interest rates on these loans are competitive with those on other conventional loans.
Cons of a jumbo loan include:
- A down payment of 10% - 20% is generally required.
- Many lenders require a higher FICO score than with conventional loans at a lower amount.
- Borrowers generally must be able to show they have significant assets in cash or savings to qualify.
A jumbo loan is best for an affluent buyer looking to purchase a higher priced property. These borrowers should have solid income, excellent credit and sufficient assets in reserve.
A balloon mortgage requires a large payment at the end of the mortgage term. The loan will be amortized as if it was a 30-year loan for a relatively short time, such as seven years. At the end of that period a large balloon payment will be due.
Pros of a balloon mortgage include:
- A balloon payment can make getting into a home more affordable for the borrower.
- This can work out well if the borrower is able to refinance prior to the balloon payment coming due, if they sell the house for a sufficient amount prior to the due date or if they have the money set aside for the balloon payment.
Cons of a balloon mortgage include:
- If the borrower cannot make the balloon payment when it comes due, they could lose their home.
A balloon mortgage can be a good fit for someone who is certain that they will be able to make the balloon payment when it comes due.
There are three main types of government insured mortgages: FHA, VA and USDA backed loans. These loans are less risky for lenders as these agencies guarantee the loans if the borrower defaults.
Each of these agencies has specific criteria to qualify.
Pros of government-insured mortgages include:
- Lower interest rates and required down payment amounts.
- Less restrictive approval requirements than with conventional loans.
- You don’t need a large down payment.
- They are available to both first time buyers and to repeat buyers.
Cons of government-insured mortgages include:
- Only those borrowers who meet a specific set of criteria can qualify.
- Some government-insured mortgages require the purchase of insurance that can push up the price of borrowing.
- These loans could have a higher overall cost than conventional loans.
- You will likely need to provide a higher level of documentation than with a conventional loan.
The three main types of government-insured mortgages are:
FHA mortgages are backed by the Federal Housing Administration. The minimum FICO score is generally 580 with a 3.5% down payment, it is 500 with a 10% down payment. These loans are a good option for buyers who don’t have a large down payment or who have blemishes on their credit history.
VA mortgages are backed by the Department of Veterans Affairs. These loans are available to veterans, active duty military and their families. VA loans do not generally require a down payment or mortgage insurance. Closing costs are generally capped and they may be paid by the seller.
There is a funding fee assessed on the loan, this fee along with any other closing costs can be rolled into the loan if desired.
These mortgages are backed by the U.S. Department of Agriculture. USDA mortgages are designed to help low to moderate income borrowers in rural areas. These loans have income limits to qualify. In some cases, eligible borrowers will not be assessed any closing costs.
These and other government-insured mortgages are generally issued through participating banks and other financial institutions. The government backing on these loans is an incentive for these banks to be willing to issue these loans.
Choosing the best type of mortgage for your situation is a key financial planning decision that can have a big impact on your financial future and your ability to afford the best home for your situation. It pays to do your homework on the seven types of mortgages listed above as well as others before moving forward.