If you're like most homebuyers, you likely know you need to take out a mortgage, but choosing between the different options can be as overwhelming as finding your dream home. While all mortgages share the same purpose—buying property—they each come with their own advantages, disadvantages, and unique terms. What’s more, the type of home loan you borrow can have a tremendous impact on your future and financial health.
Let’s go over the main types of home loans you’re likely to encounter—which fall into two categories: conventional mortgage loans and government-backed mortgage loans.
Conventional mortgage loans
A conventional mortgage is offered by a private lender—such as a bank or a mortgage company—rather than a government-sponsored enterprise, such as the Federal National Mortgage Association (commonly known as Fannie Mae) or the Federal Home Loan Mortgage Corporation (commonly known as Freddie Mac). Most of these are what’s known as “conforming,” as they still adhere to the Federal Housing Finance Administration’s (FHFA) loan limits and meet Fannie Mae and Freddie Mac requirements. However, there is a subcategory of conventional mortgages called “nonconforming,” which are less standardized.
Fixed-rate mortgages are the most common kind of conventional loan—allowing you to borrow a set amount of money and pay it back in monthly installments. Most fixed-rate mortgages come with a 15- or 30-year loan term (though other lengths are available), and all have a consistent interest rate until you sell or refinance your property. Fixed-rate mortgages are ideal if you want the ease of predictable monthly payments. They allow you to more accurately budget for other expenses without having to worry about housing market fluctuations.
There are pros and cons regarding the length of a fixed-rate mortgage. For example, you will pay less money in the long run with a 15-year loan, thanks to fewer interest payments and a lower interest rate. However, your monthly bills will be higher since you will be paying off the loan within the shorter period. With a 30-year loan, you will pay lower monthly installments if you borrow the same amount, but the additional 15 years of interest fees will result in you paying more overall.
Adjustable-rate mortgages (ARMs)
Fixed-rate mortgages are pretty straightforward, but what are adjustable-rate mortgages? The fundamental difference between the two is that ARMs only have a fixed interest rate for the first few years of the loan term. After that, your interest rate resets to reflect market conditions at specified intervals. For example, a 5/1 ARM has a fixed interest rate for the first 5 years and is subject to market fluctuations every year after that.
Adjustable-rate mortgages might work for you if you plan to relocate sooner rather than later, and only need the loan for a few years. It’s also possible that you’ll pay less per month if market rates work in your favor once they become adjustable. However, ARMs are risky bets. Your interest payments might be much higher when the first few years of your mortgage are up, which can cause financial strain—especially if you lose your source of income or the economy suffers. Some ARMs also charge prepayment penalties that make it difficult to refinance or sell your home within the first few years of living in it.
Monthly mortgage payments traditionally include two components: principal, which is a fraction of the original amount you borrowed, and interest. When it comes to interest-only mortgages, you have the option to only pay the interest portion of your monthly bill for the first few years of your loan. However, once this period is over, you then need to pay back the principal amount—which means your monthly payments will increase dramatically due to the delay in repayment.
Interest-only mortgages can be useful if you have variable income (such as if you work on commission). Still, there are drawbacks to taking out an interest-only mortgage. For one thing, it can be difficult to qualify for them. They also lengthen the time it takes for you to pay back the loan. Interest-only mortgages played a significant role in the 2007 housing crisis, because they encouraged homebuyers to borrow more money than they would have otherwise.
A jumbo mortgage exceeds the federal loan limits set by the FHFA, making it a nonconforming conventional mortgage (which we know is a mouthful). To put it simply, if you want to borrow more than the government-set limit—which is currently $510,400 in most counties—you may consider taking out this kind of mortgage.
Jumbo mortgages are advantageous for purchasing a high-end home in an expensive area, but they’re considered riskier for the lender because they do not come with government protections if a borrower defaults. As such, jumbo loans enforce stricter qualification standards: you must have a minimum credit score of at least 700 and a low debt-to-income (DTI) ratio. Different lenders will have unique criteria—and some may be more flexible than others—but many require you to have a maximum DTI of 45%.
Your chances of qualifying for a jumbo mortgage are higher if you have plentiful cash reserves, but you should be prepared to pay a higher down payment and pay potentially higher interest rates than you would with a conforming loan.
Government-backed mortgage loans
The U.S. government does not directly loan money to homebuyers, but there are multiple government agencies that purchase loans from private lenders. These are designed to make homeownership more accessible to borrowers with less-than-ideal credit scores and savings. Some government-supported loans include:
The Federal Housing Administration (FHA) insures loans from an approved list of lenders in the event that their borrowers default. FHA loans are particularly advantageous for homebuyers who cannot afford a steep upfront cost—allowing them to obtain financing with as little as a 3.5% down payment.
FHA loans are popular amongst first-time homebuyers, and you don’t need to have an exceptional credit score to qualify (the minimum is 580 to qualify for a 3.5% down payment). The FHA aims to help more people become homeowners, but there are a few conditions. First, you can only borrow so much (between $331,760 and $765,600 depending on your state and the number of people in your family). Second, you are required to pay a mortgage insurance premium (MIP). You can pay this premium upfront or over the life of the loan, which is usually around 1% of the loan’s value.
Loans issued through the United States Department of Agriculture’s (USDA) loan program are meant for families who live in rural areas. They are advantageous for low to mid-income applicants who do not qualify for other kinds of mortgages due to reasons including a low credit score and a high DTI. The government finances the entirety of a USDA-eligible home’s value, meaning borrowers do not need to make a down payment in order to purchase property. Similar to FHA loans, the USDA partners with local lenders and insures loans that are part of its program. Because local lenders have been guaranteed repayment even if borrowers default, they are able to offer low interest rates.
If you live in a rural area and are considering a USDA loan, keep in mind that you will have to purchase mortgage insurance. Another significant eligibility qualification is that your other debts cannot exceed 41% of your total income.
Department of Veterans Affairs loans are for, as you might have guessed, U.S. veterans. They are also available to eligible service members or the spouses of service members who died in the line of duty or have a service-related disability. VA loans have no need for a down payment or mortgage insurance. They also come with no prepayment penalties—which allows you to pay off your loan faster if you’re in a position to do so. The Native American Direct Home Loan program offers unique terms to Native American veterans and their spouses.
Unlike conventional loans, you will also have to pay a one-time VA funding fee if you qualify, which goes directly toward keeping the program running.
Finding the right mortgage for you
As you can see, there is no one-size-fits-all mortgage solution. You have to do your research to figure out which has the best terms for your financial situation and how long you anticipate living in your home.
Better Mortgage offers both fixed and adjustable rates for conventional and jumbo loans. We can also finance a whole range of properties, including single-family homes, multi-family homes, townhouses, and more. Get pre-approved today, and we’ll help you find the perfect mortgage for your needs.