Different Types of Mortgages Explained
Deciding which new house is for you is the fun part of home buying. What's not so fun - but totally necessary - is figuring out what type of mortgage is best for you.
Start with the Big Questions
Purchasing a home is not a decision you can take lightly. Before you start, ask yourself the following questions:
- How much money should I put down on the home? Our article "How to Save for a Down Payment on a House" will help you answer this question.
- How much should your mortgage payment be? Our article "How Much House Can I Afford" helps with this question.
- Do you qualify? Read "How to Get Approved for a Mortgage" for more information.
Once you have these answers, you will have a better understanding of your situation and you're ready for the next step: figuring out the type of loan you need. Here we will discuss the different types of mortgages available.
Conforming vs Non-Conforming
All loans fall into two categories - conforming or non-conforming. Two government mortgage associations handle what's known as conforming loans; they are Fannie Mae and Freddie Mac. The agencies set guidelines for the lenders you'll be working with if you get a conforming loan.
Non-conforming loans are those not backed by Fannie Mae or Freddie Mac. Instead, individual lenders offer these mortgages as a part of their program. The bank keeps the mortgage; unlike a loan made with Fannie Mae or Freddie Mac, these loans never reach the secondary market. Because the bank does not have to conform to a government-tied agency's rules, they can create their own rules and may accept riskier loans.
Which type of loan will you be more likely to get? It depends on the qualifications lenders are looking for and how much you want to borrow. Risky borrowers or those with a higher loan size tend to fall outside the conforming guidelines.
Following are basic guidelines to help you determine where you stand:
- Loan size. Every year, Fannie Mae and Freddie Mac set loan limits. Any loans above these limits become non-conforming. In 2017, the conforming loan limit is $424,100. Lenders consider any loan higher than this amount non-conforming. Another word for this type of loan is jumbo.
- Qualifications. Conforming borrowers usually have high credit scores. They also have low debt ratios and clean credit histories. If your credit score is lower than 680, you may not qualify for a conforming loan. Other issues that prevent approval include prior bankruptcies, foreclosures, or high debt ratios.
Lenders have been known to make up for the riskiness of a loan by charging higher rates or fees, while during other times they may lower the rates to attract a certain kind of buyer. Because different lenders have varying thresholds for risk and are not always consistent, you should always shop around and consider your options. This will allow you to find the best rates and fees available.
Government-Backed vs Conventional
Conforming borrowers have more choices - if you qualify, you get to decide between a government-backed loan and a conventional loan. You can rule two choices out right away if you do not meet the following requirements:
This loan program offered by the Department of Veteran Affairs is for veterans. VA loans offer low interest rates, 100% loans, and easy guidelines. The VA department does not fund these loans, but they do set the guidelines for them. Approved VA lenders then offer the loans to qualified veterans. The lenders must follow the VA's guidelines. The loose guidelines include:
- Minimum 620 credit score
- Stable income for the last 2 years
- Satisfactory left-over income after paying monthly obligations
- Maximum 41% total expenses versus gross monthly income
- Property must be safe and sanitary as well as have enough value for a 100% loan
- Property must be your primary residence
- Maximum loan-to-value ratio equals 100%
Borrowers purchasing a home in a rural area can apply for the USDA loan. The U.S. Department of Agriculture oversees this loan program. Borrowers eligible for this program do not make more than 115% of the average median income for the area. You can view the income guidelines and property boundaries on the USDA website. Just like the VA, the USDA guarantees the loan it approves. The guidelines they provide lenders include:
- Minimum 620 credit score
- Consistent income for the last 24 months
- Mortgage payment may not exceed 29% of your gross monthly income
- Total monthly debts may not exceed 41% of your gross monthly income
- Property must be modest, safe, and sanitary
- You must not be eligible for any other loan program
- You must live in the property full-time
- Maximum 100% LTV (loan-to-value ratio)
Once you determine you are not eligible for a VA or USDA loan, you have other options. The FHA and conventional loan are two common choices.
The mortgages known as "conventional" do not have any type of government guarantee. Instead, the government agencies, Fannie Mae and Freddie Mac, serve as their secondary market. As lenders fund the loans, they sell them to the secondary market enterprises. The loans must follow Fannie Mae and Freddie Mac's guidelines for investors to purchase them, though. The basic guidelines are as follows:
- 5% down payment required
- Max loan amount $424,100
- Minimum credit score 680
- Mortgage payment may not exceed 28% of your gross monthly income
- Total monthly obligations may not exceed 36% of your gross monthly income
- The home can be your primary residence, investment, or vacation home
Conventional loans, whether through a Fannie Mae or Freddie Mac program, require PMI (Private Mortgage Insurance) with a down payment lower than 20%. The insurance premiums you pay cover the lender if you default on the loan. The insurance company pays the bank back the money they lost. You pay PMI until you owe less than 80% of the value of your home. The amount of PMI you pay is based on your credit score and the loan-to-value ratio. Once you hit 78% LTV, the law requires banks to cancel PMI.
FHA loans are backed by the Federal Housing Administration, a government agency. Just like the VA, the FHA sets guidelines lenders must follow. The lender funds the loan and the FHA guarantees them in the face of default. FHA loans are not just for first-time homebuyers. If you meet the requirements, you can secure an FHA loan. However, there are reasons mostly first-time homebuyers use this program. First, let's talk about the guidelines:
- Minimum 3.5% down payment
- Minimum credit score of 580 to qualify for the 3.5% down payment
- Some lenders accept credit scores as low as 500 with a 10% down payment
- Mortgage payment may not exceed 31% of your gross monthly income
- Total monthly obligations may not exceed 43% of your gross monthly income
- The home must be your primary residence
FHA loans also have mortgage insurance. In fact, you pay it twice with FHA loans. You pay the first premium upfront or at the closing. Right now, it equals 1.75% of your loan amount. You also pay mortgage insurance every month. The FHA calls it annual mortgage insurance, but you pay the premiums monthly. Right now, borrowers pay 0.85% of the outstanding loan amount. On a $150,000 loan, you would pay $106.25 per month. The mortgage insurance premium is typically higher than PMI. It also lasts for the life of the loan, which is why borrowers lean towards conventional loans. However, if you do not have more than a 3.5% down payment or you have a low credit score, an FHA loan may be your best option.
Fixed or Adjustable Interest Rates
Another choice you have is whether you want a fixed or adjustable rate. The most common is a fixed rate. This means you have the same interest rate for the entire length of the loan - your monthly payment is always the same. You may find terms like 15-, 20-, or 30-year fixed rates. However, there are differences in the terms. Although the 30-year term is the most popular, you gain equity very slowly with this term.
4% interest rate
Monthly payment = $955
Cost of the loan for the entire term = $343,739
3.5% interest rate
Monthly payment = $1,430
Cost of the loan for the entire term = $257,358
This is a difference of $86,401. If you can afford the $475 higher payment per month, you stand to save a lot of money over the life of the loan.
Adjustable rate loans have a fixed rate for a short period. This is the "introductory" period. Afterwards, it adjusts according to the predetermined schedule. The adjustable rate loan, known as ARM, can change quite a bit. It is usually amortized over 30 years, just like a 30-year fixed loan, but you cannot predict the rate.
A 3/1 ARM means you have a fixed interest rate for the first 3 years of the loan. After the 3 years, the rate can adjust one time per year for the rest of the term. You cannot predict how it will adjust, but you can watch the ARM's index. Many ARMS adjust according to LIBOR. Your loan documents will show the margin, or the amount the bank adds to the current index to come up with your rate.
There are a few benefits of the ARM loan. Obviously, the lower rate helps you afford the loan more easily. However, it also helps people qualify for higher loan amounts. The lower payment means a lower debt ratio, which oftentimes means approval for a higher loan. You do have the ability to refinance before or even after the rate adjusts.
Unique Loan Types
Many borrowers opt for conventional or government-backed loans. However, there is one other option - balloon mortgages.
Balloon mortgages have a significantly shorter term than any other loan. They work similar to a fixed rate loan because the rate does not adjust. However, the entire balance becomes due on the maturity date. The terms are typically short on these loans. You will commonly find 5- and 7-year terms. This means at the end of the 5 or 7 years, the remaining principal balance becomes due.
Borrowers who benefit from the balloon loan are those who will sell the home before the maturity date. Usually, people who flip houses use this loan type. However, if you know your home purchase is temporary, a balloon mortgage may save you money in the end. Balloon mortgage payments are mostly interest during the initial term. This is how the banks make their money. You owe the entire amount in a few short years. This is not a long time for the bank to make a profit on the loan. This means you may owe most of the principal all at one time at the end of the term.
Take your time and really understand the mortgage program you obtain. In many cases, you can refinance in the future, but you cannot predict what will happen. If your credit score falls or the value of your home drops, refinancing might not be an option. Understanding the full implication of your mortgage program will provide the best results.