Updated January 30, 2018

Different Types of Mortgages Explained

Mortgage options can be super confusing. We break down the different types of mortgages to help you figure out which loan is best for you.

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Start with the Big Questions

Purchasing a home is not a decision you can take lightly. Before you start, ask yourself the following questions:

Once you have a better understanding, you're ready for the next step: figuring out the type of loan you need.

Keep reading to learn about the different mortgage types.

Conforming vs Non-Conforming

All loans fall into two categories - conforming or non-conforming.

Comforming Loans: Two government mortgage associations handle conforming loans: Fannie Mae and Freddie Mac. The agencies set guidelines for the lenders you'll be working with.

Non-Conforming Loans: These are not backed by Fannie Mae or Freddie Mac. Instead, individual lenders offer these mortgages as a part of their program.

Unlike a loan made with Fannie Mae or Freddie Mac, these loans never reach the secondary market. In other words, the bank keeps the mortgage.

You Should Know: Banks can create their own rules and may accept riskier loans. They dot have to conform to a government-tied agency's rules.

So which type of loan are you 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.

Here are some basic guidelines to determine where you stand and what type of financing is possible:

  • 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 was $424,100. Any loan higher than this amount is considered non-conforming. Another word for this type of loan is jumbo.

  • Qualifications. Conforming borrowers usually have high credit scores, also known as FICO scores.

    They also have low debt ratios and clean credit histories. If your FICO 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 to the borrower. During other times they may lower the rates to attract a certain kind of buyer.

TIP: Shop around to find the best rates and fees available, as well as affordable payments. Different lenders have varying thresholds for risk and therefore different options.

Government-Backed vs Conventional

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Conforming borrowers have more choices. If you qualify, you get to decide between a government-backed loan and a conventional mortgage.

You can rule two choices out right away if you do not meet the following requirements:

VA Loans
Only veterans can qualify for this loan program offered by the Department of Veteran Affairs. 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 for a VA loan 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%

USDA Loans
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 to finance a home purchase.

Conventional Loans

"Conventional" mortgages 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. Conventional mortgage loans must follow Fannie Mae and Freddie Mac's guidelines for investors to purchase them, though. These guidelines are:

  • 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. In other words, 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.

You Should Know: 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

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 mortgage.

However, there are reasons mostly first-time homebuyers use this program. First, let's review 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.

1. You pay the first premium upfront or at the closing. Right now, it equals 1.75% of your loan amount.

2. 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.

Consider: On a $150,000 loan, you would pay $106.25 per month in annual mortage insurance.

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.

203k Loans

An FHA 203K loan is an FHA loan that is intended for renovating real estate. Previously, homeowners applied for separate loans for purchase and renovation.

Now it is possible to buy the fixer-upper and finance the renovation with one mortgage package or seek the mortgage for renovation of an existing property.

The general requirements are the same as for an FHA loan. In addition:

  • Properties can be from 1-4 units or condos, and the borrower must intend to live there. (You should have a separate living area, unless you intend to live in a construction zone.)

  • Projects must be completed within six months

  • The money for payment of contractors is kept in escrow. For that reason, working with contractors who are dependable and do not underbid is essential.

Loan limits are up to 110% of the home's value after restoration. There are maximum limits set by the FHA, and you must borrow at least $5,000.

This type of a "fixer" loan may be preferable to a Home Equity Line of Credit (HELOC) if you actually already own the property.

You Should Know: A HELOC is a line of credit that is drawn against the existing equity in the property by the homeowner for repairs or emergencies. It is paid back with monthly payments like a credit card.

The 203K loan is a better fit for a buyer who wants to purchase and renovate all at once.

Fixed or Adjustable Interest Rates

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You must also decide whether you want a fixed or adjustable rate.

Fixed Rate: The most common kind. This means you have the same interest rate for the entire length of the loan. In other words, your monthly payment is always the same.

You can find 15-, 20-, or 30-year fixed rate terms. However, there are differences. Although the 30-year term is the most popular, you gain equity very slowly with this term.

$200,000 Loan
Interest Rate:4%
Term:30 Years
Monthly Payment:$955
Total Cost of Loan:$343,739

Interest Rate:3.5%
Term:15 Years
Monthly Payment:$1,430
Total Cost of Loan:$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: They have a fixed rate for a short, or "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.

For example:

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 mortgage ARM 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.

The ARM loan has a few benefits.

  • The lower rate means lower monthly payments, which makes it more affordable.

  • 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 have the ability to refinance before or after the rate adjusts.

Unique Loan Types

Many borrowers opt for conventional or government-backed loans. However, there are other options - jumbo loans and balloon mortgages.

Jumbo Loans
In most markets, the maximum amount for a conforming loan is $424,100. There are some high-priced markets where the maximum amount is higher, but under $636,150.

In most of Hawaii, the threshold is $721,050. Any loan amount which exceeds these thresholds is a jumbo loan.

Lenders generally require:

  • A credit score over 700
  • A higher debt to income ratio, usually above 43 percent, and cash reserves
  • High down payments, usually between of 15 to 30 percent
  • Two appraisals

You Should Know: Jumbo loans fall outside the conforming loan restrictions. As such, they are not backed by Fannie Mae or Freddie Mac.

However many lenders adhere to guidelines for "qualified mortgages" set by the Consumer Financial Protection Bureau.

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. At the end of the 5 or 7 years, the remaining principal balance becomes due.

You Should Know: Borrowers who benefit from the balloon loan usually sell the home before the maturity date. For example, people who flip houses use this loan type.

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. It means you may owe most of the principal all at one time at the end of the term.

Bottom Line

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.

More from CreditDonkey:

Pre Approval Mortgage

What Do I Need to Buy a House

How to Get Approved for a Home Loan

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