Many potential home buyers may not realize just how many mortgage options are available, but understanding these different types of home loans -- and the pros and cons of each -- is a crucial first step in the home buying process. Moreover, understanding what it takes to qualify for each type of mortgage will help you prepare to take the next step, and properly plan your repayment strategy.
What Type of Home Loan is the Best?
Your preferred mortgage will vary depending on the cost of the home you’re purchasing, your current financial standing, and whether you expect your income, home value, or interest rate to change over the next few years. Your preferred mortgage type will also depend on your ultimate goals for your property, as choosing the wrong mortgage could lead to penalties or frustrations down the line. In order to determine which mortgage choice is best for you, read on to learn the pros and cons of the five types of mortgage loans.
What Are the 5 Types of Mortgage Loans?
While niche mortgage loans do exist, the five major types of mortgages are:
- Conventional Mortgages
- Jumbo Mortgages
- Government-Insured Mortgages
- Fixed-Rate Mortgages
- Adjustable-Rate Mortgages.
Ultimately, you will only be able to access each of these different types of mortgages if you meet the necessary requirements, which will differ loan by loan. Below, we’ve broken down what you’ll need to show to qualify for each type of mortgage, and what your repayment strategy may look like if you meet the loan’s requirements.
- Conventional Mortgages include Conforming and Non-Conforming Loans, and Are Great For Borrowers with Strong Credit Histories and DTI Ratios.
Conventional mortgages can be used to purchase nearly any type of property, and will usually require borrowers to put down at least 3% –– though this amount may vary if you lack a stable employment history and strong credit score (typically 620 or higher), or have a debt-to-income ratio that’s higher than 45%. Keep in mind that if you put down less than 20% you’ll also need to pay private mortgage insurance, which will protect your lender if you become unable to make your required payments.
By definition, conventional loans are mortgage loans that are not insured by a government agency, and will include two different types of mortgages: conforming and non-conforming loans. Conforming loans meet the requirements of government-backed agencies like Fannie Mac and Freddie Mae. On top of requiring borrowers to meet the credit score and DTI parameters listed above, a conforming loan will typically only allow borrowers to take out $548,250 for a single-family home. Conversely, non-conforming loans (like Jumbo Loans) often do not meet a conforming loan’s requirements because they allow borrowers to take out a much larger amount, and may be used to purchase other types of properties like commercial properties. These loans will often require borrowers to put down at least 20% and pay much higher interest.
The Advantages of Conventional Mortgages
Conventional loans are great for borrowers with a strong credit history (a score of 620 or above), a debt-to-income ratio of 45% or less, and stable employment history because they can require as little as 3% down when you’re purchasing a primary residence. However, if you’re willing to put down 10-20% and pay PMI, you can also use a conventional loan to purchase an investment property.
The Cons of Conventional Mortgages
While conventional loans will often require borrowers to pay private mortgage insurance, you may be able to ask your lender to cancel your PMI payments once you’ve reached 20% equity. That said, these loans will still come with higher down payment requirements than government-insured loans, and require borrowers to meet strict, properly documented requirements.
- Jumbo Mortgages Can Be Used to Purchase Expensive Properties in High Cost Areas, But Will Often Require Borrowers to Cover a 20% Down Payment.
As mentioned, a jumbo mortgage is essentially a non-conforming conventional loan. These loans are considered non-conforming because they can be used to cover higher amounts than conforming, government backed loans. In 2021, the Federal Housing Finance Agency set the maximum conforming mortgage amount allowed in most areas to $548,250 for a single-family home, with $822,375 allowed in areas that were considered high cost. Jumbo loans are designed to give borrowers the ability to purchase a home that costs more than these capped amounts.
Obviously, this loan is incredibly beneficial if you want to purchase a home that is priced higher than what you’d be able to cover with a conventional mortgage. However, it’s important to note that jumbo loans will require higher credit scores (700 and above) and a very low debt-to-income ratio (below 45%) since they are considered higher risk than other types of mortgage loans. Beyond that, you’ll also need to show you have strong assets in cash or savings, that can be used to cover at least 10% of your total loan amount.
The Advantages of Jumbo Mortgages
The main advantage of a jumbo mortgage is that it can be used to purchase a more expensive home in a high-cost area, and may offer very competitive interest rates for borrowers with strong credit (a score of 700 or above), low DTI ratios (less than 45%), and funds to cover a 20% down payment.
The Cons of Jumbo Mortgages
The major pain point with jumbo loans is that it can be very difficult to qualify for these mortgages, and those who do qualify will have to make significant down payments and usually pay higher closing costs. In addition, competitive interest rates are not necessarily guaranteed, and a high interest rate on a jumbo loan can lead to very hefty monthly payments down the line.
- Government-Insured Mortgages Offer the Most Competitive Interest Rates and Down Payment Requirements, but Eligibility Will Depend on Location, Income, or Military Service.
Government-insured mortgages generally have much lower credit score and down payment requirements than other mortgage types and refer to three different types of loans. Each of these different home loans is backed by a specific government agency, including the U.S. Department of Agriculture (which backs USDA loans), the U.S. Department of Veterans Affairs (which backs VA loans), and the Federal Housing Administration (which backs FHA loans).
USDA loans can only be used in USDA-eligible areas, and are generally given to moderate or low-income borrowers who want to purchase a home in a rural area. USDA loans may be issued as direct loans –– with interest rates as low as 1% –– but income requirements will differ region by region. Additionally, these loans may also be issued as home improvement loans or grants and may provide up to $27,500 in assistance.
VA Loans are low-interest mortgages offered to active duty military and veterans that do not require borrowers to make any down payment. They may even require sellers to cover closing costs, but come with a VA Funding Fee to lower the taxpayer’s part in funding this program. Consequently, borrowers will be required to make a one-time payment to cover this fee on any VA loan.
FHA mortgages are an excellent option for borrowers with low credit scores, as applicants with a credit score as low as 500 may qualify for an FHA loan. These different types of home loans also allow some borrowers to make lower down payments –– as low as 3.5% with a 580 credit score –– though others may not qualify (borrowers with a 500 credit score will be required to put at least 10% down).
The Advantages of Government Insured Mortgages
The main advantage of FHA, VA, and USDA mortgage loans is that these different mortgage types offer the most competitive interest rates and downpayment requirements of any type of mortgage. Moreover, they also make home ownership possible for borrowers with lower credit scores, income levels, or funds available for down payments. As mentioned, interest rates on these types of loans may also fall as low as 1%, and at times no down payment may be required.
The Cons of Government Insured Mortgages
Unfortunately, eligibility for these different home loans may be limited by specific factors like location (USDA loans) or military service (VA loans). Additionally, FHA loans will require borrowers to pay two mortgage insurance premiums on top of any other down payment or interest.
- Interest Rates for Fixed Rate Mortgages Remain the Same For the Loan’s Entire Lifetime, But May Lead Borrowers to Pay A Higher Total Cost For Their Home.
Of the different types of home loans, fixed-rate mortgages are often seen as the safest because they maintain the same interest rate for a loan’s entire lifetime. This means that your monthly mortgage payments will always stay the same, and allow you to simultaneously pay down the original amount you owe plus any relevant interest.
The main way fixed-rate mortgages differ is in their terms. Fixed-rate mortgages may come in 10, 15, 20, or even 30-year terms, though the most common are 15 or 30-year terms. A 15-year fixed-rate mortgage may be advantageous to a borrower who wants to quickly build home equity and pay off their loan. However, a 30 year fixed-rate mortgage may be more advantageous to a borrower who wants lower monthly payments, especially because they may have the flexibility to make multiple monthly payments at a time.
The Advantages of Fixed-Rate Mortgages
A fixed-rate mortgage can be a great option for many borrowers because it will allow them to predict and plan for steady monthly payments. Additionally, borrowers have the ability to customize their terms and opt for lower monthly payments over a longer period (which may allow them to afford a more expensive home) or higher payments over a shorter period of time (which may help them quickly build home equity).
The Cons of Fixed-Rate Mortgages
Longer term fixed-rate mortgages may come with higher interest rates, which when paid over a term as long as 30 years, may lead borrowers to pay a much higher total cost for their home. Additionally, even if interest rates drop, a fixed-rate mortgage will not allow you to take advantage of lower interest rates. Instead, the only way to cash in on a lower interest rate will be to refinance.
- Adjustable-Rate Mortgages Offer Competitive Interest Rates During an Introductory Period, After Which Interest Rates Adjust to The Current Market Rate.
Unlike fixed-rate mortgages, adjustable-rate mortgages (ARM) have an interest percentage that will vary over time. Most adjustable-rate mortgages begin with an introductory period, during which borrowers will pay a lower rate for a limited time. For example, a “5/1 adjustable-rate mortgage” will have a lower introductory interest rate through its first five years then adjust to a new rate annually depending on the current market rate.
While this type of mortgage may allow for greater flexibility during the initial introductory period, borrowers will want to make sure to find an ARM that caps how much this interest rate can actually raise when it comes time to adjust.
The Advantages of Adjustable-Rate Mortgages
In some situations, an ARM interest rate may fall after the introductory period or further into the loan’s term –– though this should not be assumed to always be the case. Instead, the major advantage of adjustable-rate mortgages for most borrowers is simply that these types of loans allow many homeowners to save in the first few years of homeownership and enjoy greater flexibility should they decide to sell or move shortly after purchasing their home.
The Cons of Adjustable-Rate Mortgages
The main disadvantage of adjustable-rate mortgages is that monthly payments can become unpredictable and even unaffordable. Additionally, if your home value falls it may be more difficult to refinance or sell should you find yourself unable to afford your monthly payments; and even if you do manage to sell or refinance, you may face a prepayment penalty for doing so.
What is the Most Common Type of Mortgage?
Fixed-rate mortgages are the most common types of mortgages, with the majority of borrowers taking out fixed-rate mortgages with 15 to 30-year terms. Borrowers generally embrace the security of these loans, regardless of what the market is doing. However, finding the right type of mortgage for you may mean customizing your options beyond these five different mortgage types, and that’s where Noah may be able to help.
Though there are many different mortgage types available, many borrowers still struggle to find a mortgage that can meet their real time needs, or realistically fit into their home buying journey. That’s why Noah has introduced its Down Payment program. This program helps many borrowers make higher down payments from the get go, and thus qualify for different types of mortgages. To learn more about this program or Home Equity Access, click either link today, and get ready to secure the home of your dreams.