Step 4: Types of Mortgage Loans

When it comes to mortgages, you have options. There are several different types of mortgage loans available. These include conventional mortgages, such as fixed rate mortgages and adjustable rate mortgages, and mortgages that are government ensured: FHA, USDA, and VA loans. Let’s explore the different types of mortgage loans, their components, and which might be best for your situation.

Understanding Conventional Loans

Most home loans are conventional, which means they aren’t insured by the government. Roughly 80 percent of home loans are conventional loans. There are two main types of conventional loan: fixed rate and adjustable rate.

Fixed rate mortgages:

With a fixed rate mortgage, the interest rate stays the same throughout the life of the loan. This is the most popular type of mortgage among American homeowners because the mortgage payments remain the same every month. A fixed rate mortgage will enable you to incorporate your monthly payment into your budget because it doesn’t change.

However, there are some drawbacks to fixed rate mortgages. For example, the interest rate may be higher. It will also take more time to pay off since the payments over the first few years go mainly toward interest. If interest rates sharply decline, you’ll have to refinance your home in order to take advantage of the lower rates.

Adjustable rate mortgages:

An adjustable rate mortgage (ARM) is one where the interest rate on the loan changes when it goes through an adjustment period. This type of loan is most popular with house flippers and investors, but it is also a good option for buyers who don’t intend to live in the home more than a couple of years. Over the course of an adjustable rate mortgage, the loan will have an initial rate and period followed by an adjustable rate and period. Here’s an example:

If a lender offers a borrower a 5/1 LIBOR ARM (LIBOR stands for the London InterBank Offered Rate, which is the base for many ARM mortgages in the US) at 3.25% with 2/2/5 caps, the rate on the loan will remain at 3.25% for the first five years. After that, an adjustment can be made once a year. The 2/2/5 caps include the following:

  • 2% is the maximum percent change allowed for the first adjustment (up or down)
  • 2% is the maximum adjustment allowed each time the rate adjusts (up or down)
  • 5% is the maximum adjustment allowed overall, meaning the highest interest allowed on this loan would be 8.25%

Government-Backed Loans

Government-backed loans are often easier to obtain with less credit requirements, and they require little to no money down. However, you may incur a higher interest rate, and depending on the type of loan, other requirements. Here are the common types of government-backed loans:

VA loans:

If you’re active duty or a veteran of the US armed forces, then you might qualify for a home loan with no money down by getting a VA loan. VA loans also don’t require you to pay private mortgage insurance (PMI). Additional benefits of VA loans include:

  • No prepayment penalties
  • The seller can pay all the buyer’s loan-related closing costs and up to four percent in concessions
  • Lower interest rates than conventional and FHA loans (3.625% VA 30-year fixed vs. 3.85% conventional 30-year fixed)
  • VA mortgages are assumable
  • Foreclosure avoidance advocacy

To be eligible for a VA loan, you’ll need to meet the requirements set by the Department of Veterans Affairs. However, because the VA doesn’t originate the loan, you’ll still have to meet lender requirements. The VA’s eligibility requirements include:

  • Borrower must be active duty or a veteran who has available Certificate of Eligibility (COE)
  • Loan must be used for an eligible purpose
  • Borrower must have satisfactory credit (usually 620 or above)
  • Debt-to-income ratio of 41 percent or lower
  • Borrower must intend on living in the home for a reasonable period after closing
  • The income of the veteran (and spouse, if applicable) must be sufficient and stable to meet the mortgage payments, as well as the cost of living and debt obligations

FHA loans:

FHA loans are insured by the Federal Housing Administration. FHA mortgages are most popular with first-time home buyers who can’t save the roughly 20 percent down payment often needed for a conventional loan. An FHA loan only requires a down payment of 3.5 percent. Those who have credit issues are also drawn to FHA loans, because the credit score required is 580 or above. Even those who’ve had a bankruptcy or foreclosure may still qualify for an FHA-backed mortgage.

Of course, there are some disadvantages to an FHA loan. You’ll be required to pay mortgage insurance for the life of the loan, and there are limits to how much you can borrow. Those limits vary depending on where you live, so be sure to research FHA loan requirements in your area.  

USDA loans:

USDA loans are like VA loans in that they are zero-down loans, but they are designed for those buying an eligible rural or suburban home. USDA loans are issued through the United States Department of Agriculture loan program, also known as the USDA Rural Development Guaranteed Housing Loan Program. Even though USDA loans are like VA loans, USDA loans require you to pay mortgage insurance if you don’t put any money down. There are three types of USDA loans:

  • Guaranteed loans: This type of USDA loan is guaranteed by the USDA but not issued by it. A guaranteed loan needs to be obtained through a lender who participates in the program.
  • Direct loans: This loan is issued by the USDA. They are usually reserved for low- and very low-income applicants. With subsidies, interest rates for USDA loans can be as low as one percent.
  • Home improvement loans and grants: Home improvement loans and grants are great for homeowners wanting to repair or upgrade their homes. The USDA program also offers packages to combine a loan and a grant, providing up to $27,500 in assistance.

What’s a Jumbo Mortgage?

It’s called a jumbo mortgage because of its size. A jumbo mortgage, or jumbo loan, is a loan that is higher than the limit set by the Federal Housing Finance Agency (FHFA). In 2022, the limit was set at $647,200 for most of the US and at $970,800 for high-cost areas. If you’re in the market for a home that’s above the limit, you’ll likely need a jumbo mortgage to pay for it (unless you have a million dollars at your disposal). Because so much money is involved and there’s higher risk for the lender since the loan isn’t guaranteed by Fannie Mae and Freddie Mac, jumbo mortgages are difficult to get. You’ll need a credit score of at least 700 and a debt-to-income (DTI) ratio of around 40% or less to qualify.

What’s Fannie Mae and Freddie Mac?

For banks and other loan companies to lend money, they need a steady cash flow to draw from. This is where Fannie Mae and Freddie Mac come in. The oldest of the two, Fannie Mae, was created by the government shortly after the Great Depression in 1938 to make sure mortgages were reliable and affordable. Freddie Mac was established much later, in 1970, to provide an alternative option to Fannie Mae. Today, Fannie Mae and Freddie Mac are shareholder-owned companies that operate under a congressional charter. These companies buy mortgages from lenders and either hold them or package loans into mortgage-backed securities (MBS) that can then be sold. This process ensures lenders always have a steady supply of money to loan, and buyers will be able to obtain affordable mortgages.

Conforming vs. Non-Conforming

You may hear these terms when you’re going through the loan process. Basically, a conforming loan is one that meets the guidelines set by the FHFA. A non-conforming loan, on the other hand, doesn’t meet the guidelines. Loans that are considered non-conforming include jumbo loans and government-backed loans like FHA, USDA, or VA loans. Conforming loans tend to have lower interest rates and fewer requirements than non-conforming loans, but for those who are purchasing extremely expensive real estate or need a government-backed mortgage, a non-conforming loan is a great option.

Risky Home Loan Features to Avoid

The housing market learned several difficult lessons during the 2008 housing crash, especially around mortgages. The subprime mortgage crisis proved that risky loans could have severe repercussions, but that doesn’t mean there aren’t still dodgy practices out there you’ll want to avoid.  Here are a few:

  • Balloon loans: This is a mortgage where you pay just the interest on the loan for the first few years. While this might be attractive because the initial payments are so low, the lender will expect the entire principal of the loan to be paid in one lump sum, usually within three to seven years after the loan originated. This means the borrower will have to pay the entire loan off at one time in what is known as a “balloon payment.”
  • Leasepurchase agreements: Also known as “rent to own,” this is where the seller acts as the landlord for a certain amount of time. As the renter, you’ll pay an initial fee, then monthly payments. A portion of these monthly payments (which are typically higher than the average rent for the area) is applied toward the purchase of the home. Often, there’s a catch to this. The seller may collect an extra $400 every month toward the home purchase, but they could keep a portion of this as a “convenience fee” for saving money for you. At the end of the rental period, the buyer will finalize the transaction. However, if the buyer can’t purchase the home or no longer wishes to do so, the seller may be able to keep the money that was applied toward the home purchase.
  • Prepayment penalties: Many lenders allow borrowers to pay off as much as 20 percent of their mortgage each year. Some borrowers might want to pay off more than 20 percent, such as when the home is sold or refinanced. In these cases, this is known as “prepayment.” Some lenders have language in their agreements that allow them to penalize the borrower if they wish to sell, refinance, or pay more than 20 percent of their loan in one year. Prepayment penalties are often listed in the agreement as “soft” or “hard” penalties. A soft penalty allows the borrower to sell their home at any time, but they will be penalized if they refinance. A hard penalty will penalize the borrower whether they sell or refinance. The amount of the prepayment penalty is usually 80 percent of six months’ interest on the loan. For example, if a homeowner has a $500,000 loan with an interest rate of 6.5 percent and a monthly payment of $2,700, their prepayment penalty would be 80 percent of six months of payments, or $16,200. This equals roughly $13,000 to cover the penalty.

Once you find the right type of loan, you might want to start thinking about those monthly mortgage payments. Getting a lower interest rate and paying points on your mortgage may help reduce your expenses. We’ll discuss interest rates and mortgage points in step five.