If you are looking into buying a home for the first time, or even if you have some experience with prior home purchases, determining which mortgage is right for you can be a daunting proposition. With all of the different types of mortgages out there, how can you figure out which one is compatible with your specific financial situation and home-buying needs? MPA breaks down some of the most common home loan terms you will likely hear tossed around as you embark on the home buying process.
Different loans have different requirements for borrowers and are more applicable for different situations. Borrowers may find certain types of loans more appealing because of lower down payment requirements and interest rates. If a borrower is looking to purchase a high-value property, they may be exploring loans that exceed conventional lending limits. No matter what, it is important for prospective home buyers to thoroughly educate themselves on the varying types of mortgage loans before entering into a housing purchase.
According to Investopedia, a conventional mortgage loan is a common type of home loan that is not insured by the United States government but rather through a private lender. Examples of private lenders offering these loans typically include banks, local credit unions, or even companies exclusively dedicated to giving out mortgages. Although conventional loans are not secured through the federal government, they can be (and usually are) guaranteed by the government, generally through the Federal National Mortgage Association, which is commonly referred to as Fannie Mae, or the Federal Home Loan Mortgage Corporation, known as Freddie Mac.
Qualifying for a conventional mortgage loan can be a little more complicated than some other available mortgage options. Borrowers are usually required to fill out an official mortgage application and provide the prospective lender with their current credit score, full credit history, pay stubs to prove their income, and recent bank statements. If any large unexplained money transfers show up on bank statements, the borrowers will be asked to explain their cash flow in an effort to prevent money laundering and other illicit use of funds.
The interest rates on conventional home loans are typically at or above market interest rates, as opposed to the rates on loans issued through the federal government, which tend to be lower.
When the government insures a home loan as opposed to a private entity such as a bank, it falls into the category of a government-backed loan, as noted by Experian. Basically, the structure of these loans is such that if the borrower defaults, i.e., stops making mortgage payments (per Nolo), the government is on the hook to pay the lender back for the value of the loan. Because the government's commitment to pay makes a loan less risky for the lender, government-insured loans are typically offered with lower interest rates than current market rates. They may also provide options for lower down payments or even no down payment at all.
Three agencies within the United States federal government can issue a government-insured loan: the U.S. Department of Agriculture, or USDA; the Department of Veterans Affairs, or the VA; and the Federal Housing Administration, or FHA. Each agency has different requirements for its lending system. For example, the VA only offers loans to those who have served in the U.S. Armed Forces and their family members, and the USDA determines eligible zones in which it will provide home loans. The loans are typically not issued through the federal government agency itself but through a private lender who works with the federal government on the back end. Some private lenders do not offer government-insured loans, and others provide some types but not others, so it is always worthwhile to do your research beforehand.
Within the world of conventional and government-insured home loans, there are other variables, such as how interest rates will work on your mortgage. You will likely hear two terms to describe mortgage loan interest rates: fixed-rate loans and adjustable-rate loans. Rocket Mortgage explains that a fixed-rate mortgage has an interest rate that is, well, fixed, meaning it will not change for the entire length of your loan, whether your loan is 15 years, 30 years, or a custom term you and your lender have agreed to. Whatever interest rate your lender offered and you accepted when signing your loan paperwork is the rate you will pay.
With fixed-rate mortgages, your monthly mortgage payment — both principal and interest — will remain the same for the term of the loan, although other aspects of your monthly payment may change. For example, if you pay monthly into an escrow account that you use to make annual payments on your home insurance premiums or your property taxes, your monthly mortgage payment may increase if either of those costs goes up. But, the actual principal and interest of your loan will remain the same. The set expectations associated with fixed-rate mortgage loans have led to them being the most popular type of home loan in the country. The predictable schedule of a fixed-rate loan also means you can anticipate when you will start paying down more of your loan's principal and subsequently acquire more equity in your home.
Adjustable-rate mortgage loans are exactly what they sound like: loans with interest rates that can be adjusted throughout the loan, as opposed to fixed-rate mortgage loans, where the rate always stays the same no matter what. As The Federal Reserve Board explains, with adjustable-rate mortgages, the interest rate can change based on the market interest rate, but rate changes can also happen even if the market rate stays the same. Anyone interested in pursuing an adjustable-rate mortgage should understand that the monthly mortgage payment they make at the beginning of their loan term may significantly increase throughout their loan period.
Adjustable-rate mortgages are often presented with the option of making payments only on the loan's interest at the beginning, meaning that monthly payments will typically be much lower than those for a fixed-rate mortgage. For this reason, adjustable-rate mortgages can be a good option for people who do not anticipate staying in their home long-term and want to take advantage of a lower rate at the beginning of their mortgage term because they plan to sell the property before their interest-only payment period ends. Adjustable-rate mortgages are often desirable for house flippers and people who plan on owning a home for only a few years. If you plan on staying in your home long-term, however, a fixed-rate mortgage is usually a better choice because then you will be able to budget for a set housing expense every month.
For the really big spenders, you may hit a point at which you are taking out a loan that is much larger than an average mortgage. For homes that are too expensive to finance with traditional loans, borrowers can take out what is called a jumbo loan. Jumbo loans, according to NerdWallet, are also often referred to as non-conforming conventional mortgages because they do not conform to the requirements to be guaranteed by Fannie Mae and Freddie Mac federal agencies. If a borrower defaults on a jumbo loan, the lender is left out to dry. For this reason, the requirements to be approved for a jumbo loan are typically much stricter than those for traditional mortgage loans.
The limits for separating what is defined as a traditional loan vs. a jumbo loan are technically set at the local level, usually by each county's housing supervisors. However, there is a federal standard for jumbo loans, established by the Federal Housing Finance Agency, that most counties adhere to when setting their own limits. That limit caps out at $647,200. If you are looking to borrow more money than that limit, you will likely need a credit score of at least 700 and probably closer to 750. You also need to prove that you do not have a substantial amount of other debts or that your income enables you to pay those debts adequately.