There are a lot of mortgage options to consider, but choosing a mortgage doesn't have to be overwhelming. This guide will answer questions about types of mortgage loans, how they compare to each other and how to find the best loan type for you.
Adjustable-Rate vs. Fixed-Rate Mortgages
One of the more important decisions you'll have to make when comparing the types of mortgages is whether to get a fixed-rate or adjustable-rate mortgage. In order to choose the right type of rate for your circumstances, be sure you understand the differences.
Adjustable-rate mortgages, commonly known as ARMs, make up a small share of the mortgage market. These loans can vary in structure and terms, but the defining feature is that your interest rate can change at some point. Often, ARMs will have a fixed period that's followed by an adjustable period. A 5/1 ARM, for instance, is fixed for the first five years, then adjusts yearly after that.
When your rate changes, it could go up or down, depending on prevailing rates at the time your loan adjusts. That means your monthly payment can change — sometimes significantly — and there is no way to plan for this over the life of your loan. These loans often make a good choice when interest rates are high or you don't plan to stay in a house beyond the initial fixed period.
Fixed-rate mortgages are far more popular among homebuyers. The interest rate on these loans stay the same over the entire life of the loan, regardless of how the market rates change during that time.
This stability is attractive for most homebuyers, and it does make it much easier to plan long term. However, if you get a fixed-rate mortgage at a time when interest rates are high, you're then stuck with that rate until you sell your home or choose to refinance.
15-Year vs. 30-Year Fixed Rate
The two most popular types of fixed-rate mortgages are the 30-year and 15-year fixed. Although the basic structure is the same, there are some key differences.
- The interest rate is fixed and the loan is paid off over a 30-year term.
- Interest rates are higher than 15-year loans due to the longer term.
- Your monthly payment will be lower.
- The interest rate is fixed and the loan is paid off over a 15-year term.
- Interest rates are lower because you're borrowing for a shorter term.
- Your monthly payment will be higher.
Conforming Loans vs. Non-Conforming Loans
Another common set of terms you might encounter when comparing mortgage types are "conforming" and "non-conforming."
A conforming loan must be a conventional mortgage that can be sold to Freddie Mac or Fannie Mae, the two federally sponsored mortgage companies. The loan itself can't be backed by the government, and it must meet conventional loan criteria for things like borrower credit score and total loan amount.
A non-conforming loan is any type of loan that doesn't fit the conforming loan criteria. It may be too large to be conforming (a jumbo non-conforming loan), or it might be a government-backed VA, FHA or USDA loan. We'll get into the details on those loan options below. The advantage of a non-conforming loan is that it typically comes with more relaxed guidelines for your credit score or down payment.
Mortgage Loan Types
Once you've considered the above factors, it comes down to weighing the three main types of mortgages against each other to decide which one will work best for you. You'll want to compare conventional, government-backed and jumbo loans.
Conventional Home Loans
Conventional loans are the most common type of mortgage on the market, accounting for over 70% of mortgages. They have stricter criteria than government-backed loans. You'll typically need a credit score of at least 620 and a down payment of at least 3% of your home's purchase price.
Additionally, unless you put at least 20% down, you'll likely have to pay mortgage insurance, an extra fee to offset the lender's risk because of your low equity in the home. Higher standards for your overall debt-to-income ratio are common, which is the amount of your monthly income that goes toward paying off debt.
These loans are a good option if you have enough savings to make a significant down payment, good credit and relative financial stability.
Government-Backed Home Loans
If you think a conventional loan might not be a good fit, there are several federally backed loans you can consider. These loans are backed by the Federal Housing Administration (FHA), the U.S. Department of Agriculture (USDA) or the Department of Veterans Affairs (VA). They are sold by standard lenders, but because lenders aren't bearing all the risk, they often offer more flexible qualifications for borrowers with these loans.
Each type has slightly different criteria, so let's look at each one in turn.
FHA loans are available to homebuyers with a credit score of at least 580, verifiable employment history and at least a 3.5% down payment.
You must also have a debt-to-income ratio lower than 50%, no foreclosures in the last three years, and use the loan to finance your primary residence.
Note: Paddio currently looks for credit scores of 620 and above.
USDA loans have more limited availability than FHA loans. The main differentiating factor is the home must be in a qualified suburban or rural area. USDA loans also have income limits, the current standard USDA loan income limit for 1-4 member households is $110,650.
One of the most attractive benefits of the USDA loan is that there is no down payment.
VA loans are only available to military service members, Veterans and surviving spouses. These loans don't require a down payment and they typically have lower interest rates compared to most other loans. There's no mortgage insurance on VA loans, but there is often a VA funding fee.
Jumbo loans exceed the limit for conforming loans in your area. In most parts of the country, that limit is $726,200 for a single-family property. This means if your home were to exceed the loan limit in your area, it’s a jumbo loan.
These loans may have similar interest rates to conforming loans, but they could have higher credit score and down payment requirements due to the size of the loan. You'll need to demonstrate a strong ability to handle the large monthly payment that comes with these loans.
Find the Right Type of Mortgage for You
Buying a home involves a lot of decisions, and the type of mortgage you’ll use is one of the biggest choices you'll make. Not sure which mortgage is right for you? Get in touch with a Paddio specialist today.