Owning a house is a point of pride for many Americans, and with good reason. It can be a good investment that allows you to build equity, which provides financial security, rather than spending money on rent every month.
65.8 percent of Americans are currently homeowners, according to Census data. Many more Americans aspire to be homeowners, but there are also some barriers that can make it difficult to buy your first home. For example, you’ll typically need to have a sizable down payment and be able to qualify for a mortgage loan.
Requirements vary depending on the type of loan you choose. If you’re considering buying a home, the first step is to understand the types of mortgage loans available to you and know what to look for in each loan so you can compare your options. To find the best loan for your financial situation, contact your lender for specific information.
What to Look for in a Mortgage Loan
Loan Term
Your choice of loan term, which could be 15 years, 30 years, or another term, will impact your monthly payment and how much interest you pay over time. Generally speaking, loans with a shorter term tend to cost less over time but have higher monthly payments. If you need to keep your monthly payment low, a 30-year mortgage is a popular option, but will cost you more money over time.
Interest Rate Type
Mortgage loans typically either come with fixed or adjustable interest rates. Fixed-rate mortgages can be attractive because the monthly payment doesn’t fluctuate, which makes these loans more predictable and secure. With an adjustable-rate mortgage, the interest rate could change based on the market, which could increase your monthly payment after the initial fixed period.
The Consumer Financial Protection Bureau also warns that adjustable-rate mortgages marketed towards borrowers with low credit scores pose a risk of a higher interest rate and more frequent adjustments. If you struggle with poor credit, you may want to apply for an FHA loan as well and compare your options.
Requirements
Every type of mortgage has different requirements, and you may be precluded from applying for special programs like a VA loan or USDA loan. You should narrow down your options based on what’s available to you. If you have a low credit score or a smaller down payment, you’ll have an easier time getting approved for an FHA loan, but these are typically more costly than conventional mortgages.
10 Types of Mortgage Loans
Conventional Fixed Rate Mortgage
A conventional fixed-rate mortgage is generally available to good or excellent credit borrowers and offered by a private lender, Fannie Mae, or Freddie Mac. They typically come in 15-year or 30-year terms, and the monthly payment stays the same for the duration of the term, since the interest rate does not change.
You’ll likely need to show proof of income, employment, and assets to apply. You won’t likely qualify if your credit score is less than 620 or your debt-to-income ratio is higher than 43 percent. Additionally, if you can’t put down 20 percent on a conventional mortgage, your lender will require you to pay private mortgage insurance premiums until you’ve achieved 20 percent equity. The minimum down payment on a conventional fixed rate mortgage is three percent, but your individual down payment requirement may be higher if your credit score is lower. There are a few companies that can provide down payment assistance to borrowers with limited cash, usually in exchange for a share of future appreciation.
Adjustable Rate Mortgage (ARM)
ARMs typically start with a fixed interest rate period followed by a period of interest rate fluctuation based on the market. These loans typically come with a 30-year term. Common fixed periods are three, five, seven, and 10 years, and the most common adjustable period is one year, which indicates that you get a new rate annually.
ARMs can follow different structures as well. Those targeted at poor credit borrowers often come with risky features like more frequent adjustments or prepayment penalties. You should make sure you understand the terms of the agreement and be prepared for potential interest rate changes. Freddie Mac has historical data on 5/1 ARMs, which start with a five-year fixed interest rate period, so you can estimate future fluctuations.
Interest-Only Mortgage
Typically a type of adjustable-rate mortgage, an interest-only mortgage allows the borrower to pay only the cost of interest each month for an initial period. Once the period ends, the borrower makes principal and interest payments, which means the monthly payment will jump much higher. You’ll typically pay a fixed interest rate only for five, seven, or 10 years, followed by an adjustable interest rate plus principal payments.
First-time homebuyers sometimes enjoy the flexibility that an interest-only mortgage provides in the early years. Borrowers get greater cash flow at first, and can defer higher monthly payments until they’re earning more income. However, during that initial period, you won’t be building any equity in your home. And since you can’t predict the future of your financial situation, that higher monthly payment could come at a time when you can’t afford to pay it.
FHA Mortgage
An FHA mortgage is a loan that is backed by the Federal Housing Administration and issued by an approved lender. These loans are available on one to four-unit properties and require a down payment of at least 3.5 percent, provided that you have a credit score of 580 or above. If your score is below 580, you may still qualify, but you’ll be required to put 10 percent down. You can, however, get funds from local down payment assistance grants. FHA loans come with fixed rates and terms of 15 or 30 years.
An FHA loan is usually easier to qualify for and has lower interest rates for fair-credit borrowers than a conventional mortgage. However, you are required to pay an upfront 1.75 percent of the loan plus annual ongoing mortgage insurance premiums to the FHA for up to the entire life of the loan, depending on your term and how much you borrow. For this reason, FHA mortgages can be more costly than a conventional mortgage over time.
VA Mortgage
Veterans, Service Members, and some military spouses may be eligible for a VA mortgage. VA loans are issued by private lenders, and part of the loan is guaranteed by the U.S. Department of Veteran Affairs. That means lenders have less risk to worry about, which translates to more favorable interest rates for you. There’s no minimum credit score to apply (it’s up to each individual lender if you qualify), but you will need to meet income requirements. It’s often possible to get a VA loan with no down payment and no mortgage insurance.
As long as you don’t already have an active VA loan or a previous foreclosure on a VA loan, the only borrowing limits are set by the lender, and no down payment is required. However, keep in mind you’ll need to pay the VA funding fee. For first-time homebuyers, that’s 2.3 percent of the purchase price for the home you choose. Only veterans receiving disability compensation and surviving spouses are exempt from the funding fee. Still, given that VA loans have the lowest rates in the industry, they usually end up being a good deal for the borrower.
USDA Mortgage
The U.S. Department of Agriculture backs mortgages as part of its Rural Development Guaranteed Housing Loan program. These loans are designed to help low to moderate-income Americans in some rural and suburban areas to purchase single-family homes. Check your eligibility with the USDA to see if this type of loan is an option for you.
USDA loans typically come with low interest rates and more flexible credit guidelines, but most lenders require a credit score of 640 or greater. These fixed-rate loans require no down payment, similar to a VA loan, but there is a one percent upfront USDA funding fee that is usually financed into the loan. You’ll also pay an annual fee equal to 0.35 percent of the loan amount, which is usually rolled into your monthly payment.
Balloon Mortgage
A balloon mortgage comes with low interest rates but may be risky for borrowers. With a balloon mortgage, you pay low or no monthly payments for an initial period, and then pay the balance as a lump sum at the end of that period. These loans usually have short terms, such as five or seven years. Some people choose these loans because they only plan to stay in the home they’re buying for a short time, but there’s always a risk that your home will depreciate and selling your house won’t cover the lump sum. Other people use balloon loans and refinance before the lump sum payment is due.
Nonconforming Jumbo Mortgage
Jumbo mortgages are designed for borrowers buying luxury homes with purchase prices that exceed the conforming loan limits established by the Federal Housing Finance Agency (FHFA). In most of the country, that means any single-family home that costs more than $548,250 in 2021 will require a jumbo loan, but in high-cost areas, the limit is higher.
Typically, jumbo mortgages come with stricter credit requirements than conventional mortgages. However, the APR may be similar. You’ll still need to make a 20 percent down payment to avoid private mortgage insurance, but, with some lenders, you can also put as little as 10 percent down to be approved.
Rehabilitation Mortgages
Rehabilitation loans are designed to finance fixer-upper homes. Two common types of rehabilitation mortgages generally available are:
With a rehabilitation mortgage, you can borrow the purchase price plus the estimated cost of repairs or renovations in one loan. However, there are more complicated application requirements for each of these programs. You might also be charged some extra fees from the lender. And with a 203(k) loan, unless you’re doing minor work, you’ll need to pay a consultant to oversee the rehabilitation of your home.
Mobile or Manufactured Home Loans
You have several options for mobile or manufactured home loans, including conventional mortgages from Fannie Mae and Freddie Mac, FHA-backed loans, and VA-backed loans.
How to Choose the Right Mortgage for You
The types and variations on mortgage loans can be overwhelming, since each one comes with different requirements and features. Here’s how to start selecting the best loan for you:
- Eliminate any options you may not be eligible for, such as VA or USDA loans
- Look at your finances to see how much house you can afford, and check your credit report to see which types of loans you’re likely to qualify for.
- If you need to, save up some money for a down payment and work on improving your credit.
- Unless you have certain unique needs, you’ll likely want to start by comparing conventional fixed rate mortgages and FHA loans.
- Prequalify with several lenders, as long as they’re using a score estimate or soft credit pull to check your information, to get an idea of what your rate might be.
- Choose one or more lenders and apply for pre-approval within a two-week period. This will cause a small dip in your FICO credit score.
- Once you’ve chosen the home you want to buy, you can formally apply for the loan.
The information contained herein is provided for free and is to be used for educational and informational purposes only. Consult a financial professional for specific help with your situation.