Types of Mortgage Loans, Explained
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Your new home could be one of the most significant purchases you make and it could also be the largest investment you have made to date. But before you start looking at homes to buy, you will have to explore the different mortgage options to finance your purchase. However, all types of home loans are different, and only a few people know this. This is why researching the real estate industry before you move forward in the home-buying process is essential.
You will have to consider several costs in addition to the down payment you will be required to make. This guide covers the different types of mortgage loans and their pros and cons.
In this article
Types of Mortgage loans
Conventional loan
A conventional loan is one of the most basic mortgage loans, not backed by the federal government. It is a loan offered by credit unions and banks, and they are flexible in purpose. You can use the loan amount to buy a primary or secondary residence. The borrowing amount will be based on the down payment and income guidelines established by Freddie Mac and Fannie Mae and the loan limits set by the Federal Housing Finance Administration (FHFA).
There are two loan options- one is conforming, and the other is non-conforming. The conforming loan will conform to the standards that the FHFA establishes, including the debt, credit, and loan size. In 2022, conforming loan limits stand at $647,200 across the majority of areas, and it is $970,800 for the expensive areas.
In contrast, the non-conforming loans do not follow the FHFA standards but work with homebuyers looking to buy more costly homes or those with an unusual credit history.
Conventional mortgages often have a 20% down payment requirement, and if you put in a lower amount, you will have to pay the private mortgage insurance (PMI) until you have at least 20% equity in the home.
Pros and cons of conventional loans
Pros
- Lower borrowing costs as compared to other mortgage types
- Available from several lenders
- Sellers can contribute towards the closing costs
- Could be used for a primary home, a second home, or an investment property.
Cons
- FICO score of 620 or higher
- The down payment requirement is also higher
- If the downpayment is lower than 20 percent, borrowers need to pay PMI
- Extensive documentation requirement
- The debt-to-income ratio should be 43 percent and even higher in some cases.
Who is it suitable for?
The loan is ideal for those with a solid credit score who can make a significant down payment.
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Government-insured loan
You might be aware that the U.S. government plays a role in making homeownership easier for more people. However, it is not a mortgage lender. There are different government-sponsored loans, each with a unique qualification procedure. You can choose from three types of government-backed mortgages- The U.S. Department of Agriculture (USDA), the Federal Housing Administration (FHA), and the U.S. Department of Veterans Affairs (VA).
Pros and cons of government-insured loans
Pros
- Ideal option when you do not qualify for a conventional loan
- No need for a large down payment
- The credit requirements are relaxed
- Available for first-time and repeat buyers
- There is no mortgage insurance or down payment requirement for VA loans
Cons
- The loan limits are lower than conventional mortgages
- High overall borrowing costs
- Requires extensive documentation to prove eligibility
Who is it suitable for?
If you cannot qualify for a conventional loan because of your credit score or the low cash reserves for the down payment, you might want to consider USDA-backed and FHA-backed loans. And if you are a veteran, military service member, or eligible spouse, a VA-backed loan is much better than a conventional loan.
FHA loans
FHA backs the FHA loan, and it comes with a competitive interest rate. The loan makes homeownership easier for people without requiring a solid credit score or a big down payment. You will only need a FICO score of 580 if you want to get the maximum loan of 96.5 percent at only a down payment of 3.5 percent. In this loan, the seller can contribute to the closing costs.
Pros and cons of FHA loans
Pros
- Low down payments
- Flexibility on the credit score
Cons
- If you want a lower down payment, it will require PMI
- Only available for primary residences.
Who is it suitable for?
An FHA mortgage is suitable for those who had credit bumps earlier but enjoy a good pay history now and can only afford a small amount in down payment.
VA loans
Another type of government-backed loan, a VA loan, can offer low-interest and flexible mortgages to individuals who belong to the U.S. military and their families. You do not need to make any down payment, and there is no insurance or credit score you need to worry about.
There is also no limit to the amount you can borrow, which will determine if you need to make a down payment. If you don’t buy a home more expensive than the home loan limit, there is no down payment requirement. Even the closing costs remain usually capped and could be handled by the seller. However, the home purchased must be a primary residence.
Pros and cons of VA loans
Pros
- No down payment requirement
- Flexible credit score criteria
Cons
- Must prove eligibility.
- Limited to active duty and qualifying family members of the U.S. Armed Forces
Who is it suitable for?
VA loan is suitable for active duty or veterans of the U.S. military and those looking to buy a primary residence.
USDA loans
The USDA loans are backed by the U.S. Department of Agriculture and can help borrowers with moderate to low income, but you need to meet the income limits to buy a residence in USDA-eligible areas. The limits are specific to the neighborhood you are buying a home in. Some loans will not require a down payment, but there will be extra fees.
This includes the 1 percent upfront fee of the loan amount and an annual fee. Most borrowers under this program do not qualify for mortgages from other sources. The loans are offered by various online and local lenders.
Pros and cons of USDA loans
Pros
- Ideal for lower to middle-income households in rural areas.
- There is no minimum credit score requirement.
Cons
- Geographical restrictions
- Comes with PMI, which adds to the monthly payment amount.
Who is it suitable for?
A USDA mortgage is ideal for those looking to buy a home in a qualified area and fall in the lower-income group. It also suits someone with lower credit scores and makes qualifying for other mortgages harder.
Jumbo loan
A Jumbo mortgage falls outside the limits of FHFA, and it is very common in expensive areas like San Francisco, Los Angeles, New York, and Hawaii, where the prices are usually higher. This is why it is a nonconforming conventional loan, and if you are buying a luxury home, this loan is a good choice.
The eligibility requirements are more stringent since lenders see the larger mortgages as riskier than the conforming loans. It requires a credit score in the range of 700 and has a higher down payment requirement than conventional mortgages. Lenders also like to see high cash reserves for the loan.
Pros and cons
Pros
- Enables purchase of a more expensive house
- The only way to get homeownership is in expensive areas.
Cons
- FICO score of 700 or higher
- The borrower will have to show assets in the form of cash or the savings account
- Extensive documentation requirement
- There is a downpayment requirement of at least 10 percent to 20 percent
- The debt-to-income ratio should not be over 45 percent.
Who is it suitable for?
The jumbo loan is only suitable for borrowers who want to buy a home with a high selling price or a price that exceeds the conforming loan limits. However, you should have enough funds for a downpayment and a high credit score.
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Fixed-rate loan
Another home loan option is a fixed-rate mortgage. As the name suggests, it has the same interest rate over the entire loan tenure. This means the monthly payments will stay the same for you. The loans usually have a tenure of 15 years or 30 years.
Pros and cons of fixed-rate mortgages
Pros
- The monthly payments remain the same throughout the loan tenure.
- Helps manage the housing budget with ease.
Cons
- In case of a decline in interest rates, you will need to refinance the loan to get a lower interest rate.
- The interest rates are usually higher than those offered on flexible-rate mortgages.
Who is it suitable for?
Homeowners who want to reside in the home for a minimum of 5 to 8 years should consider this mortgage option. It will help avoid any monthly payment changes and allow you to stick to the budget.
Adjustable-rate mortgage (ARM)
Adjustable rate mortgage is the opposite of fixed interest rate loans. It has an interest rate that fluctuates with the market conditions. Some products have specific interest rates for a couple of years, and then the loan will change into a variable interest rate for the remaining part of the term. Let us take an example here, there could be a 6-year and 6-month ARM where the interest rate remains fixed for the initial six years, but it will adjust once every six months at the end of the initial period. Always read the fine print before you choose an ARM to know the rate increase and the amount you will pay when the introductory tenure ends.
Pros and cons of ARMs
Pros
- Low-interest rates in the initial years of borrowing.
- Helps save money in interest.
Cons
- If the home value drops in a few years, it becomes harder to sell or refinance.
- Due to the adjustable rate, the monthly mortgage payments could become unaffordable, leading to a loan default.
Who is it suitable for?
ARMs could be a good choice if you do not intend to reside in the home beyond a few years. It will help save on the interest payments, but you should be okay with the risk that you will have to make higher monthly payments if you still reside there.
Other mortgage loans
Construction loans
Those who want to construct a home can consider a construction loan. You can also get a construction loan specific to a project and then apply for a different mortgage loan to pay it off.
Interest-only mortgage
When you get an interest-only mortgage, you only make the interest payment for a specific period, which usually ranges between five years to seven years. This is then followed by payments for the principal and interest. Since this is an interest-only loan, it is not possible to build home equity as quickly. Still, the loan works well for homebuyers who want to consider refinancing to sell and those who can expect to pay a higher monthly amount at a later stage.
Piggyback loans
Piggyback loans are basically two: the first is for 80 percent of your home price, and the other is for the remaining 10 percent. The balance of 10 percent will be your down payment. The loan is aimed at helping you avoid paying for the mortgage insurance, and it might sound interesting and appealing, but piggyback loans do require two closing costs, and there will be interest accrued on both loans.
Balloon Mortgage
A balloon mortgage has a big payment to be made at the end of the loan tenure. You will make the payments according to the 30-year term but only for a very short period of time and when the term ends, you will have to make a big payment on the balance. This might not be manageable for everyone.
FAQs
Can I have more than one mortgage on a home?
You can have a primary mortgage on your home, and the additional mortgage will be called a home equity loan. In most cases, you will not be eligible for a second mortgage on the same property.
Can anyone apply for a mortgage?
All lenders have an underwriting and application procedure. You will only be eligible if you have an asset and the necessary credit score. You must also have a consistent income higher than your outstanding debt to carry the value of your home over the years. Additional requirements could vary based on the type of lender you are working with.
Can I get a mortgage with bad credit?
It helps to have good credit when applying for a mortgage, but it is unnecessary. You can still qualify for a mortgage but might have to pay a higher interest rate. Talk to the loan officer about improving your credit because even one percentage point can save you thousands in the long term.
The bottom line
With the knowledge of all the different types of mortgage loans, you can now pick one that fits your financial situation, credit score, and mortgage requirement. Each lender is different and will offer varying terms on the mortgage, Hence, you should shop and find one that offers the ideal terms on the loan.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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