If you’re searching for a house, there’s a good chance you might also be searching for a mortgage. With so many choices, it’s hard to know which mortgage type is right for you. A variety of factors will impact which mortgage type to choose, including, but not limited to, the property price, type, and location, as well as your credit score, income, and overall financial health.
The following summary of the common mortgage types should help you get started.
Conventional – Conforming and Nonconforming
When you apply for a mortgage, you’ll have to decide between two basic types of loans: a government loan and a conventional loan.
A conventional mortgage loan is simply a mortgage that is not backed by the U.S. government. Conventional loans that are conforming meet the criteria needed to be sold to Fannie Mae and Freddie Mac, minimizing the risk to the lender. A conventional nonconforming mortgage loan is a mortgage not backed by the U.S. government that does not meet the criteria needed to be sold to Fannie Mae and Freddie Mac.
Conventional conforming mortgages typically require a minimum credit score of 620 and a down payment between 3% and 20%. Loans with down payments below 20% require private mortgage insurance (PMI). Under a conventional loan, there are two types of interest scenarios to choose from.
Fixed Interest Rate – A fixed rate mortgage is a loan where the monthly payment remains the same for the entire duration of the loan, even if market interest rates change over time. The principal and interest portions of each monthly payment vary throughout the life of the loan but the overall monthly payment does not change. Because the monthly payments are locked in for the full duration of the loan, fixed rate mortgages offer certainty and predictability to the borrower. Fixed rate mortgages commonly range from 10 to 30 years in duration.
Adjustable Interest Rate – Adjustable rate mortgage (ARM) loans typically have an introductory period with a fixed payment, followed by a period of time when the interest rate may rise, potentially resulting in a higher payment. These loans are often noted with two numbers which represent the length of the fixed rate period and the frequency of the rate adjustment, respectively. For example, a 5/1 ARM has a 5-year introductory fixed rate period followed by 1 rate adjustment per year for the remainder of the loan. The primary benefit of an ARM is that the introductory interest rate is usually lower than the fixed rate mortgage at the time when it is taken, potentially creating savings for short- and medium-term borrowers. If you plan to stay in your home long term, be sure to consider the risk of rates rising in the future and be sure you can manage the higher payment.
Jumbo Loan – Jumbo loans are common for expensive home purchases, often in high priced markets. Jumbo loans are mortgages where the loan amount is larger than the maximum allowed for the lender to sell the loan to Fannie Mae and Freddie Mac. Since the loan is not eligible to be sold, the lender typically requires a more stringent qualification process to verify the borrower’s ability to repay the loan. Because of this, jumbo loan borrowers are often required to have a credit score of 700+ and a down payment of 20% or more.
Balloon Loan – A balloon mortgage is a loan with a relatively short term (typically between 5 and 7 years) where the normal monthly payments do not completely pay off the loan balance over the duration of the loan. This leaves a large outstanding balance at the end of the loan that needs to be paid off in one lump sum payment, called a balloon payment. While there may be specific situations where a balloon loan is appropriate, be sure you have the ability to make the balloon payment at the end of the loan. While refinancing or selling the home prior to the balloon payment might be a possibility, there is some risk associated with this strategy if the real estate market changes and you are unable to refinance or sell the home.
VA Loan – VA loans are government backed mortgages by the Department of Veterans Affairs (VA) available to certain members of the U.S military and eligible surviving spouses. VA loans can be a great option if you qualify, with less stringent credit requirements and lower interest rates than conventional fixed rate loans. Best of all, most VA loans require zero down payment and zero private mortgage insurance (PMI).
FHA Loan – For borrowers with low incomes, limited cash for down payments, and/or low credit scores, an FHA loan might be a good option. An FHA loan is a mortgage that is insured by the Federal Housing Administration (FHA) and is intended to increase mortgage accessibility for borrowers who might have a harder time qualifying for conventional loans. Borrowers with a credit score between 500 and 579 can typically qualify with a 10% down payment, while borrowers with credit scores exceeding 580 can put down as little as 3.5%. FHA loans are typically available in either a 15-year or 30-year term.
FHA loans require mortgage insurance premiums (MIP) to be paid by the borrower to protect against the risk of loan defaults. The MIP is paid in two parts; a one-time upfront payment at closing and an ongoing annual MIP which is included in the monthly payment. For down payments of less than 10%, mortgage insurance is required for the duration of the loan. For down payments of 10%, mortgage insurance is typically required for 11 years.
USDA Loan – USDA loans are backed by the U.S. Department of Agriculture and are intended to provide mortgage loans to low income borrowers living in rural (and some suburban) areas. These loans typically have lower interest rates than conventional loans and require 0% down. There is a 1% guarantee fee required at closing which can be rolled into the loan amount, as well as an ongoing annual fee of 0.35% which is paid as part of your monthly payment for the life of the loan.
In order to be eligible for a USDA loan, you’ll need to purchase a home in a USDA designated area and have household income not exceeding 15% above the local median income. A credit score above 640 is typical, although borrowers with lower credit scores can be approved with additional requirements.
Which is Right for You?
Many of the various loan types require specific qualifications, so you should be able to quickly eliminate the loan types that do not apply to your situation. You can narrow down your decision even further by knowing your credit score, how much cash you have on hand for a down payment, and your maximum monthly payment. At CCCSMD, a HUD-approved housing counseling agency, we guide you on the path to homeownership, including an understanding of the mortgage types you may be eligible for. Call (800) 642-2227 today to schedule your mortgage counseling session with one of our Financial Advocates.