An important first step for aspiring homebuyers is to decide which type of home loan will best serve their needs. The interest rate, length, down payment, borrower qualifications and extra fees associated with different types of mortgage loans will all play a role in the decision. To help make the choice a bit easier, let’s talk about mortgage basics and compare the advantages and disadvantages of mortgage types.
Related: Pros & cons of buying a starter home
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Fixed-Rate vs. Adjustable-Rate Loans
When it comes to understanding types of mortgage loans, the difference between an adjustable-rate mortgage and fixed-rate mortgage is the first thing to consider.
Fixed-rate mortgage loans are exactly what they sound like: The interest rate is fixed for the entire life of the loan. The term can vary. These loans offer a steady monthly payment and relatively low-interest rate. Borrowers can usually make extra payments toward the principal if they want to pay off the mortgage faster, as prepayment penalties are rare.
Pro: The monthly payment is fixed, and therefore predictable.
Con: If you take out a fixed-rate loan when interest rates are high, you’re locked into that rate for the entire term — unless you’re able to refinance later and get a lower rate.
30-Year Fixed-Rate Mortgage
A 30-year fixed-rate home loan is by far the most common type of mortgage, according to Freddie Mac. However, because payments are made over a relatively long period, lenders tend to see them as riskier than shorter home loans, and thus ask for higher interest rates.
15-Year Fixed-Rate Mortgage
A 15-year loan may have a lower interest rate, and you will pay less in total interest than you would on a 30-year loan. On the flip side, the shorter term means monthly payments may be much higher.
An adjustable rate mortgage (ARM) has an interest rate that fluctuates after an initial fixed-rate period of months to years. The variable rate is typically tied to a benchmark index rate that changes with market conditions.
ARMs are often expressed in two numbers, like 7/1 or 5/1. A 5/1 ARM typically has a rate that’s fixed for five years and then adjusts every year, up to a cap, if there is one.
Pro: The initial interest rate of an ARM is usually lower than the rate on a traditional fixed-rate loan, so it’s easy to be drawn to the teaser rate, but it could end up costing more in interest than a fixed-rate loan over the life of your mortgage. An ARM might work best for someone who expects to sell the property before the rate adjusts.
Con: Rate increases in the future could be dramatic — though there are limits to the annual and life-of-loan adjustments — typically leaving many adjustable-rate mortgage holders with much higher monthly payments than if they had committed to a fixed-rate mortgage.
Conventional vs. Government-Insured Loans
The most popular type of mortgage, a conventional loan, is originated by a bank or other private lender, and it is not backed or insured by the government. Then there are several types of government-insured loans, some requiring little or nothing down.
Conventional loans usually have stricter requirements than government-backed home loans. Lenders typically look at credit scores and debt-to-income ratio, among other factors, in evaluating conventional loan applications.
Your down payment may be less than 20%, but if so, you’ll need to purchase private mortgage insurance (PMI) that insures the lender. PMI can be paid monthly or as an upfront premium that can be paid by you or the lender. PMI needs to stay in place until your loan-to-value ratio reaches 78%.
Pro: A variety of property types qualify for a conventional mortgage, and PMI can make it possible for borrowers to qualify for a conventional loan if they put down less than 20%.
Con: Conventional loans tend to have stricter requirements for qualification and may require a higher down payment than government loans.
Federal Housing Administration (FHA) loans are not directly issued by the government. Certain lenders can issue FHA loans on behalf of the government, and the FHA insures the loans.
Qualifying for an FHA loan is often less difficult than qualifying for a conventional mortgage, so FHA mortgages can be a good choice for people with less-than-stellar credit scores or a high debt-to-income ratio. With at least a 580 FICO credit score, you might qualify to put just 3.5% down; with a score of 500 to 579, you could put just 10% down. FHA mortgages come with an additional insurance charge called a mortgage insurance premium (MIP) — upfront and annual.
Pros: FHA loans have lower down payment and credit score requirements. Additionally, FHA loans may allow a non-occupant co-signer to help borrowers qualify.
Cons: The MIP stays in place for the life of the loan if the down payment is less than 10%.
The U.S. Department of Veteran Affairs backs home loans for members and veterans of the U.S. military and eligible surviving spouses. Similar to FHA loans, the government doesn’t directly issue these loans; instead, they are processed by private lenders and guaranteed by the VA.
Most require no down payment. Although there’s no minimum credit score requirement on the VA side, private lenders may have a minimum of 580 to 660.
Pros: You don’t have to put any money down or deal with monthly PMI payments.
Cons: There’s a one-time VA “funding fee” on purchase loans, which ranges from 1.4% to 3.6%.
FHA 203(k) Loan
Got your eye on a fixer-upper? A 203(k) loan helps buyers finance both the purchase of a house and repairs. Current homeowners can also qualify for an FHA 203(k) loan to finance the rehabilitation of their existing home.
The generous credit score and down payment rules that make FHA loans appealing for borrowers often apply here, although some lenders might require a credit score above 580. With a full 203(k), the lender will assign a loan consultant to ensure that the right contractor gets hired and the work gets done as promised. A limited 203(k) loan allows you to do cosmetic upgrades worth about $35,000 and is offered by more lenders.
Pros: An FHA 203(k) loan can be used to buy and rehab a property that wouldn’t qualify for a regular FHA loan, and it requires as little as 3.5% down.
Cons: These loans require you to qualify for the value of the property, plus the costs of planned renovations. The rate can be higher than that of a standard FHA loan. Additionally, you’ll pay an upfront and monthly mortgage insurance premium.
Fannie Mae HomeStyle Loan
For fixer-upper fans, an alternative is the Fannie Mae HomeStyle Loan, which requires only 3% to 5% down but a minimum credit score of 620.
Pros: No upfront MIP is required, and you may cancel mortgage insurance after 12 years or once you reach 20% home equity. The rate is often lower than that of an FHA 203(k).
Con: You must meet credit score thresholds.
Conforming vs. Non-conforming Loans
Both conforming and non-conforming mortgages are types of conventional mortgages.
Mortgages that conform to the dollar limits set by the Federal Housing Finance Agency are called conforming loans. The limit changes annually, based on federal guidelines. As of 2021, the conforming loan limit is $548,250 for a single-family home in most of the U.S., and goes up to $822,375 in certain higher-cost areas.
Pros: Conforming loans may have lower interest rates and fees than non-conforming loans.
Cons: The amount that can be borrowed is limited.
Non-conforming loans aren’t as standardized as conforming loans, meaning rules can vary more from lender to lender. This can include features like eligibility, rates and others.
Pros: There may be no limit on loan size, allowing you to purchase a more expensive home. They also can offer people with poor credit who may not qualify for a conforming loan access to a home loan.
Cons: Because non-conforming loans tend to be a bit riskier for lenders, they generally come with higher interest rates and can have higher requirements.
A reverse mortgage allows homeowners 62 and older to turn part of their home equity into cash. There are several factors to weigh, including the youngest homeowner’s age, the loan rate and costs, the desires of heirs, and payout type.
Pros: The homeowner doesn’t have to make any monthly payments, and they can choose a lump sum, a monthly disbursement or a line of credit — or some combination of the three.
Cons: The interest rate can be higher than traditional mortgage rates. The homeowner will also typically pay mortgage insurance, an upfront fee, an origination fee and third-party fees.
Another type of mortgage loan is a jumbo mortgage, which is a home loan above the amounts set by the conforming loan limits, mentioned above. As such, it is a type of non-conforming loan. Also known as a jumbo loan, a jumbo mortgage can be obtained through private lenders.
Pros: Jumbo loans make it possible for buyers to purchase a more expensive property. Plus, there’s no mortgage insurance requirement.
Cons: The application requirements for a jumbo loan can be steep, including a larger down payment, and interest rates and closing costs can run higher.
A USDA mortgage loan is a type of mortgage loan offered to eligible rural homebuyers. The loans are issued through the USDA loan program by the United States Department of Agriculture as part of its rural development program.
Pros: There’s zero down payment required, and interest rates tend to be low due to the USDA guarantee.
Cons: Buyers are restricted to rural areas for this loan type, and there are income limits. Plus, you have to pay a guarantee fee, though it’s typically less expensive than mortgage insurance.
As its name suggests, an interest-only mortgage is a mortgage type where you only make interest payments for a certain number of years at the start of the loan term. Your principal stays the same during this time. Once the initial time frame — usually five or 10 years — is over, your loan becomes fully amortized, meaning you start paying interest and principal each month from there on out. These loans don’t tend to be widely available.
Pros: Interest-only loans can make monthly payments lower during the introductory period, allowing you to use the money that would have gone to principal payment for other purposes.
Cons: Because the homeowner is not making payments toward the principal, they aren’t building any equity. Additionally, their payments will increase significantly once the introductory period ends.
Among the smorgasbord of different mortgage types, which is best for you? With so many types of home loans, it’s a good idea to do your homework and shop around.
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