There are several different types of home loans (mortgages) available to home buyers. We’ll attempt to explain them, simply, in this article.
For those who are first time buyers, you should focus on fixed FHA or Conventional loans.
The combination of the other programs is typically better suited to those who have more experience, but I’ll include everything so that you can get a sense of the whole picture.
You can adjust the term length of the loan for any of these loans. Since purchasing property is usually a considerable financial investment, typically the life of the loan is over many, many years – 15, 20, 25, & 30 year terms are most common.
The basics: the shorter the term length, the higher your monthly payments. The benefit is that you will pay less interest over the life of the loan. Conversely, the longer the term length, the lower your monthly payments, but you’ll pay more interest over the life of the loan.
Option 1: Fixed Rate vs. Adjustable Rate
As a buyer, one of your first options is to understand if you want a fixed rate or adjustable rate loan. All loans fit into one of these two categories, or a combination of the two. Here is the main difference between the two types:
Fixed Rate Mortgage Loan
Fixed-rate mortgage loans have the same interest rate for the entire repayment. Because of this, the size of your monthly payment will remain the same, month after month and year after year. It will never change.
This is true even for long-term financing options, such as the 30-year fixed-rate loan. It has the same interest rate and the same monthly payment for the entire term.
I’ll add a qualifier to the previous statement. Even if you have a fixed interest rate – what can change our monthly payment amount is if you have your property taxes, and homeowners insurance included.
Property taxes and insurance rates will certainly not remain steady over a 30 year term. It is the only thing that can increase a loan with a fixed interest rate.
Adjustable Rate Mortgage (ARM)
Adjustable rate mortgage loans (ARM) have an interest rate that will change or “adjust” from time to time.
Typically, the rate of an ARM will change every year after an initial fixed permanence period. A hybrid ARM loan is one that begins with a fixed or variable interest rate, before changing at an adjustable rate.
For example, the 5/1 ARM loan carries a fixed interest rate during the first five years, after which it begins to adjust every year or annually. That is what 5 and 1 means in the name.
As you can imagine, both types of mortgages have certain pros and cons associated with them.
In a nutshell: the ARM loan starts at a lower rate than the fixed rate of loan, but has the uncertainty of subsequent adjustments. With an adjustable mortgage product, the rate and monthly payments may increase over time.
The main benefit of a fixed loan is that the rate and monthly payments never change. But you will pay for that stability through higher interest charges, compared to the initial rate of an ARM.
Conventional loans vs Government Insured Loans
You will have to decide between a fixed and adjustable rate mortgage type, as explained in the previous section. But there are other options too.
You will also decide if you want to use a government-insured mortgage loan (such as FHA or VA) or a conventional “regular” type of loan. The differences between these two types of mortgages are discussed below.
A conventional mortgage loan is one that is not insured or guaranteed by the federal government in any way.
This distinguishes it from the three types of government-backed mortgages explained below (FHA, VA and USDA loans).
Mortgage loans secured by the government include the following:
The Federal Housing Administration (FHA) mortgage insurance program is administered by the Department of Housing and Urban Development (HUD), which is a federal government department.
The government insures the lender against losses that could result from buyer default. Advantage: this program allows you to make a down payment as low as 3.5% of the purchase price. Disadvantage: you will have to pay private mortgage insurance (PMI), which will increase the size of your monthly payments.
The U.S. Department of Veterans Affairs (VA) offers a loan program for military service members and their families. Similar to the FHA program, these types of mortgages are guaranteed by the federal government.
This means that the VA will reimburse the lender for any loss that may result from buyer default. The main advantage of this program (and it is large) is that buyers can receive 100% financing for the purchase of a home. That means there is no down payment.
The United States Department of Agriculture (USDA) offers a loan program for rural buyers that meet certain income requirements.
This type of mortgage loan is offered to “rural residents who have a stable, low or modest income, and still cannot obtain adequate housing through conventional financing.” The income must not exceed 115% of the adjusted median income of the area [AMI]. The AMI varies by county.
Hybrid: It is important to keep in mind that buyers can combine the types of mortgage types explained above. For example, you can choose an FHA loan with a fixed interest rate or a conventional mortgage loan with an adjustable rate (ARM)
Option 3: Jumbo Loans (Non-Conforming) vs. Conforming Loans
There is another distinction that must be made, and it is based on the size of the loan. Depending on the amount you are trying to borrow, you may fall into the jumbo or compliant category. Here is the difference between these two types of mortgage.
• A conforming loan is one that meets Fannie Mae or Freddie Mac’s insurance guidelines, particularly with regard to size. Fannie and Freddie are the two government-controlled corporations that buy and sell mortgage-backed securities (MBS).
Simply put, they buy loans from the lenders that generate them and then sell them to investors. A conforming loan is within its maximum size limits and, otherwise, “conforms” to the pre-established criteria.
• A jumbo loan, on the other hand, exceeds the limits of compliant loans established by Fannie Mae and Freddie Mac. This type of mortgage represents a greater risk for the lender, mainly due to its size.
As a result, huge buyers typically must have excellent credit and higher down payments, compared to conforming loans. Interest rates are generally higher with jumbo products, too.
Although it is my greatest desire to help you understand your options, I also recommend that you continue researching beyond this website. Education is the key to making decisions in your favor, as a buyer.
Feel free to call or email us with any questions as our partner realtors may be able to connect you with a local lender to help explain your options.