Types Of Home Loans: Options To Explore When Buying Or Refinancing A Home
*As of July 6, 2020, Rocket Mortgage is no longer accepting USDA loan applications.
Buying a home can seem overwhelming at times, especially when you realize just how many types of home loans are available. But having a variety of mortgages can help you find the best home financing option. Here, we break down the different types of mortgages to help you understand the benefits and differences of each type and decide what’s right for you.
The Different Home Loan Categories
The first category that all mortgages fall into are conforming and nonconforming loans. The distinction is determined by whether the loan meets (or conforms to) the guidelines of government-sponsored entities Fannie Mae or Freddie Mac.
Conforming loans are loans that can be purchased by Fannie Mae or Freddie Mac. These loans must meet certain requirements set by the Federal Housing Finance Agency including:
- Credit: In order to have a conforming loan, a client needs a qualifying credit score of 620 or higher. Beyond the score itself, negative marks on your credit can also have an impact on whether you qualify.
- Debt-To-Income Ratio: When evaluating how much house you can afford, mortgage lenders calculate your DTI ratio. This is a comparison of your gross monthly income with your monthly debts, including installment debts like a mortgage, car payment or student loans, and revolving debt like credit cards.
- Loan Limits: Loans that are above the local conforming loan limit are jumbo loans and are considered nonconforming. In general, the conforming loan limit for a one-unit property is $647,200. However, if you live in a high-cost area, limits are set on a county-by-county basis up to an absolute ceiling of $970,800. This upper limit is also the blanket limit for properties built in Alaska and Hawaii. If you have a property that has multiple units, loan limits are higher.
Any loan that doesn’t get the backing of Fannie Mae or Freddie Mac is considered nonconforming, including loans from government agencies. These types of loans have less strict requirements that the borrower has to meet, allowing some buyers to get a mortgage with a lower credit score or no money down.
Conforming Vs. Nonconforming Mortgage Loans
The first category that all mortgages fall into is conforming and nonconforming loans. A conforming loan is one that meets (or conforms to) the guidelines of government-sponsored entities Fannie Mae or Freddie Mac. Any loan that doesn’t get the backing of Fannie Mae or Freddie Mac is considered nonconforming, including loans from government agencies.
The requirements for something to be a conforming loan break down into a few categories.
Credit: In order to have a conforming loan, a client needs a qualifying credit score of 620 or higher. Beyond the score itself, negative marks on your credit can also have an impact on whether you qualify.
For example, you may have a harder time qualifying or you may not qualify at all if you have multiple late mortgage or rent payments in the last year. Additionally, if you’ve had a more serious issue like a bankruptcy, you could have to wait up to 4 years in order to get a mortgage.
Government loans and other private lender offerings often allow you to qualify sooner than you might for a conforming loan if you have a lower credit score or dings on your credit.
Debt-To-Income Ratio: When evaluating how much house you can afford, mortgage lenders calculate your DTI ratio. This is a comparison of your gross monthly income with your monthly debts, including installment debts like a mortgage, car payment or student loan, and revolving debt like credit cards.
Loan Limits: Loans that are above the local conforming loan limit are jumbo loans and are considered nonconforming. In general, the conforming loan limit for a one-unit property is $647,200. However, if you live in a high-cost area, limits are set on a county-by-county basis up to an absolute ceiling of $970,800. This upper limit is also the blanket limit for properties built in Alaska and Hawaii. If you have a property that has multiple units, loan limits are higher.
Understanding Different Types Of Mortgage Loans
There are several types of loans, each available to help borrowers in different ways, based on their financial goals and qualifications. Mortgage loans differ in many ways, including:
- The minimum credit score required.
- The minimum down payment required.
- The length of the loan term.
- The mortgage rates charged.
- Whether the loan conforms to government-backed guidelines.
The home’s property classification – whether it’s a primary home, secondary residence or investment property – can affect the type of loan you choose to get. For example, primary residences may have lower interest rates and down payment requirements and fewer restrictions than second homes and investment properties. To help you have more financial flexibility with these higher-risk properties, you may opt for a loan that offers the lowest down payment requirement or longer term, if possible.
Conventional loans are backed by either Fannie Mae or Freddie Mac. As mentioned earlier, these may also be called conforming loans.
Conventional loans have a variety of features. To qualify for nearly any conventional loan, you need a median FICO® Score of 620 or better. From an affordability standpoint, you won’t qualify for a mortgage with monthly debt payments greater than 50% of your gross monthly income.
- Down payments as low as 3%: If you’re a first-time home buyer or if you qualify based on income, you can purchase a one-unit primary property with as little as 3% down. In no event will the down payment for a single-family primary residence need to be more than 5%. The size of the down payment necessary does change if you’re buying a home with multiple units or using the home as a vacation residence or investment property.
- Mortgage insurance goes away: If you make a down payment of less than 20% on a conventional loan, you’ll end up paying for private mortgage insurance. The good news is once you reach 20% equity or the midpoint of the loan (whichever is sooner), you can request that PMI be canceled pending a valuation by an appraiser confirming that the property hasn’t lost value at all. The 20% figure is based on getting the 20% equity through your payments. It’s possible to have PMI canceled based on things like home improvements or general market value increases, but the timing and amount of equity necessary may change.
- Occupancy flexibility: Unlike government loans, conventional loans through Fannie Mae and Freddie Mac aren’t restricted to primary residences. You can use them to buy second homes and investment properties, as long as you meet the necessary qualifications.
- Stricter guidelines: You’ll need a higher qualifying credit score and lower DTI than you might on some government loan options. You could also end up with a higher necessary down payment depending on your situation.
- Mortgage insurance: While there’s mortgage insurance on conventional loans, no one likes paying PMI at all if they can avoid it.
Government-backed loans are insured by government agencies, making them less risky for lenders because they are not held liable if you default on your mortgage. There are three types of government-backed loans, each of which has its own pros and cons, as well as different criteria that needs to be met in order to qualify.
VA loans are available to eligible active-duty service members, reservists, veterans and surviving spouses of those who passed in action or as a result of a service-connected disability. There’s no down payment required. While the VA doesn’t set specific guidelines for credit scores, lenders have their own policies. Rocket Mortgage requires a 580 credit score for eligibility.
- No down payment required: You don’t need a down payment when getting a VA loan. This could enable you to save on closing costs.
- Be able to afford more: If you’re getting a fixed-rate loan through the VA, you can qualify with a DTI ratio as high as 60% with a 640 median credit score, higher than any non-streamline refinance loans from any of the major mortgage investors. This translates into being able to afford more home if you need it.
- Convert all of your equity into cash: The VA loan is the only one you can use to take cash out up to the full value of your property. Rocket Mortgage requires that you have a 680 median FICO.®
- VA funding fee: While they don’t have mortgage insurance, VA loans do have a funding fee that’s paid upfront. Depending on your service status, down payment and the number of times you’ve used a VA loan, this fee is anywhere between 1.4 – 3.6% of your loan amount generally. For VA Streamlines (refinancing from one VA loan into another to lower your rate or change your term), the fee is 0.5%. In many cases, if you don’t want to pay it at closing, it can be built into the loan amount. Surviving spouses, active-duty servicemembers who have received a Purple Heart, and those receiving VA disability are exempt from the funding fee.
- Limited audience: In order to qualify for a VA loan, you need to be an eligible member of the military, a veteran or a surviving spouse.
FHA loans allow you to qualify with less-than-perfect credit. You can get an FHA loan with a qualifying credit score of as low as 500, but you’ll need a 10% down payment, and this option is offered by very few lenders. Rocket Mortgage and most others require a qualifying score of 580 to get a loan with a 3.5% down payment.
- Flexible credit guidelines: You can qualify with a score as low as 580. Additionally, if you have a score higher than 620, qualifying DTI is decided on a case-by-case basis; affordability guidelines can be more flexible, depending on your situation. Additionally, if you have blemishes like account collections or bankruptcies, you may be able to get a loan sooner than you otherwise might with other programs. Finally, you can qualify with nontraditional credit sources like cell phone, electric and cable bills through manual underwriting if you don’t have a traditional credit history.
- Low down payment option: You only need to come up with 3.5% of the purchase price.
- Mortgage insurance premium: With any FHA loan, you’ll pay both an upfront and a monthly mortgage insurance payment. The upfront payment can be built into the loan amount. If your down payment is 10% or more, you pay a mortgage insurance premium (MIP) for 11 years. If the down payment is less than 10%, MIP is paid for the life of the loan.
USDA loans are for those with qualifying incomes who want to buy property either in a rural area or one on the edge of suburbia. If you want to live in that area and you meet the income guidelines, you can purchase a one-unit property without a down payment. Rocket Mortgage does not offer USDA loans at this time.
- No down payment required: Having no down payment allows you to spend money on other expenses related to moving.
- Lower fees than FHA: There’s both an upfront and annual guarantee fee (equivalent to mortgage insurance), but they are lower than similar fees for FHA loans.
- Eligibility area: If you want to get a USDA loan, you have to be in an eligible area. The USDA maintains an eligibility map.
- Income limits: You can’t get a USDA loan if your household makes more than 115% of the area median income. The household part is an important distinction because other loans with income limits typically only count those named on the loan.
- Guarantee fees: Although the fees are lower than they would be for FHA, they still exist. Additionally, monthly guarantee fees stick around for the life of the loan no matter what.
- You can’t take cash out: With a USDA loan, you can only buy a single-family primary property or refinance.
- No working farm property: Despite being aimed at rural and underdeveloped areas, your property can’t be on the site of a working farm.
A jumbo loan is a loan that is worth more than the conforming loan standards for the area your property is in. This type of loan is used to buy high-value properties.
- You can buy a more expensive home: The conforming loan limit in most parts of the country is $674,200 so a jumbo loan allows you to finance properties that are over that amount.
- Similar interest rates: The interest rates on jumbo loans are similar to the interest rates on conforming loans.
- More difficult to quality: A credit score of at least 700 and a low DTI ratio are required to qualify for a jumbo loan.
- Requires a large down payment: You’ll need to put 10 – 20% down on the property in order to finance the rest with a jumbo loan.
Balloon mortgages are less common and more risky. With this type of loan, you make interest payments for a set amount of time, much like you would with a 30-year loan. At the end of the term, you’ll make one large payment to pay off the remainder of the loan.
- Lower monthly payments: Because you are likely just paying interest, the monthly payments on a balloon mortgage are lower than other types of loans.
- More risk: Balloon mortgages are riskier for both lenders and borrowers because they require a lump sum payment at the end of the term.
What Are The Different Mortgage Rate Types?
When you get a mortgage, there are a couple of different interest rate structures. You either have a fixed-rate mortgage or an adjustable-rate mortgage that changes over time, subject to market conditions and caps on increases. Let’s dig in and get a little more detail.
With a fixed-rate mortgage, you’re going to pay the same amount of annual interest every year over the life of the loan. This means that your monthly payment stays more constant. There are a couple of scenarios in which it could change, including the following:
If you made a down payment of less than 20%, once you reach that 20% equity amount on a conventional loan, mortgage insurance can be canceled with a home valuation to verify that your home hasn’t lost value. If you don’t request cancellation, PMI will automatically cancel at 22% equity or the midpoint of the loan, whichever is first.
Your mortgage payment can also change if your property taxes or homeowners insurance go up or down, assuming you have an escrow account that splits these costs into monthly fees added to your mortgage.
- Consistent mortgage payment: Your mortgage payment is more consistent. Because of this, it can be easier to plan your budget and think about future expenses.
- Higher interest rate: Interest rates won’t be as low on a fixed-rate mortgage as the initial rate would be on an ARM. The reasoning for this is that with a fixed rate, the lender has to attempt to forecast the cost of inflation more than they do with a rate that eventually adjusts.
Adjustable-Rate Mortgage (ARM)
Adjustable-rate mortgages have rates that adjust over time. However, they don’t move right away. ARMs have what’s called a teaser period at the beginning of the loan. During this time frame, which can last 5, 7 or 10 years typically, the rate is fixed. At the end of the fixed period, the rate adjusts up or down based on market conditions, once or twice per year.
When the rate adjusts, it’s tied to a market index. Conventional loans are based on the Secured Overnight Financing Rate (SOFR). Government loans from the FHA and VA base their rate on the 1-year Constant Maturity Treasury. To get to the final rate, the index level on the day of adjustment is added to a margin.
It’s also important to note that even if interest rates go up dramatically, they can’t go up indefinitely year after year. There are caps on the initial adjustment, each subsequent change and over the lifetime of the loan. The easiest way to explain this is to tie it all together with an example. Let’s say you see an ARM that’s being advertised as a 7/6 ARM with 2/1/5 caps.
Looking at those first two numbers, the 7 represents the number of years the rate stays fixed. The 6 represents that the rate will adjust every 6 months.
There are caps associated with your loan which outlines the maximum your rate can adjust up or down. In the above example:
2: There is a 2% increase/decrease cap on the initial adjustment
1: The rate won’t increase/decrease more than 1% each adjustment after that
5: The rate won’t increase/decrease more than 5% for the life of the loan
The only thing besides caps limiting how much an interest rate could potentially go down based on market conditions is the margin. When an interest rate adjusts, the loan is re-amortized so that it fully pays off by the end of the term. Typically, the terms for ARMs are 30 years, although they don’t necessarily have to be.
- Teaser interest rate is lower than fixed rates: Investors can have the rate start lower since adjustment is built into the loan, meaning they don’t have to plan as far out for inflation.
- Pay your loan down sooner: You can take advantage of the lower interest rate to pay down your loan sooner. If you pay down your loan during the fixed period, you’ll end up with a lower balance than you would otherwise at the time of the adjustment.
Because the loan amortizes this when adjustments are made, if you have a lower balance, the required monthly payment could be lower than it otherwise would be. This would help lessen the effect of an uptick in interest rates.
This might be good for people who move around a lot. If you’re someone who moves quite a bit, you may find that you end up selling your house and paying off your loan before the rate ever gets a chance to adjust.
- Lack of payment certainty: Because the payment adjusts, you don’t have any certainty as far as what your payment will be after the fixed-rate period at the beginning of the loan.
You won’t always be able to refinance into a fixed rate. One of the ways that people often try to avoid the rate going up each year at the end of the teaser time frame is to refinance into a fixed-rate loan, but you have to be able to qualify for that. Even if your credit is in shape and you make a good income, you could have a difficult time if property values have dropped.
What Are The Terms Of Different Types Of Home Loans?
The terms of a mortgage can technically refer to any of the contract provisions associated with a mortgage, but typically, when loan terms are referred to, it specifically references the amount of time you have to pay off the loan.
When it comes to choosing a loan term, you have several different options, each with its pros and cons.
The 30-year term is generally the longest you can get. The only exception is if you have trouble making your payments and your mortgage servicer approves a loan modification for a longer term. Although this isn’t always the case, most loans come with a 30-year term.
Here are the pros and cons of a mortgage with a 30-year term.
- Lowest monthly payment: It’s the cheapest monthly payment you can get if all other things are equal because it’s the longest monthly term. This makes it easier to fit into your budget.
- Greater flexibility: Because there's a lower monthly payment, you do have a level of greater flexibility. You can also make extra payments toward the principal in order to pay less in interest over time, and even cut months or years off the loan. Just make sure you’re aware of whether your lender charges prepayment penalties and for how long. Rocket Mortgage does not.
- More interest over time: With a longer term, you’ll end up paying a lot more interest over time. This is because investors need some motivation in order to buy a loan with a longer payoff period. Because you owe more interest, if you’re in the home for a short period of time, your payoff from selling the house might not be as high.
With a 15-year mortgage you pay off your loan in a much shorter time frame. There are benefits and downsides to this.
- Less interest over time: With a shorter payoff time frame, you end up paying less interest in exchange for giving the investor the quicker payoff.
- Lower interest rate: In addition to paying less interest by virtue of the time frame, you get a lower interest rate as well.
- Higher monthly payment: Because of the shorter term, your payment could be hundreds of dollars more than what it would be on a 30-year fixed.
Although everyone thinks about 30- and 15-year terms, there are other options. On government loans, you also have 20- and 25-year options for terms.
On the conventional side, you can get a fixed-rate term of anywhere between 8 – 30 years, so you can really customize your options. We call this the YOURgage®. You may find that this gives you the opportunity to shave years off your term while still being comfortable with your payment because you have the flexibility to pick your exact term.
The Bottom Line: Which Of The Different Types Of Mortgages Is Right For You?
The variety of loans available makes financing a house a little more custom fit for your needs and goals. It’s important to learn about each one, its pros and cons and its qualifications, to make an educated decision on which is best for you. Speaking to a licensed mortgage expert can help. If you’ve done your research and you’re ready to start your home buying journey, apply for a mortgage today with Rocket Mortgage.