We look at the most popular loan options for home buyers and their respective pros and cons
There are several types of mortgage loans that appeal to a wide range of borrowers with unique housing needs and financial situations.
This list provides an overview of interest rates, qualified borrowers, advantages, and potential drawbacks for each loan type.
1. Fixed-rate mortgage or conventional home loans
About 90% of home buyers choose a 30-year fixed-rate loan, making it the most popular mortgage type in the country.
As its name suggests, the interest rate does not change over the course of 30 years. This means that borrowers can enjoy lower monthly payments because the mortgage is stretched over a long time.
This arrangement also protects homeowners from potentially drastic spikes in monthly payments due to fluctuations in mortgage rates. However, you’ll pay more interest over the loan’s lifetime.
Most lending institutions also offer mortgage terms of 15 and 20 years – however, borrowers will need to repay the principal in a shorter time frame, so monthly payments will be considerably higher.
The advantage of shorter-term loans is their lower interest rates. Each mortgage payment repays a larger fraction of the principal, so 15- and 20-year loans cost significantly less overall.
2. Adjustable-rate mortgage (ARM)
An ARM home loan starts with a rate that remains constant for a specified period, but it switches to an adjustable interest rate for the remainder of its term.
Also called the “teaser” rate, it is initially set below the market rate of most comparable fixed loans. Nevertheless, it is expected to rise at regular intervals called the adjustment frequency. According to Freddie Mac, ARMs will surpass fixed rates if held long enough.
ARMs are significantly more complex than fixed-rate loans because adjustments are tied to indexes like Treasury bills or certificates of deposit.
Upon signing your loan, borrowers agree to pay at a rate that can be marginally higher than the adjustment index. You also agree to a ceiling or the maximum rate that the mortgage can reach throughout its lifetime.
ARMs start much cheaper than fixed-rate mortgages, at least for the first three to seven years. However, monthly payments can change frequently and subsequent adjustments will follow current market rates – not the initial below-market value.
Fixed rates are relatively safer and more predictable for most, but variable rates can be advantageous for short-term homeowners who expect to move in a few years.
3. Interest-only mortgage
Fixed-rate and ARM loans require monthly payments to amortize both the principal and interest. By contrast, interest-only loans require that borrowers pay just the interest for the first several years of the term.
Once the initial period ends, the borrower will start paying both the interest and principal. You can typically see interest-only loans as a structure of repaying ARMs.
For instance, a borrower will pay only the interest during the first 10 years of a 10/1 ARM agreement. After the 10th year, the rate will adjust annually and you will start paying for the principal as well.
The bottom line is that interest-only loans are highly complex and isn’t recommended for most borrowers. You can enjoy low monthly payments during the interest-only period, but costs will sharply rise when that’s over.
4. Jumbo mortgage
Jumbo mortgages are loans that exceed the amounts set annually by the Federal Housing Finance Agency (FHFA).
You need a jumbo loan if the property you want to buy exceeds $548,250 in 2021. The limit is $822,375 for high-cost locations like some areas in California and Washington, D.C.
If the price does not conform to FHFA thresholds, you need to have a solid credit score of 680 or higher. Moreover, the lender may require you to put away up to 12 months of mortgage payments on a cash reserve.
Since you are borrowing a large amount, there are additional fees that can lead to steeper closing costs. The jumbo mortgage lender can also require at least two appraisals on the home’s value before approval.
Read more: 7 ways to succeed as a mortgage broker
5. FHA loan
This type of home loan is guaranteed by the Federal Housing Administration (FHA) and issued by a government-approved lender.
Designed to help low- to moderate-income borrowers, FHA loans allow down payments as low as 3.5% if you have a credit score of 580 or higher. You can still qualify if you have a credit score between 579 and 500, but you need to make at least a 10% down payment.
Would-be borrowers also need to have a debt-to-income ratio (DTI) of 50% or less to get approval. The DTI is the percentage of your pre-tax income that you use to pay student loans, auto loans, credit cards, mortgages, and other debts.
Regardless of the down payment amount, FHA requires borrowers to pay for mortgage insurance to protect the lender in case of default.
6. VA loan
VA mortgage loans are insured by the US Department of Veteran Affairs (VA). Like conventional mortgages, they can be issued by banks, private lenders, and credit unions.
Active military personnel and veterans who meet the required length of service can qualify for a VA loan. Surviving spouses of service members who died while on duty are also eligible.
Unlike most other mortgages, VA home purchase loans don’t require mortgage insurance and down payment. Interest rates also tend to be lower than FHA home loans and fixed-rate mortgages.
The program also offers cash-out refinancing to replace a conventional mortgage with a VA loan. Borrowers can also finance the cost of home improvements.
Just remember that VA loans have some limitations and potential drawbacks for some borrowers. For example, you cannot purchase a vacation home or investment property. A VA-endorsed appraiser must first evaluate whether the property meets the department’s standards.
Lastly, the borrower also needs to pay a funding fee to cover the costs of foreclosing – in case the mortgagor defaults.
Read more: The best cities for veteran homebuyers
7. USDA loan
Backed by the US Department of Agriculture, USDA loans are designed to help low-income applicants purchase homes in rural areas and some suburbs. The program allows you to obtain loans directly from USDA or a participating lender with interest rates as low as 1%.
To qualify, you must have a debt ratio of 41% or lower. USDA will likely consider higher DTIs if your credit score is at least 680.
USDA also issues home loans to applicants deemed unable to secure mortgages from traditional channels. These are borrowers who are below the low-income limit and without “decent, safe, and sanitary housing.”