Home Loans 101 - The Different Mortgage Types Explained
Which type of mortgage is right for me? This is one of the most common questions sent in by readers. This article seeks to answer those questions. Below, you will find an explanation of the different types of home loans in use today.
If you've been researching home loans for some time, and you're ready to move forward with the process, use the link provided below. Otherwise, keep reading below to learn about the different financing options you have. You can always come back to this link later on.
Good News and Bad: Fewer Mortgage Types Available
Home buyers today have fewer mortgage options than people who bought during the housing boom. Those were the days of "exotic" mortgages, when lenders were tailoring their home loan products to meet the needs of unqualified borrowers. It was the start of subprime lending, stated-income mortgages, pay-option ARM loans, and other risky products.
And then came the housing crash. All of those bad loans went belly up, and so did the lenders who made them. You know the rest of the story -- foreclosure crisis, bank failures, bailouts, recession, etc.
So now here we are in 2012. Most of those risky mortgage types are no longer available. New restrictions have been placed on the lending industry. We have gotten back to the basics. This is both good news and bad news for home buyers:
- It's good news, because you won't be nearly as confused when shopping for a mortgage loan. There were many different options to choose from before. But things are much simpler now. Translation: Less homework for you.
- It's bad news because you may find it harder to qualify for a loan. If you have a lot of debt, or a bad credit score, you might not be able to qualify at all. Most of the "backdoor" mortgage options are gone. Translation: Well-qualified borrowers only.
When choosing a type of mortgage loan today, it will basically come down to two choices. Do you want a fixed or adjustable-rate loan? Do you want a conventional or government-backed loan? Once you answer these two questions, the rest of the process is pretty straightforward.
First Choice: Fixed or Adjustable-Rate Home Loans
The different types of mortgages available today can be placed in one of two categories. They either have a fixed rate of interest, or an interest rate that adjusts over time. Technically, there's a third category of "hybrid" loans. But I'll get to that later. As a home buyer, this is one of the first decisions you'll have to make about the loan you want to use.
So how do you choose between these mortgage types? First, you need to understand how they work. Next, you need to consider the pros and cons of each type. And lastly, you should choose the loan that best supports your long-term housing plans.
Let's start with the basics...
- Fixed-rate mortgage: This type of home loan carries the same interest rate for the entire term (length) of the loan. The interest rate makes up part of your monthly payment. It's also the only component that has the potential to change over time. So if you get a mortgage with a guaranteed fixed rate, your monthly payment is guaranteed to stay the same -- for the entire life of the loan.
- Adjustable-rate mortgage: These are also referred to as ARM loans for short. Unlike the previous option, this type of mortgage has an interest rate that changes over time. This also means that the size of your monthly payment will change over time. It might adjust up or down, depending on market conditions at the time of adjustment. But they usually adjust upward, resulting in a larger monthly payment.
- Hybrid ARM loan: Most of the adjustable-rate mortgages offered today are considered "hybrid" loans. They get this name because they start off with a fixed rate for a certain period of time. After that period, the rate will begin to adjust. The most popular example is the 5/1 ARM loan, which carries a fixed rate of interest for the first five years. The rate will change every year after that. Some lenders offer 1-year, 3-year and 7-year ARMs, as well.
You can probably see the benefit of using a fixed-rate loan. Your payments will never go up, no matter how long you stay in the house. But what about the ARM loan? Why would anyone choose a type of loan that has so much unpredictability? The answer lies within the initial savings.
During its initial fixed-rate period, the hybrid ARM generally has a lower interest rate than a traditional 30-year fixed-rate mortgage. So you could pay less money in interest during that time, if you went with the adjustable loan.
The table below shows the average mortgage rates at the time this article was published, in June of 2011. There are four different types of mortgage loans shown here. Two of them are fixed-rate / FRM loans (15-year and 30-year options), and the other two are hybrid adjustable / ARM loans. I want you to focus on the difference between the 5/1 ARM and the 30-year FRM.
By choosing the hybrid loan option, a borrower might get an interest rate that's 1.22 percent less than the 30-year fixed option. This is a fairly standard differential -- adjustable mortgage loans almost always have a lower rate during the initial period. Check out the current rates in the Freddie Mac weekly survey, and you'll probably see the same thing.
So I've just explained the biggest pros and cons of these two types of mortgages:
With an ARM, you can probably save money during the first few years by securing a lower rate (when compared to a 15- or 30-year FRM). But after the initial fixed-rate period, your loan's interest rate will begin to adjust to keep pace with market conditions. They usually adjust upward, which means you'll have a larger monthly payment.
With the fixed-rate option, you'll have the same interest rate for the entire life of the loan. This is true even if you keep the loan for 30 years. You'll pay a higher rate than the initial rate on an ARM loan, but you won't have any of the uncertainty that comes in the later years of an adjustable loan. You're basically paying a premium for long-term predictability.
Match the Home Loan to Your Long-Term Plans
Think about your long-term plans. How long do you think you'll be in the home? Is this a temporary "starter home" you might be selling in a few years? If so, you might consider using an ARM to reduce your interest costs. If you plan on growing old in the home, you're better off with a fixed-rate loan that offers more stability.
If you would like to learn more about these types of mortgage loans, start here:
Fixed versus adjustable-rate mortgages
That pretty much covers your first major decision during the home-buying process. Let's move on to the second decision you'll have to make. Do you want to use a conventional mortgage or a government-backed loan?
Second Choice: Conventional or Government Loan
A conventional mortgage is one that is not insured by the government in any way. This home loan is made in the private sector with no form of government backing.
A government-backed loan is insured by some type of federal agency, such as the Department of Veteran Affairs (VA) of the Department of Housing and Urban Development (HUD). The loan may still be made in the private sector, but the lender receives insurance from the federal government.
There are several types of government mortgages:
- FHA loan -- This mortgage is made by lenders in the private sector (known as FHA-approved lenders) and is insured through the Federal Housing Administration. If the borrower defaults on the loan, the lender gets paid by the FHA. Learn more or apply
- VA loan -- This program is reserved for military service members and their families. It can be used to finance 100 percent of a home purchase, which eliminates the need for a down payment. This program is managed by the Department of Veteran Affairs. If you're a military member, you should have a VA specialist somewhere within your command. They can provide you with details about the program.
- USDA loans -- These used to be called RHA loans, for the Rural Housing Administration. The program is overseen by the United States Department of Agriculture, or USDA. This type of mortgage loan is reserved for people who live in certain parts of the country. There are income restrictions as well. They are sometimes referred to as "farmer loans," due to the geographical and demographic nature of the program. But you certainly don't have to be a farmer to qualify. The program is designed for low-income residents of rural areas. Learn more
The Rise of the FHA Loan
The FHA home loan is by far the most popular and widely used of the government programs. As of June 2011, FHA loans accounted for about 30 percent of the overall mortgage market. Their market share was in the single-digit percentages just a few years ago.
Why are they so much more popular today? Because the private mortgage market has gotten stricter with its lending requirements since the housing crash. So a lot of home buyers with less-than-perfect credit have no choice but to use the FHA program (with its more flexible lending guidelines).
This is the government-backed loan I want to focus on the most. The other two programs (VA and USDA) are something of a no-brainer. Those programs are probably your best option, if you qualify for them. But there's more to consider when choosing between a conventional or FHA loan. So let's talk about those considerations.
The biggest benefit for this type of mortgage is the down payment. With an FHA home loan, your down payment could be as low as 3.5 percent of the purchase price. A conventional home loan, on the other hand, will require a minimum down payment of 5 - 10 percent. The FHA program is also more lenient than the conventional mortgages. So if you have a below-average credit score or other qualification problems, it might be your best option. It might even be your only option.
There are also certain drawbacks to the FHA program. You'll have to pay a premium for government mortgage insurance. This helps the Federal Housing Administration cover its own losses resulting from lender insurance claims. Actually, you have to pay two different premiums -- upfront and annual. You can learn about this and other disadvantages here.
Choosing the Right Type of Mortgage for You
We've covered a lot of different mortgage types up to this point. But how do you choose the best one for your situation? Here are some questions that will help you decide.
1. How much do you have for a down payment?
If you can afford a 20-percent down payment on a house, you're probably better off using a conventional loan. You'll avoid mortgage insurance if you go that route (it's only required on loans that make up more than 80 percent of the purchase price).
If you can't afford to put that much money down, you might want to consider the FHA program. You'll pay extra insurance on the loan, but your down payment could be as low as 3.5 percent if you meet the requirements.
2. What's your credit score?
To qualify for a conventional mortgage, you will probably need a FICO credit score of 640 or higher. But the government programs are a bit more flexible. Many home buyers with credit scores below 640 have to rely on the FHA loan. So check your credit score. Find out where you stand. It will help you decide which type of mortgage to use. It will also help you negotiate with the lender (by better understanding your qualifications).
3. How long will you be in the house?
You'll have an easier time choosing between the fixed-rate and adjustable loan by thinking about your long-term plans. The longer you plan to stay in the home, the more you should lean toward the fixed-rate mortgage. But there are certain scenarios where it makes sense to use an ARM.
Here's an example from my own experience. When I was in the military, my wife and I bought a home in Maryland. We knew were would only be there for three to four years, at the most. We purchased the house because home prices were appreciating in the area, so it was a good investment (and better than living in an apartment).
We used an ARM loan to get a lower interest rate. We sold the home at the end of the tour, before the mortgage started to adjust. So we saved money during our stay, and we got out of the loan before the rate went up. This is an example of using the right type of mortgage for your situation.
Some people use an adjustable loan even when they plan to stay in the home for a long time. The logic is that they can enjoy having a lower rate for the first few years, and then refinance the loan before the first adjustment period. This makes sense on paper. But what if you can't refinance? A lot of things can prevent you from refinancing -- not enough equity, bad credit score, etc. So there's no guarantee you'll be able to refinance down the road.
Pre-Approval is the Next Logical Step
Now you know how to choose the right type of home loan. Where do you go from here? What's the next step in the process? I recommend that you get pre-approved by a lender. During this process, the lender will request a bunch of documents from you and examine your financial situation. Then they will tell you (A) if you're qualified for a mortgage and (B) how much they are willing to lend.
Pre-approval is not a commitment. The lender is not obligated to give you that amount. It just lets you know where you stand. And you're not obligated either. You can get pre-approved by two or three different mortgage companies to compare their offers. This will help you find the lender with the lowest rates and fees.
Note: This article is not all-inclusive. It gives you a good introduction to the different types of home loans available today. But there's a lot more for you to learn. I recommend that you go back through this article and follow the hyperlinks I've provided. You can also use the search tool at the top of this page to find certain topics. But don't stop there. Continue your research beyond this website. Make some phone calls. Talk to some lenders. The more information you gather, the easier it will be to choose the right type of loan. Good luck!
Where to Go Next
You can apply for the types of loans described in this article by using the link below. This is the only mortgage website that gets the Home Buying Institute seal of approval:
Get up to 4 offers at LendingTree.com
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