Types of Mortgages | Loans for Homebuyers & Homeowners
To the average consumer, a mortgage is a pretty basic financial product. You’ll use the funds from the loan to cover most of the purchase price of the home, then make monthly repayments over many years. At the end of the term, the mortgage is fully repaid, and you’ll own your home free and clear.
But the mortgage equation gets more complicated in that there are many types of mortgages. There are so many different types of home loans that you can practically customize the financing on your house.
But before you can do that, you’ll first need to know what those options are.
How Many Types of Mortgage Loans Are There?
Not only are there many different types of mortgages, but they’re also several mortgage programs, as well as very specialized types of home loans.
Here are the 11 most common types of mortgages for homebuyers or homeowners:
- Fixed-Rated / Conventional Mortgage
- Adjustable-Rate Mortgage (ARM)
- Balloon Mortgage
- Interest-Only Mortgage
- Jumbo Mortgage
- FHA Mortgage
- VA Home Loan
- USDA Mortgage
- Second Mortgage
- State & Local Government Assistance Programs
- Reverse Mortgage
Fixed-Rate / Conventional Mortgage
These are the most basic types of mortgages, and the ones most familiar to consumers. As the name implies, you’ll have the same rate throughout the term of your loan. And for that reason, your monthly payment will also remain stable throughout the term. Loan terms can range from 10 years to 30 years.
Conventional mortgages are available in nearly every housing market in the US. They’re referred to as conventional mortgages because they are not government guaranteed. The loans are funded by either the Federal National Mortgage Association (FNMA, or “Fannie Mae”) or the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”).
How Much Can You Borrow with a Conventional Mortgage?
The maximum loan limit for single-family homes is $510,400 for 2020. However, higher limits are available in areas determined to be high cost, as well as for two-to-four family properties.
One of the major advantages of conventional mortgages is that they don’t require private mortgage insurance (PMI) if you have or will have at least 20% equity in the property. However, PMI will be required if your equity is less.
How Does PMI Work?
PMI provides insurance to cover the lender on a certain percentage of your loan amount should you default. The insurance coverage is provided by private insurance companies, as opposed to government insurance provided on FHA, VA, in USDA loans.
With PMI in mind, conventional mortgages can be obtained with a down payment as low as 3%. Naturally, the cost of PMI premiums will be higher the lower your down payment is.
One major advantage conventional mortgages have over FHA and VA loans is that they are available for non-occupied properties. This includes both vacation homes and investment properties.
Adjustable Rate Mortgage (ARM)
ARMs are a major step up on the mortgage complication ladder.
They typically start with a lower initial rate than fixed-rate mortgages. They also include an initial fixed-rate period, which will be three, five, seven, or ten years. After that initial period, they adjust every year.
How Do ARM Interest Rates Work?
Rate adjustments are calculated based on an established index, like the 12-month LIBOR Index, plus a margin. For example, if you have a five-year ARM at 3%, and it has a 2% margin, your rate will rise to 4% if the LIBOR index is 2% at the time of the adjustment (2% plus 2%).
Fortunately, ARMs come with interest rate caps. They’re usually expressed in three numbers, representing the initial rate adjustments, subsequent adjustments, and a lifetime maximum adjustment.
For example, an ARM that has caps of 2/2/5 means your first adjustment cannot increase by more than two percentage points. Subsequent adjustments are also limited to 2%, and the maximum lifetime adjustment is 5%.
If you have an ARM that starts at 3%, your first adjustment would be limited to no higher than 5%. Subsequent adjustments would be limited to additions of two percentage points. And the maximum you can pay over the life of the loan is 8% (3% plus 5%).
Should I Consider An Adjustable Rate Mortgage?
These loans carry much greater risk than fixed-rate mortgages. You should only take an ARM if you expect to pay off the loan during the initial fixed-rate term.
But ARMs do have one significant advantage over fixed-rate mortgages, other than the lower initial rate. If you make extra principal payments on an ARM, your monthly payment will be recalculated at the next adjustment date. Assuming your interest rate remains the same, your monthly payment will be lower based on the reduced outstanding principal balance.
Balloon mortgages aren’t as popular as they used to be since they carry higher risk. A balloon mortgage offers a slightly lower interest rate than a fixed-rate mortgage, but that rate is only in effect for three, five, seven, or ten years.
In theory at least, at the end of the initial term, you’ll need to pay off the loan. You can do this either by selling the home or by refinancing into a new mortgage.
But most balloon mortgages today offer a rate reset at the end of the balloon term. That is, your rate will be reset to whatever the prevailing rate is on 30-year fixed-rate mortgages at the time of the adjustment. If the increase in the interest rate exceeds a certain amount, generally 2%, you may need to be re-qualified for the mortgage upon reset. This, of course, holds the possibility you won’t be approved at a higher rate.
Balloon mortgages are not quite as risky as ARMs, but they’re a lot riskier than fixed-rate mortgages.
As the name implies, you’ll only pay the interest on your mortgage for a certain amount of time. For example, you may take a 30-year mortgage that has an interest-only term ranging from three years to as long as ten years.
The good news is that the interest-only feature will result in a very low monthly payment.
But the bad news is that when the loan resets at the end of the interest-only term, your monthly payment will be higher than what it would’ve been had you taken a fully amortizing mortgage.
The reason for the increase is the shorter term of principal amortization. For example, when you take a typical 30-year fixed-rate mortgage, your loan principal amortizes over 30 years. But with an interest-only mortgage, the amortization term is reduced.
If you take a 30-year mortgage with a five-year interest-only term, principal amortization will take place over the last 25 years of the loan. The five-year reduction in the principal payment term will make the remaining payments substantially higher than they would be on a traditional 30-year fixed-rate mortgage.
Like ARMs, interest-only mortgages should only be considered if you plan to either pay off or pay down the mortgage by the end of the interest-only term.
We just described the conventional loan limit above. But if the loan amount required to purchase or refinance your home is higher, you’ll need to turn to what’s known as a Jumbo mortgage. These are so-called because they exceed the conventional mortgage maximum limits.
Banks and other financial institutions typically provide jumbo loans. Because they have higher loan amounts, they’re considered to be higher risk loans for the lenders. As a result, they have stricter requirements, that can include a higher interest rate, larger down payment requirement, and higher credit scores.
The higher down payment requirement usually eliminates the need for PMI, but some Jumbo loans will exceed 80% of a property’s value, and will, therefore, require the insurance coverage.
One primary reason to go with a Jumbo mortgage, apart from the obvious benefit of much higher loan limits, is the fact that many are customized. For example, a particular Jumbo program may work specifically with physician loans. This is a unique program, because physicians may not qualify for a mortgage easily early on in their careers. The combination of a relatively low income and high student loan debt can make qualifying for a mortgage under other programs more difficult.
But physician loans are specifically designed for the unique financial situation physicians represent. For example, even though a physician may not qualify for other loan types, physician loans may accommodate the borrower by recognizing the significant future potential income a medical professional can earn.
“FHA” is short for the Federal Housing Administration. The agency doesn’t make the loans but instead provides the mortgage insurance that acts as an inducement for direct lenders to make them available to borrowers.
FHA provides mortgage insurance coverage in place of PMI. That’s because FHA loans are usually made to borrowers who are considered higher risk to lenders. Down payments are typically minimal – 3.5% is the norm – and borrowers often have less than perfect credit.
FHA mortgages are available through banks, mortgage banks, and mortgage brokers. Loan limits match those of conventional loans.
VA Home Loans
VA home loans are designed specifically for veterans. If you qualify, a VA mortgage can equal 100% of the purchase price of the home you’re buying or refinancing. Qualifications are somewhat relaxed compared to conventional loans, for the benefit of veterans.
Once again, the VA doesn’t actually make the loans. Instead, they provide mortgage insurance through what is known as a VA funding fee. For most eligible veterans, the funding fee will be 2.3% of the loan amount. The veteran doesn’t pay this directly. Instead, the fee is added to the loan amount and financed over the term of the loan. Alternatively, the property seller or some other interested party can pay the funding fee for the veteran.
VA loan amounts match those of conventional loans, but under certain circumstances, they can be extended to much higher amounts. The loans are available through participating lenders, but it’s always best to work with one that specializes in VA mortgages.
USDA mortgages are a special loan type provided by the United States Department of Agriculture, primarily for financing in rural areas. However, this loan type is also widely available in many metropolitan areas.
Much like VA mortgages, USDA mortgages are available in amounts up to 100% of the property value. But borrowers can also add up to 6% in closing costs to their loan amount. Mortgage insurance is also provided by the US government through the US Department of Agriculture. However, unlike VA mortgages, USDA mortgages are available to non-veterans.
But USDA loans are designed specifically for low-to-moderate-income borrowers. They can also be used to make repairs or renovations to the subject property. This makes these loans a good choice if you qualify under the income limits, and need to purchase a property that will require significant upgrading.
USDA mortgage loan amounts are lower than other types of mortgages and vary considerably from one county to another. However, they’re usually sufficient for property values in lower-priced rural areas.
If you apply for a USDA mortgage, you should be aware that there are very specific property requirements. For example, the home must generally be no more than 2,000 square feet, have no inground pools, and not be designed to produce income.
A second mortgage is a general description of any home financing that’s in anything other than the first lien position. If you already have a first mortgage or have been approved for one on a new home purchase, any additional financing will qualify as a second mortgage.
Second mortgages come in two basic types.
Home Equity Loans
Home equity loans have fixed rates and terms and can be used as secondary financing for a property. They can be taken at the time of purchase, to lower the down payment requirement, and help the borrower avoid the PMI requirement. But they can also be used by existing homeowners as a way of taking equity out of their homes without needing to refinance the first mortgage.
The second type of mortgage is a home equity line of credit or HELOC. It’s essentially a revolving line of credit secured by your home. Usually issued by banks, you’ll be given a credit limit against the equity in your home. You can access those funds anytime you like, and when you repay them, you’ll restore your credit limit for future use.
Interest rates typically work on a variable basis, and of course, your monthly payment will rise and fall based on the interest rate, as well as the amount of the credit line you’ve accessed.
The loans are typically used to take equity out of a home you already own. But they can sometimes be used in a second position behind the first mortgage on a purchase.
Because either loan type is secured by your home, it usually carries an interest rate only slightly higher than the one on your first mortgage. Even better, there are typically little or no fees necessary to obtain either loan type.
State and Local Government Mortgage Assistance Programs
States, counties, and large cities often make home loan funds available to borrowers within their jurisdictions. They’re usually designed to help low and moderate-income borrowers become homeowners. Though they’re rarely outright first mortgages, they more typically function as a second loan to cover the down payment on a property.
They’re most commonly used in conjunction with FHA loans. Since FHA loans require a 3.5% down payment, the local government loan will provide the funds for that down payment. FHA typically accepts these arrangements.
Since the loans are small, and usually carry very low interest rates, they won’t significantly increase your monthly payment. But many have a provision where if you pay the loan on time for several years, the remaining outstanding balance will be forgiven.
Bond issues usually provide funds for state and local government mortgage assistance programs. For that reason, funds will be available only if a recent bond issue has been approved and funded. But they won’t be available if there hasn’t been a recent bond issue.
You can check with your lender or with your local government to find out if any such financing programs are available.
You may already have heard of reverse mortgages, even though they’re both unique and relatively new. But they’re primarily designed to help elderly homeowners stay in their homes, as well as access funds from the loan for basic living expenses.
The reason they’re referred to as “reverse” is because instead of the borrower making loan payments to the lender, the lender makes monthly payments to the borrower.
As the lender makes payments, the indebtedness on the property increases. Maximum loan limits are established based on the age of the borrower and the value of the property. The loan will need to be repaid either when the borrower sells the property, or when the borrower dies.
Is A Reverse Mortgage a Good Idea?
A Reverse Mortgage is an excellent way to provide money for additional living expenses, but it can ultimately leave the homeowner with little or no equity in the property once the loan amount maxes out.
To qualify, you have to be at least 62 years old. Proceeds from the loan can be taken either in monthly payments, as a lump sum, or even set up as a credit line you can access when funds are needed. There are no income or credit requirements to qualify; however, you must either own your home free-and-clear or have substantial equity.
The loans are actually backed by the FHA, and they can only be obtained through lenders that specialize in the loan type.
What is the Best Type of Mortgage Loan to Get?
For most home buyers, a fixed-rate mortgage will be the best choice. It may not necessarily provide the lowest monthly payment, but it does provide the security of both a fixed interest rate and monthly payments throughout the term of the loan. This predictability removes much of the risk associated with mortgage financing.
One of the significant advantages with a fixed-rate mortgage is that making additional principal payments will reduce the term of your loan. They won’t lower your monthly payment, but they chop months or even years off the back end of your loan.
Another major advantage of conventional mortgages is that they can be used to purchase non-owner-occupied properties, like vacation homes or investment properties. Other loan types don’t offer those options.
You can even create your own method of making extra principal payments on your loan each year, which will reduce your mortgage term to a certain desired length. For example, by making one additional mortgage payment per year, you can reduce a 30-year mortgage down to 25 years and nine months. This will eliminate more than four years of payments.
Whether you choose a fixed-rate mortgage, an ARM, a balloon, or interest-only, it’s important to get the best mortgage rate available for that loan type. A rate difference of just one-eighth of a point can add up to thousands of dollars in extra interest payments over a 30-year term. You owe it to yourself to shop.
Purchasing vs. Refinancing
Also, understand there are significant differences in the mortgage process if you’re purchasing a home versus refinancing the one you already own.
The more you know, the more you’ll come to realize refinancing isn’t just about getting a lower rate. There may be mitigating factors that will make it in your best interest to not refinance, even if a lower rate is available.
How To Choose Among The Various Loan Types
Conventional mortgages have several advantages, but that doesn’t mean conventional loans are the best choice for everyone.
If you’re a veteran, you’ll generally be better off with a VA mortgage. Not only do you not have to make a down payment, but VA mortgages don’t come with monthly mortgage insurance premiums. That will result in a lower monthly house payment.
If you have impaired credit, you’ll almost certainly be better off going with an FHA mortgage. Though they don’t usually accept borrowers with poor credit, their guidelines are more relaxed to accommodate credit issues.
If you qualify as low or moderate-income and live in a county that offers USDA loans, it can be a major advantage. Like VA loans, USDA loans don’t require you to make a down payment. And if the property needs major repairs, they can generally be included in the new loan amount.
If you can work with any loan, but particularly FHA, VA, or USDA, it will be mission-critical to work with a lender that’s knowledgeable in that specific area. You’ll need to work with the best mortgage lender, especially in the case of VA and USDA loans. Not all lenders have true expert status in those two loan types.
What is the Most Common Type of Mortgage Loan?
Because they have fewer restrictions and are available for more property types, conventional mortgages are the most common type taken by consumers. But how common a loan type is shouldn’t be a criterion in determining which mortgage is right for you.
If you’re a veteran, a VA loan will undoubtedly be the better choice. For individuals with impaired credit, FHA is the preferred mortgage. If you’re purchasing a very expensive property, and need a considerable loan amount, jumbo mortgages will be the best option. And if you live in a rural area, you may find a USDA mortgage to be the preferred option.
Which Type of Home Loan Is Right For You?
For most borrowers, a fixed-rate mortgage will be the best option. That’s because it’s the lowest risk mortgage you can take. It has none of the variables that come with ARMs, balloons, and interest-only mortgages. And if interest rates drop, you can always refinance to get the benefit of lower interest and a lower monthly payment.
But before deciding on which loan program or loan type to take, first explore your options with a loan officer from a mortgage lender. Armed with the information in this guide, you should be able to ask the kinds of intelligent questions that will lead you to the program that will work best for you.