Navigating the home mortgage maze can be challenging, particularly for first-time home buyers. Adding to the confusion is the fact that several types of mortgage loans can fit into multiple categories used to define home finance.
To sort through the types of home mortgages available to you and ensure you understand terminology, here is a quick primer on types of home mortgage loans:
Fixed or Adjustable Rate Mortgages
Every mortgage can be defined by the type of interest rate it involves, whether fixed, adjustable or a combination. Choosing whether to pursue a fixed rate or an adjustable rate loan will be one of the first decisions you will likely encounter as you apply for financing.
- As its name would imply, a fixed rate mortgage is a home loan in which the interest rate remains constant throughout the life of the loan.
Many borrowers prefer a fixed rate mortgage because they wish to avoid any surprises. Even with long-term loans of 30 years, the monthly home payment remains the same, year after year, unless you decide to refinance your loan for a more favorable rate down the road.
By contrast, the interest rate for an adjustable rate mortgage, or ARM, will change every year. In nearly all cases, your loan will have a limit as to how much it can adjust up or down over a given period of time or over the lifetime of your loan.
Often, a loan’s interest rate will not change until after a period of time has passed following the loan’s initial rate. For this reason, such ARMs are often referred to as a hybrid product.
For example, a mortgage may carry the same interest rate for the first five years of the loan, then adjust on an annual basis.
The main advantage of a fixed rate mortgage is consistency of payments. However, your interest rate will be higher than the initial interest rate of an adjustable rate mortgage.
On the other hand, the interest rate of your ARM could later move upward to a point higher than the rate of a fixed rate mortgage.
Government Insured or Conventional Mortgages
You’ll also have to decide whether you want to use a government-insured home loan or a conventional type of loan.
- A conventional home loan is a mortgage that is not guaranteed by the federal government. It typically requires a larger down payment and stricter criteria for qualifying.
By contrast, the three types of government-backed mortgages are insured by a federal government agency. While it may be easier to qualify for a government-backed loan, there may be greater insurance cost added to your monthly payment. Government-insured loans include:
- FHA. The Federal Housing Administration (FHA) mortgage insurance program is sponsored by the Department of Housing and Urban Development. While you will need to pay mortgage insurance, an FHA loan carries the advantage of requiring a smaller down payment, as low as 3.5 percent.
- VA. This type of government-insured loan is backed by the Department of Veteran Affairs, and is available to members of the military and their families. Although similar to an FHA loan, this loan program makes home loans with as little as 0 percent down.
- USDA. The USDA loan home program is administered by the Rural Housing Service (RHS). This type of mortgage loan is restricted to rural properties and borrowers who can show a modest income, and do not qualify for conventional financing. Additional restrictions apply.
Conforming or Non-conforming
One additional set of terms you are likely to hear in conjunction with home financing is conforming versus non-conforming loans. This differentiation simply refers to whether a loan meets underwriting guidelines of Fannie Mae or Freddie Mac, the government-controlled corporations that purchase and sell mortgage-backed securities.
- A conforming loan is one that falls within maximum size limits, as well as other criteria.
If a loan is non-conforming due to size, it is known as a jumbo loan. Because these loans represent a greater risk to lenders, they typically have higher interest rates, and require greater down payments and higher credit scores.
Understanding the different categories of home mortgages can help you understand your available home loan options. Keeping in mind the combinations of mortgage types, such as fixed-rate FHA loan or adjustable-rate conventional mortgage, will help you to better analyze your options when financing your next home.