Types Of Home Loans: Which Is The Right Option For You?

Did you know that there are many different types of home loans? If you're thinking about buying a house, it can seem confusing to know exactly which type of loan fits you best.

Learning the several different types of home loans, their features and qualifications will help you find the right option for your financial goals.

First, what is a mortgage loan, anyway? A mortgage loan is an agreement between you and a lender to obtain financing for a home. As a borrower, you can obtain a loan through mortgage lenders.

There are several different ways to categorize mortgage loans. For example, you may consider them by mortgage type, rate type and mortgage term.

Understanding your mortgage options begins with understanding the most common kinds of home loans, including conventional loans, government-insured loans and jumbo loans. Let's go over the details of these types of mortgage loans.

Conventional Loans

A conventional loan is a type of loan that isn’t backed by the federal government. It is the most standard home loan and the preferred option for many borrowers. Compared to government-backed loans, conventional loans may have stricter qualifications:

• Credit score: In most cases, you'll need a minimum credit score of 620, though you may receive a lower interest rate if you have a higher credit score.
• Debt-to-income (DTI) ratio: DTI refers to how much debt you have relative to your income. You can calculate DTI by totaling your monthly debt payments and dividing by gross monthly income to come up with a percentage. Gross monthly income refers to everything you earn in one month before taxes or deductions. In most cases, lenders look for a DTI no larger than 50%.
• Assets: Assets refer to money you have in other accounts, including cash or cash equivalent. These include checking or savings accounts, money market accounts and certificates of deposit (CDs). Physical assets (boats, cars, RVs) and nonphysical assets (pensions, 401(k)s) are also considered.

Conforming Loans

Most conventional loans are conforming loans. Conforming loans meet the basic qualifications for Fannie Mae and Freddie Mac to purchase. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that purchase mortgages from lenders and sell them back to real estate investors as mortgage-backed securities.

These loans have what’s called a conforming loan limit, which is the maximum amount you can borrow with this type of loan. The conforming loan limit for 2022 is $647,200 for a single-family home, except in high-cost areas, where the conforming loan limit is $970,800.

In order to qualify for a conforming loan, you'll generally need to have a minimum credit score of 620, a minimum 3% down payment and a maximum DTI of 50%.

Non-Conforming Loans

A non-conforming loan, on the other hand, cannot be sold to Fannie Mae and Freddie Mac. The rules for a conforming loan come from the Federal Housing Finance Agency (FHFA). If a home doesn't meet those rules, it cannot be considered a conforming loan. If it doesn't fit requirements by the FHFA – including an amount above the conforming loan limit – it will be considered a non-conforming loan.

Government-Insured Loans

Government-insured loans are mortgages that are backed by a federal government agency. The agency insures the loaned amount in case the borrower defaults on the loan. Three examples of government-insured loans include FHA loans, USDA loans and VA loans.

FHA Loans

An FHA loan is a loan backed by the Federal Housing Administration (FHA).

FHA loans can sometimes come with lower interest rates and lenders can accept applicants with lower credit scores. You typically must have a credit score of at least 580 to be eligible for an FHA loan. You can still be approved with a 500 credit score with some lenders as long as you meet their requirements, which may include a higher down payment and a lower max DTI. If you’re at or above a 580 credit score, you may be able to borrow with just 3.5% down.

In order to get an FHA loan, you'll need to get an FHA-certified home appraisal, which means your home will be inspected to meet certain regulations and standards. You must also pay a Mortgage Insurance Premium (MIP), which helps protect your lender if you happen to stop making your mortgage payments. You'll only have to pay a MIP for 11 years if your down payment is 10% or greater. Otherwise, you should expect to pay MIP throughout the life of your FHA loan.

USDA Loans

A USDA loan is backed by the U.S. Department of Agriculture (USDA). Residents of designated rural areas are the only ones who can get a USDA loan as it's set to encourage development in low-populated areas.

You must meet certain income levels, too. You cannot exceed 115% of the median income in your area. You don’t have to make a down payment and can qualify with a credit of 640, which may help you if you're a low- to moderate-income borrower. You may be able to roll your closing costs into the loan itself.

VA Loans

A VA loan, which is backed by the U.S. Department of Veterans Affairs (VA), is for active members of the military, veterans and eligible surviving spouses. The VA determines who qualifies for a VA loan and borrowers must obtain a Certificate of Eligibility (COE). This is a document that certifies your eligibility to qualify for a loan. The VA also decides which lenders can provide the loan to borrowers.

A VA loan is ideal for those with a low credit score, higher DTI or down payment challenges. You can qualify for a VA loan with a credit score as low as 500, though most lenders look for a credit score between 580 and 650.

VA loans typically do not require a down payment or private mortgage insurance (PMI). However, you’ll likely have to pay for a VA funding fee, which supports the program for future military members.

Borrowers may also pay limited closing costs and lower interest rates for a VA loan.

Jumbo Loans

A jumbo loan is a perfect example of the type of loan that falls outside of FHFA conforming loan limits. As non-conforming loans, they do not follow al of the standards set by Fannie Mae or Freddie Mac.

Since lenders take on a higher level of risk when they approve borrowers for jumbo loans, this means that they typically require a higher interest rate and minimum down payment as high as 20%. Lenders will also typically require a credit score of at least 680.

Lenders may also require proof that you have the funds available to pay back the loan. You may also pay more in closing costs compared to other types of loans for homes.

Once a home buyer chooses their mortgage loan type, they’ll need to decide on an interest rate type to repay their loan. The interest rate is the amount a lender charges as a percentage of the principal – the amount you borrow and have to pay back.

As a rule of thumb, the type of rate you choose will impact whether your interest rate will stay the same or fluctuate over the life of the loan. Two common interest rate types include fixed-rate and adjustable-rate mortgages.

Fixed-Rate Mortgages

A fixed-rate mortgage simply means that your payment does not change over the lifespan of your loan. Both principal and interest are set at a fixed amount, regardless of what's happening with interest rates. It's worth noting that while the principal and interest stay the same, other parts of your monthly payment could change. That includes what you pay for your property taxes and mortgage insurance.

Advantages Of Fixed-Rate Mortgages:

• Fixed-rate mortgages offer predictability from month to month because you know what your payment will be.
• Locking in a low interest rate can save you thousands over the life of the loan.

Disadvantages Of Fixed-Rate Mortgages:

• Unless you refinance, you must keep the same interest rate you had at closing. That means locking in at a high interest rate could cause you to pay more over the life of the loan.
• Paying off the principal takes time because interest is front-loaded into your payment schedule.
• Fixed-rate loans usually do not offer the lowest possible interest rate.

Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) has an interest rate that changes based on the current market. More specifically, it adjusts based on an index. ARMs usually offer a fixed, low interest rate for a certain period of time, then increase or decrease as time goes on. This means that your mortgage bill can be less predictable throughout the life of the loan.

Your mortgage agreement will also have caps. Periodic caps restrict the amount your interest rate can change over a set period of time. Lifetime caps limit how much your rate can shift over the entire length of your loan.

Advantages of adjustable-rate mortgages:

• Homeowners who know they will move before the fixed-rate period ends may want to opt for an ARM.
• You may end up with lower monthly payments once your fixed-rate period ends, if interest rates are low.
• Cap rates are attached to many types of ARMs to help limit how much the interest rate fluctuates.

Disadvantages of adjustable-rate mortgage:  

• Monthly mortgage payments can vary, making it more difficult to budget.
• Some ARMs charge prepayment penalties when borrowers sell off the home or refinance in the early stages of repayment.
• Discounts usually do not outweigh the benefits of a lower fixed interest rate.
• When market interest rates are low at the time of closing, a fixed-rate mortgage versus an ARM will guarantee a low interest rate over the life of the loan.

Home buyers also have to determine their mortgage term — the length of time it will take them to pay off their principal and interest. The most common mortgage terms are the 30-year mortgage and the 15-year mortgage.

30-Year Mortgages

Based on a loan amortization schedule, a 30-year mortgage shows exactly how much you'll pay per month over the course of 30 years until you completely pay off your mortgage. Many borrowers prefer a 30-year mortgage because of lower monthly mortgage payments. A mortgage divided by 30 years of regular payments will be lower than a loan due in half or a third of that time.

Spending less per month on your mortgage also opens up your budget and could help you afford a more expensive home, although it’s never a good idea to borrow more than you can comfortably afford.

It's important to note that additional time to pay off the loan also means you'll accumulate more in interest. You might pay in smaller portions along the way, but the total cost will be higher relative to mortgages with shorter terms.

15-Year Mortgages

A 15-year mortgage allows you to repay your loan over the course of 15 years. If you choose this term, you'll incur a lower total cost over time but higher monthly payments. Home loans with 15-year terms give you half as much time to pay back your loan in full, but that also means you’ll have half as much time for interest to generate on your principal balance.

For some borrowers, the spike in monthly payment requirements makes shorter-term home loans too difficult to pay back. Typically, 15-year mortgages carry lower interest rates than 30-year mortgages and the equity you invest into your home builds quicker.

Which home loan types appeal to you? There's a lot to consider – mortgage type, rate type and mortgage term.

Keep in mind that you're not alone when making the decision about the right type of loan for you. Your mortgage lender can help you decide on the best loan for your situation. If you're ready to move forward in your home-buying journey, get started with Rocket Mortgage®.