Buying a home is one of the largest and most complicated purchases most people make. And as the average American doesn’t have hundreds of thousands of dollars saved, most people can only secure their housing by getting a home loan.
One of the first decisions a home buyer needs to make is identifying which type of mortgage is best for them. There are six main types of mortgages, each with its benefits and drawbacks. First-time home buyers should understand all six mortgage types to choose the best option for their needs and circumstances.
Let’s take a look at a breakdown of each type of mortgage loan.
Six Different Types Of Mortgages
Here are the six different types of mortgages.
1. Conventional Loans
A conventional loan, also known as a traditional mortgage loan, is the most common type in the United States. Essentially, the government does not insure or guarantee a conventional mortgage loan. Instead, these loans are offered by private lenders, such as banks and credit unions. Since conventional loans aren’t government-backed, they can sometimes come with stricter qualifications and higher rates.
Pros of Conventional Loans:
- A buyer can be approved with as little as a 3% down payment.
- A conventional loan can be taken out for a primary home, secondary home or investment property.
- Sellers can contribute to closing costs.
Cons of Conventional Loans:
- Buyers who have a down payment under 20% of their home purchase price must pay private mortgage insurance (PMI).
- A conventional loan requires stricter qualifications. Generally speaking, conventional loans require the home buyer to have a credit score of at least 620 and a debt-to-income ratio that is 36% or lower.
2. Jumbo Loans
As the name suggests, a jumbo loan is used for a substantial-sized mortgage. If an individual purchases an extremely expensive property and the required mortgage loan amount is outside conventional FHFA limits, they’ll likely need to take out a jumbo loan. (Note the conventional loan limit ranges between $726,200 to $1,089,300, depending on the area.)
Jumbo loans are typical in high-cost-of-living areas like New York City, San Francisco, Los Angeles and Hawaii.
Pros of Jumbo Loans:
- Jumbo mortgages usually come with similar interest rates to conventional loans.
- They allow home buyers to purchase luxury homes.
- Jumbo loans might be the only lending option when purchasing an expensive property.
Cons of Jumbo Loans:
- As jumbo loans are lending out a significant amount of money, lenders have more stringent qualifications, such as:
- Buyers must have a credit score of 700 or higher.
- A down payment between 20-30% is required.
- This option also requires a low debt-to-income ratio.
- Having cash reserves after closing costs and a down payment is another eligibility requirement.
3. Government-Issued Loan
Government-backed loans are mortgages insured by various federal agencies. The federal agency covers the loan if the borrower defaults on the loan. This government backing allows mortgage lenders to mitigate their risk and offer mortgages to a broader range of people, including disadvantaged groups who would otherwise struggle to get approved for a loan.
People not approved for a conventional loan often seek a government-issued mortgage.
Types of Government-Issued Loans
There are several types of government-issued mortgages, including:
- Federal Housing Administration (FHA) loans
- Veterans Affairs (VA) loans
- U.S. Department of Agriculture (USDA) loans
Each of these types of loans has its own set of qualifications.
Pros of Government-Issued Loans:
- They often have less-strict qualification requirements (lower credit scores, lower down payment).
- They might be the only mortgage loan option for some individuals who don’t meet the qualifications of other loan types.
Cons of Government-Issued Loans:
- FHA loans require FHA mortgage insurance.
- Some government-issued loans are only available to specific groups of people. For example, VA loans are only available to veterans, current service members and eligible spouses.
4. Fixed-Rate Mortgage
A fixed-rate mortgage is a loan with an interest rate locked in for a specific term (usually 15 or 30 years). This type of loan means the monthly payment usually stays the same, which makes it easier to budget.
Pros of a Fixed-Rate Mortgage:
- Monthly payments are predictable and easy to budget.
- The interest rate is locked in for a specific term, so if interest rates rise, the home buyer isn’t impacted until the end of the term.
Cons of a Fixed-Rate Mortgage:
- If interest rates drop, the home buyer will continue to pay their higher rate unless they refinance (which comes with additional costs).
5. Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage is just as it sounds — the interest rate on the mortgage adjusts to match current market conditions. Usually, this type of mortgage begins with a fixed rate and transitions to an adjustable rate after a specific term. For example, the home buyer may get the fixed rate for the first five years and transfer it to an adjustable rate afterward.
Pros of Adjustable-Rate Mortgages:
- Often buyers are given an extremely low introductory rate for the beginning period of their mortgage loan. This low rate can result in a significant reduction in interest paid.
- When interest rates are low, the homeowner benefits and also has a low rate.
Cons of Adjustable-Rate Mortgages:
- After the introductory period is over, mortgage payments will fluctuate, which can make budgeting more difficult.
- If interest rates increase rapidly, the monthly mortgage payment can increase substantially, which can increase the risk of loan default.
6. Reverse Mortgage
A reverse mortgage is one where the home buyer makes no monthly payments while they live in the home. Instead, the buyer must make one lump sum payment when the mortgage term ends. A reverse loan isn’t free money, as the loan still includes monthly interest and fees. This means the loan continues to grow and is much larger at the end of the term. A reverse mortgage is most commonly given out to seniors.
Pros Reverse Mortgages:
- Usually only given out to seniors (62 and older)
- A solution for people who are “house-rich and cash poor” that allows older people to leverage their equity to have a more comfortable retirement
Cons of Reverse Mortgages:
- There are many scams related to reverse mortgages, so home buyers should always be careful and verify they’re working with real sellers and lenders.
- It’s not a good short-term option.
- It might mean heirs cannot keep the property.
- A reverse mortgage is considered a high-risk loan. A buyer can default and lose their home if they fail to meet the requirements of their mortgage, including:
- Not using the home as a primary home for most of the year
- Failing to pay property taxes
- Failing to pay homeowners insurance
- Not keeping up with maintenance repairs required by the lender
Choosing The Right Type Of Home Loan
A mortgage loan is a big commitment that shouldn’t be taken lightly. Knowing the types of mortgage loan options allows home buyers to make a more informed decision. After researching and understanding the types of home loans, the next step in the home-buying process is to speak with a mortgage broker and move into the home you’ve been waiting for.
You might also be interested in: Mortgage Refinance- 5 Great Benefits Of Refinancing
