Buying a house can be one of the most important investments anyone can make. Not only does it provide you with a place to live, but it allows you to build your wealth through ownership of an appreciating asset. With interest rates on mortgages at all-time lows, now is a better time than ever to buy a home.
However, before buying a home, it is important to understand the different types of mortgage loans available to you. Not all loans are created equal, and some types of loans will only make sense to certain individuals depending on their circumstances.
In this post, we will give an overview of the eight different types of mortgages while also considering their advantages and disadvantages.
1. Fixed-Rate Mortgages
Fixed-rate mortgages are the most common type of mortgage and are also called conventional loans. One of the advantages of a fixed-rate conventional loan is that borrowers know what to expect as far as the interest rate and monthly payments go because the rate is consistent and doesn’t change from month to month.
With fixed-rate loans, interest rates and monthly payments will stay the same for the duration of the loan, making it a very transparent lending process where borrowers will not have to worry about their payment changing from one month to another.
Fixed-rate mortgages are typically available in five different periods. They can either be for 10, 15, 20, 30, or 40-year loans. The monthly payment costs are broken down into principal, interest, taxes, and insurance.
Borrowers looking for the lowest possible monthly payment within a conventional loan would be best served by looking into a 30 or 40-year loan. This is because the payments are divided by the amount of time it takes to pay back the loan. A loan that is extended for 30-40 years is a lot more affordable when the price is divided over a longer time frame.
However, we would be remiss not to mention that while the payment might be lower over a longer duration, the amount of interest paid will be more because the interest is being charged over a 30–40-year time frame.
2. Interest-Only Mortgages
Unlike fixed-rate mortgages, where the borrower is paying both principal and interest right off the bat, an interest-only mortgage allows a borrower to forgo paying the full conventional loan payment right away for the first few years.
By opting for an interest-only mortgage, borrowers can take advantage of paying only the interest portion of the role for up to 10 years if they so choose.
While delaying paying any principal can significantly reduce monthly payments, it should be noted that those payments are just delayed, and the principal of the purchase will need to be paid off eventually.
Ultimately, borrowers going this route will spend a longer amount of time paying off the loan, but this can be advantageous if you’re looking to save extra on your monthly payment from the onset of your loan. The money saved can then be used to pay off the principal later down the road.
3. Adjustable-Rate Mortgages
An adjustable-rate mortgage (ARM) is a mortgage that doesn’t have a set monthly interest rate. These loans charge variable interest from month to month, depending on changing economic conditions.
These loans often start as fixed-rate loans for the first months of the mortgage; however, after the fixed-interest period is over, the interest rate will adjust based on the reference interest rate of the ARM index in addition to a set amount of interest above that index rate (the ARM margin). The ARM index derives its rate from the prime rate, short-term US Treasury Bond rates, and the Federal Reserve Fund rate.
Having an adjustable rate can save borrowers money if the economic conditions are right and interest rates are low. However, the rate is sensitive to economic data and can go up if the Federal Reserve begins raising the benchmark interest rate.
It is important to note that these types of mortgages can have the potential to save borrowers money at the start of their loan term. However, borrowers of this type of loan do not have the peace of mind of knowing how high their interest rate can rise and can get into a situation where the payment becomes unmanageable.
4. VA Loans
This special type of mortgage is only available to members of the US Military. Veteran’s loans (VA loans) are specifically designed to make it easier for veterans to buy a house. Spouses can also be eligible for VA loans in some cases. A VA loan is unique in that it doesn’t require a down payment. This makes homeownership much more accessible to members of the armed forces.
5. FHA Loans
These loans are granted by the Federal Housing Administration are available to qualified borrowers who meet the minimum credit score and down payment requirements. The down payments on FHA loans are typically as low as 3.5% compared to the standard 20% that is common with conventional fixed-rate loans.
FHA loans were developed when Congress created the Federal Housing Administration in 1934 during the Great Depression. It was at that time when the US experienced its greatest housing crisis, with default and foreclosure rates at an all-time high.
This led lenders to only provide funds up to 50% of a property’s market value. Conventional loans at that time also had a short repayment schedule in addition to balloon payments. Because these stringent loan obligations were difficult to meet, only 40% of Americans at the time owned a home, and those who didn’t meet the obligations had a very difficult time securing a reasonable loan.
With so many housing difficulties, the US government was forced to create an agency that could combat the housing problem and offer more affordable loans backed by the government.
The programs implemented made it less risky for lenders to loan money and also made it easier for borrowers to qualify for a mortgage. Since the FHA was introduced, homeownership rates have risen to nearly 68% as of the second quarter of 2020.
Four Types of FHA Loans
Having gone over a brief history of the FHA, here’s an overview of four different types of FHA loans. FHA loans can be granted for many different reasons and allow borrowers to put down a minimum of 3.5% for a down payment.
1. Home Equity Conversion Mortgage
This type of FHA loan is a reverse mortgage program that assists seniors who are 62 or older convert equity in their homes to cash while still maintaining title ownership. These funds can be withdrawn as a fixed monthly amount or as a line of credit, and sometimes both.
2. FHA 203(k) Improvement Loan
If you’ve ever looked into FHA loans, you’ve probably stumbled across the 203(k) improvement loan. This loan is specifically designed for borrowers looking to make renovations to the home they are purchasing.
The 203(k) allows lenders to lend money to borrowers for both the purchase of the home and the cost of home improvements. This can be beneficial to those looking to buy a fixer-upper and who don’t have a lot of cash available for a large down payment.
3. FHA Energy Efficient Mortgage
Similar to the FHA 203(K), this loan program is designed to lend money that can cover the cost of home improvement upgrades. However, unlike the 203(k), the FHA energy-efficient mortgage is specifically tailored toward upgrades that can lower your energy costs.
Expenses covered under this loan include things like installing solar panels or wind energy on the property. Because cleaner energy homes have lower utility bills, the FHA is incentivized to provide this type of loan because they feel confident that the offset energy costs will leave more money for the borrower to make the monthly mortgage payment.
4. Section 245(a) Loan
The final type of FHA loan is the section 245(a) loan. Borrowers who wish to qualify for this loan are individuals who expect their income to increase.
Under this type of loan, borrowers can take advantage of a graduated payment mortgage (GPM) which starts with lower initial monthly payments that will gradually increase over time. These loans also come equipped with a growing-equity mortgage (GEM) which has scheduled increases in monthly principal payments which can shorten the duration of the loan.
6. Jumbo Loans
Jumbo loans refer to loans that are more valuable than the limit backed by the US government. They often carry higher interest rates than those available on smaller mortgages. While the jumbo loan limit can change over time, the current limit is $700,000.
When taking on a jumbo loan, it is important to recognize that these loans cannot be bought back by the FHA, or any other lender for that matter. These loans are typically used to finance luxury properties as well as homes in highly competitive local real estate markets.
Because these are high-value loans, these mortgages come with different underwriting requirements and tax implications. Over the last decade, these loans have become more popular as the housing market continues to remain strong.
7. Piggyback Loans
This type of loan is available to borrowers who choose to avoid paying private mortgage insurance (PMI). PMI is usually required for borrowers that choose to put down less than 20% for a down payment.
If you’re a borrower looking to avoid PMI and would rather take out a second loan, a piggyback loan could be a viable option where you will pay a small monthly payment that replaces the private mortgage insurance. This allows buyers to get a conventional mortgage without having to put down 20% in cash.
8. Balloon Mortgages
Balloon mortgages require borrowers to only have to pay interest for a specified amount of time. This can vary but is typically for the first five years of the loan.
After this time elapses, the borrower will then transition to paying just the principal amount of the loan. After the principal payment period is over, the borrower will then have to pay a lump sum payment at the end of the loan term to pay the remaining balance of the loan.
This type of mortgage can be advantageous to buyers who are looking to make very low interest and principal payments during the initial payment phase of the loan. However, it can be risky once the lump sum payment is due.
It is not only risky for the buyer who might be forced to liquidate the property if they don’t have enough funds to pay the balloon payment at the end of the loan term, but it is also risky for the lender who is left with the uncertainty of whether they will get their money back in full.
With that in mind, borrowers looking into this type of mortgage should proceed with caution and speak to a qualified lender who can go over which mortgage option is most suitable for them.
Conclusion
Having gone over the eight main types of mortgages, you can rest easy knowing you have no shortage of financing options. However, it is important to be prepared before jumping into such a large financial decision.
It’s important to research your options and come to a conclusion on which loan best fits your finances and lifestyle. While buying a home is usually never an easy process, we hope that this article gives you a bit more confidence in being able to assess the different loan options that are available to you today.
By knowing what these options are, you can put yourself in a position where you can get the best loan possible! Oftentimes buying a home can seem like a marathon. Although it may take some time, it will be worth it in the end!
