If you’re preparing to buy a home, you’ll most likely need a loan (often referred to as a mortgage when it concerns real estate). But all mortgages are not alike — depending on your financial situation and what type of home you’re looking for, some loans might be a better fit than others. There are a lot of options, but it doesn’t have to be overwhelming. Read on to learn about common loan types, as well as the types of borrowers they might benefit.
The first thing to know is the difference between privately insured and federally insured mortgages. The majority of home loans are considered traditional or conventional mortgages, which means a private institution like a bank backs them. If you fail to repay the loan, there’s no guarantee for the lender (beyond the foreclosure sale of the house). This is why you must have good credit and a steady income to qualify. And if you make a down payment of less than 20%, you’ll be required to pay for private mortgage insurance (PMI). Federally insured mortgages, on the other hand, are backed by a government agency. If a borrower defaults on their loan, the government will help compensate the lender.
FHA (Federal Housing Administration) loans are a common type of federally insured mortgage. An FHA loan allows individuals with lower incomes or credit scores to become homeowners because the requirements aren’t as tough and the down payment can be as low as 3.5%. Keep in mind that there are limits to the amount of an FHA loan (depending on the specific housing market), and if the down payment is less than 20%, you will still have to pay for PMI.
VA (Veteran’s Affairs) loans are another type of federally insured loan. These loans are limited to active duty service members and veterans. They are unique because they do not require a down payment or private mortgage insurance.
USDA (U.S. Department of Agriculture) loans are a third type of federally insured loan. Generally, these loans are for modest-income borrowers in rural and suburban areas. To be eligible, borrowers must meet income guidelines and property cap requirements. Often no down payment is required and funds are also available for home renovations and improvements. As an example, a family of four in Kingfisher, OK must have an adjusted income of less than $60,850 to qualify for a USDA loan.
When it comes to your loan’s interest rate, there are generally two types: a fixed-rate mortgageand an adjustable-rate mortgage.
Fixed-rate mortgagesare the most common. In this case, the interest rate remains the same for the length of the loan – usually for 15 or 30 years. A mortgage payment will be lower with a longer term (e.g. 30 years), but the interest rate is often a bit higher.
With many adjustable-rate mortgages, the interest rate is set for the beginning of the term and then fluctuates. A common example is a 5/1 adjustable-rate mortgage. In this instance, the rate is set for the first 5 years then will adjust annually based on market conditions. The intro rate is often enticingly low, but then it can increase dramatically. If you plan on selling your home and moving before the introductory rate ends (or you think mortgage rates will fall in the future), this could be a good option.
Interest-only mortgages are not very common, but they make sense for some individuals. Borrowers pay only the interest on the loan, but they make periodic (say, quarterly or annually if they have an income that fluctuates) principal payments. Usually, borrowers must demonstrate that they have significant income and assets before a bank will issue this type of loan. It may make sense if you plan to flip or sell a home after a short period of time.
Most loans are conforming, which means they adhere to limits set by the federal government. But if you live in an area where real estate prices are high or you want to buy a more expensive home, you may need a non-conforming loan called a jumbo mortgage. In most areas of the country, the loan limit for a single-family home is $484,350, so if you want a mortgage for more than that, a jumbo loan is in the cards. You’ll need excellent credit and often a bigger down payment to qualify for a jumbo mortgage.
Balloon mortgages are a unique type of loan in which borrowers make set monthly payments for a number of years and at the end of the term, the remainder of the loan is due. This is usually a very large number — hence the image of your payment blowing up like a balloon. Many balloon mortgage borrowers plan on refinancing before the large payment is due, but keep in mind that interest rates might rise or home values might fall over the course of the loan.
To find out which type of loan is right for you, it’s best to start the pre-qualification or pre-approval process with a loan officer at a bank, credit union, or mortgage brokerage.