Before purchasing a home, you should understand the types of mortgage loans available and determine which one is best for your long-term financial situation. Decide how long you plan to stay in the home, calculate your down payment, review your credit score and outstanding debt and take into account your income stability. Then, compare loans on interest rates, points, closing costs, and for some, adjustment features.
Conventional loans vs. government loans
A conventional mortgage refers to any mortgage not insured or guaranteed by the federal government.
- These loans may be conforming, meeting the standards of Fannie Mae and Freddie Mac, or non-conforming, which is determined by the loan amount. Loans over the conforming loan limit of $417,000 are considered jumbo mortgages.
- Conventional mortgages typically involve larger down payment and credit score requirements than government loans.
Mortgage loans backed by the federal government are referred to as government loans.
- The FHA loan is the most popular and is backed by the Federal Housing Administration (FHA).
- FHA loans allow for down payments as low as 3.5 percent, but require mortgage insurance. After the mortgage crisis, their increase in popularity wiped out subprime lending with low down payments and lenient credit score requirements.
- The VA loan, reserved for the military, is another widely-used government loan.
Fixed-rate loans vs. adjustable-rate loans (ARMs)
A fixed-rate mortgage is the most common mortgage available to the borrower. The interest rate on a fixed-rate loan does not change during the entire duration of the loan. There are no associated mortgage indexes, margins or caps.
- Monthly mortgage payments remain constant throughout the life of the loan, unless you refinance.
- The 30-year fixed-rate loan is the most common mortgage. It’s amortized over thirty years, with early payments going toward interest, and later payments toward principal.
- The next most popular term is the 15-year fixed loan that raises monthly payments significantly, but considerably reduces the interest paid.
An ARM has a variable interest rate that changes with its associated index throughout the life of the loan. All ARMs have a pre-set margin and are linked to a major mortgage index.
- An ARM usually offers an initial rate for a certain time period. After that period, it adjusts to its fully-indexed rate, the margin plus index.
- Adjustment caps limit the rate change that can occur in certain time periods.
- The three types of caps include: Initial – the rate changes at the time of the first adjustment; Periodic – the rate changes during each period; and, Lifetime – the rate changes during the life of loan.
- All ARMs carry risk as the monthly payments change.
Most ARMs are hybrids that carry an initial fixed period followed by an adjustable period. Typically they are based on a 30-year amortization.
- Many types of ARMs exist, from one month to 10 years.
- Most borrowers get ARMs for the lower initial payment, and refinance the loan after the fixed period.
- Buyers often select an ARM if they plan to stay in the home for less than five years.