Buying a home in cash is inarguably the best way to purchase property when it comes to your wallet. The interest on a conventional 30-year mortgage can almost double the total cost you pay for your property. Consequently, that $300,000 loan will net the bank close to an additional $200,000 or more in interest over the years. While this is great for the bank, this is less than great for your pocketbook. That’s why it’s so important to know what types of mortgage loans are available to you.
However, mortgages are an increasingly unavoidable reality for many Americans due to the rising cost of…well, everything. Increased living costs mean less money in savings, which translates to that house savings account taking much longer to accrue more than a pittance. If you’re one of these Americans who wants to get into your dream home now instead of ten years from now, it’s best to walk into the process armed with a basic understanding of the massive debt you’re about to take on.
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What is a Mortgage?
The term “mortgage” is vaguely threatening in a way, especially when thrown around angrily by big bankers and government officials like it’s the boogeyman secretly hiding in every American’s closet. In reality, mortgage is simply a fancy word for the eye-poppingly large loan you take out to purchase a home.
While mortgages aren’t inherently threatening, they are inevitably complex, and knowing more about the types of mortgages can only work to your advantage. This knowledge process begins with a basic breakdown of some of the common terms you’ll hear in a lender’s office:
- Conforming mortgages are mortgages that meet local loan guidelines and lending limits, as defined by the government and/or government-backed agencies.
- Non-conforming mortgages break at least one standard that conforming loans followed, and therefore have alternative terms.
- Conventional mortgages are conforming mortgages that aren’t part of government programs or otherwise guaranteed by the government.
- Unconventional mortgages, or government-backed mortgages, are loans guaranteed by government agencies. If a borrower defaults on a government-backed mortgage, that agency will pay the debt to the lender.
- Mortgage term refers to the length of time you have to pay your loan off. They will also define your interest rates.
- Principal refers the amount of the loan itself.
- Interest is the money you pay on top of the principal.
Conforming vs Non-Conforming Mortgages
Amongst the many types of mortgage loans, each earns the status of conforming or non-conforming based on the amount of money a lender will loan a borrower. In short, conforming loans meet standard underwriting guidelines for the mortgage program in question (underwriting is a fancy term for the mortgage approval process). On the other hand, nonconforming loans do not follow the standards set for conforming/conventional loans.
Conforming loans fit government standards and the standards set by their sponsored companies and are the least-risky options for lenders. A conforming status allows lenders to confidently offer better terms.
These government-sponsored companies – such as Freddie Mac or Fannie Mae – are responsible for writing and upholding the guidelines for conforming and conventional loans. Subsequently, they often buy loans given by the lender so the lender can then fund the mortgage in full. However, these companies have a limit on what they will fund determined by their standard guidelines. If you purchase a loan that exceeds these limits, or has terms outside of the guidelines, the loan becomes non-conforming.
Some standards of conforming loans include:
- Loan limits: in 2016, the conforming loan limit ran from $485,000-$726,000 for a single-family home, depending on the area’s living costs
- A minimum credit score of 620 on fixed-rate mortgages
- A minimum credit score of 640 on adjustable-rate mortgages
- A debt-income ratio of no more than 50%, but more commonly around 36%
- A minimum down payment of 3-5%
If even a single condition of the mortgage falls outside the standard, then the entire mortgage becomes a nonconforming loan. Frequently, a government agency or underwriting company will be unable to guarantee these loans. As a result, nonconforming mortgages come with their own terms.
- Follow government and government-backed lender’s standards
- Have lower interest rates than non-conforming loans
- Unconventional conforming loans come with high fees and interest rates, but are government guaranteed
- Exceed limit amounts or break other standards set by government-sponsored companies
- Often have requirements such as perfect credit or large down payments
- Charge high interest rates
When you purchase a mortgage, one of the first steps you’ll take is to specify the conditions of your interest rate. Depending on the circumstances, as well as your lender, you may be able to lock your rate, select for a flexible rate, or choose a third, non-standard option. These various types of mortgage loans each comes with their own benefits and drawbacks, and learning the difference among them is an important step in your home-buying journey.
Fixed-rate mortgages (or conventional mortgages, as they are sometimes called) are loans that charge a fixed rate for the duration of the loan. If you sign up for a 4.0% interest rate on your loan in 2020, you’ll still be paying 4.0% interest on your loan in 2035. Fixed rate mortgages are standard for the average borrower.
While the interest rate may initially seem to be higher than adjustable-rate options, you will usually spend less in the long run with a fixed rate. These mortgages come in a variety of terms, depending on location and situation, but 15- and 30-year mortgages are the most common.
- The interest rate remains steady
- Your monthly payment never changes
- There are no surprise fees or mandatory loan insurance requirements
- Initially, fixed-rate mortgages carry more interest
- If the adjustable-rate market dips in a way that would benefit you, you can’t take advantage of the lower rates without fully refinancing your loan
- Fixed-rate loans aren’t guaranteed by the government even if they are conforming, which means lenders have discretion in charging higher interest or requiring larger down payments
- Conventional loans that don’t require 20% down on the loan require PMI (private mortgage insurance)
- This is a fee that protects lenders against your defaulting on the loan but does NOT go toward your loan. Might as well just burn your cash and call it good.
- In some cases, you may have your PMI removed, but only once you reach 20% equity in your home
Best for: borrowers who know their budget and want to stay on a set payment for the duration of their loan.
Adjustable-rate mortgages (ARMs) are loans with fluctuating interest rates that reflect changes in the economy and federal mandates. ARMs allow homebuyers to take advantage of lower interest rates without refinancing, but they automatically refinance your loans to higher interest rates based on market demands.
There are multiple varieties of ARMs to consider for prospective homebuyers, including:
- Variable rate mortgages. This is another name for the traditional ARM, but the definition of variable rate mortgage fluctuates with the mortgage term. Rates adjust on a set schedule depending on third party lender rates and the lender’s profit margin. Many also set a maximum cap on your potential interest rate.
- Hybrid ARMs. These come with an initial fixed rate for a set period of time, after which the rate fluctuates. One common example of a 30-year hybrid ARM is called a 5/1 loan, in which you pay a fixed interest rate for five years, then the adjustable rate for the last 25 years of your loan.
- Option ARM. This type of ARM is often used to sign borrowers onto larger loans they would otherwise be unqualified for. Option ARMs come with four payment options:
- A set minimum
- Many ARMs carry a lower initial interest rate
- When the interest rate is lower, your monthly payment is lower
- Borrowers can qualify for more expensive homes
- Some ARMs allow borrowers to refinance into a fixed-interest mortgage at the end of the initial fixed-interest period
- After the fixed, low-interest rate time period expires, your interest will hike to match economic demand
- When the interest rate jumps, so does your monthly payment
- You will likely pay more for your house overall, and may even lose your home if the market crashes (looking at you, 2008)
Best for: homebuyers who plan to move before the fixed interest rate expires, those who are predicting lower future interest rates, or those who may qualify to refinance their mortgage at the end of their initial fixed-ARM period.
Interest-only mortgages (technically a type of balloon mortgage) give homebuyers the option to pay only the interest charged on your mortgage instead of the principal of the loan for a predetermined period of time – usually 5 to 10 years. This drastically lowers the initial payment, making it a lifesaver for homeowners who find themselves in a pinch. The initial catch is that interest-only loans require borrowers to prove they have substantial assets or a proven credit history to qualify.
Secondly, at the end of the interest-only period, the monthly payment doubles or triples to start paying down the principal of the loan. Some interest-only borrowers may be able to refinance their mortgage at the end of the period, but since the interest is mostly or completely paid off by that point, you’ll only cost yourself more money in the long run.
- Lower initial payments
- Homeowners may be able to qualify for larger loans
- Can be a lifesaver for homeowners who suddenly lose a job or find themselves drowning in unexpected medical bills
- Payments double to triple at the end of the interest-only term
- Difficult to refinance at all
- If refinancing is possible, borrowers will pay even more on their mortgage in the long-term
Best for: borrowers who have high monthly cash flow or large savings, self-employed borrowers with increasing incomes, or incomes that vary monthly. Those who receive large annual bonuses they can put toward principal payments may also benefit from interest-only mortgages.
Some types of mortgage loans are guaranteed by a government agency. This means that government agencies will pay off the defaulted loan in order to bail out the lender. However, these loans have strict conditions and eligibility requirements that may be unfavorable for those who have other options. Qualifying groups for these loans are defined based on financial status, private vs public sectors employees, and/or geographic location.
Subprime mortgages are loans that borrowers who have bad or no credit and/or no money can qualify for. They are designed to make houses affordable for those experiencing financial and credit setbacks such as divorce, expensive medical bills, and chronic unemployment. However, as they are given to high-risk individuals, they often have ridiculously high interest rates and penalties.
Best for: those experiencing unprecedented or unavoidable financial hardships.
Indian Home Loan Guarantees
Indian Home Loan Guarantees are HUD-backed loans only available to Native Americans, Alaskans, and Hawai’ians. They come with their own terms and conditions depending geographic location and financial status.
Best (and only) for: cultural or geographical Natives who qualify financially.
State and Local Programs
State and local loan programs may offer struggling borrowers alternative options for homes or areas in need of repair or repopulation. They come in a variety of rates, locations, and other conditions. As a result, whether or not they’re a good choice is situation dependent.
Best for: those who can’t get lower interest rates through another mortgage program.
FHA loans are mortgages that come bundled with mortgage insurance to protect against loan default. They are guaranteed by the Federal Housing Administration and come with small down payments. These loans are primarily geared toward first-time home buyers or those with a FICO credit score as low as 500.
- They often require as little as 3.5% down on a loan
- They allow those with poor credit scores to get into a home
- Mortgage insurance premiums (MIPs) are required. This is like PMI; except borrowers will be paying the premium for the life of the loan.
- Those who can afford more than 10% down can have the MIP term reduced…to a mere 11 years
Best for: borrowers with poor credit and/or down payments less than 20%
USDA/RHS (United States Department of Agriculture/Rural Housing Service) loans are a type of mortgage offered to borrowers in rural or agricultural locations who may have lower incomes or credit scores. They may come with income caps and/or property value limits, but usually have no down payment requirement. In some cases, underwriters may accept credit scores as low as 500-580. However, they require upfront guarantee fees, as well as annual fees, which you cannot remove (unlike some PMI).
- No down payment required
- Loans come with below-market interest rates
- You can’t refinance these loans
- Prepayment penalties are atrociously high
- Designed for those who can’t actually afford a home yet to get approved for loans they often ultimately can’t afford
- You cannot remove the upfront guarantee and annual fees
Best for: income-restricted individuals in qualifying areas.
VA loans are tailored and available to veterans and current United States military members (and sometimes their spouses or beneficiaries). They Department of Veteran Affairs guarantees these loans and there is no need for a down payment. There are also no credit score requirements and no PMI or other insurance premiums. However, they require an upfront funding fee.
- Military veterans can purchase a home with no down payment or credit score
- PMI and MIP are not required
- Allow financially struggling current or former servicemembers to purchase a home
- VA loans come with a funding fee, which can range from 1.25-3.3% the value of your home, depending on:
- Military status
- If/amount of down payment included
- How many times you’ve financed a home through a VA loan
- If the housing market crashes, you could potentially end up owning more than the market value of your house
Best for: military members or spouses who need low interest rates and no down payment on their loan
Non-conforming mortgages are the mortgages that are not backed by government agencies. They offer homebuyers alternatives to conforming or traditional loans, but they come with their own risks that need to be carefully examined in each individual situation. While a non-conforming mortgage is occasionally the best choice for borrowers taking out large loans or in unique financial situations, if you’re not careful, they can lead to losing your home or ultimate financial ruin.
Combo/piggyback loans are used to circumvent the Private Mortgage Insurance (PMI) provision that lenders include on conforming loans. These allow buyers to put down a smaller down payment and take out two loans in combination to cover the cost of the house. It’s important to choose the lender of these loans carefully, otherwise you may end up paying more than you should for your home.
One piggyback formula is an 80/20 combination loan: you take out a mortgage at 80% of the home’s value and a secondary loan for the remaining 20%. A common situation looks like this:
A borrower puts down 10% on their home. A home equity loan or line of credit is taken out to cover an additional 10% of the cost, for a total of 20% “down” on the loan. The borrower then finances the remaining 80% with a traditional mortgage.
- Borrowers can avoid PMI
- They allow borrowers to take out loans they otherwise couldn’t afford
- One loan can be paid off faster, leaving a second loan smaller than a total single mortgage would cost
- They often carry a variable interest rate on the second loan
- The interest on the second loan may cost more than the predicted PMI would have
Best for: those who will pay less on the second mortgage than the lifetime cost of PMI on an alternative loan; or those who plan never to refinance, or to refinance 15 years in on a 30-year loan.
These types of mortgage loans charge interest for a set period of time – usually five to ten years – after which the entire principal is due at once. For those who believe they will have the full principal saved up at the end of the interest-only term, this can be the best choice to purchase a home. However, if you can’t pay the principal at the end of the interest-only period, you automatically default on the loan, which makes balloon mortgages risky propositions. (Did we mention balloon mortgages are largely responsible for the 2008 housing market crash?…)
- Lower initial payments
- Borrowers can take out larger loans than they would otherwise qualify for
- The entire principal is due at the end of the interest-only term
- Failure to pay the principal in full is a near-automatic default on the loan
- Difficult to impossible to refinance
Best for: those who are in a job with guaranteed promotions; those who are just starting a thriving self-employment position; or those who expect a wealthy relative to die before the interest-only term expires.
Jumbo mortgages are just that: mortgages too jumbo for the Federal government to guarantee or purchase. The current limit is around $700,000-$800,000, depending on the area’s living costs. With a jumbo mortgage, the borrower can’t get the lowest available interest rates that smaller loans are guaranteed. They also require minimum credit scores – usually a FICO of 700 or more – and a down payment of at least 10%.
Best for: buyers of high-value homes who meet the minimum requirements and can afford the payments. (In other words, NOT best for 99.9% of Americans. Please don’t jumbo if you can help it.)
Other Types of Mortgage Loans
Second mortgages, also called home equity loans, are decent types of mortgage loans for those who have some equity built up in their home and need to translate that into quick or long-term cash. These are loans paid to the homeowner from the lending institute against the equity held in a home. A home equity line of credit is a revolving equity loan held against your ownership in a house.
Second mortgages and home equity lines of credit will charge higher interest than your original mortgage, but they are a quick way to get some cash in your hands for things like sudden unemployment, unexpected medical expenses, or emergency repairs.
The idea of most mortgages is to own more equity in your home, not less. Reverse mortgages turn that idea upside down and shake the loose change out of its pockets.
Reverse mortgages are types of mortgage loans designed for senior homeowners seeking to supplement limited retirement incomes by borrowing money against the value of their home. The money is tax-free and deposited into their accounts monthly or as one lump sum.
If this sounds dangerous and/or stupid, that’s because it more than has the potential to be. You trade equity – what you own in the home – for money, which means you are selling all or part of your home to the bank on a promise to buy it back again. With traditional mortgages, the principal (amount borrowed) goes down as you pay off the loan. On the other hand, with a reverse mortgage, the more interest accumulates, the less of your own home you own. These are risky loans that expire when the person does.
Homeowners who take out reverse mortgages never have to make payments, but the lender will maintain a lien on the home for the amount of the reverse mortgage upon the borrower’s death. In addition, homeowners who take out a reverse mortgage will have to repay the mortgage out of the loan’s proceeds. In turn, this can significantly drain the equity seniors often depend on for end-of-life care and expenses. While reverse mortgages can make sense in certain situations, as a rule, they should be approached with caution.
Mortgage term refers to the length of your loan. While you can pay off your loan faster, a mortgage term defines the maximum amount of time you have to pay your debt. The various types of mortgage loans have different term requirements depending on the conditions of the contract, such as your creditworthiness and the house’s location.
15-year mortgages often have lower interest rates, which will cost lest in comparable interest than other loans. They also have the advantage of giving you the shortest standard timeline to full homeownership. However, buyers beware: 15-year mortgages come with highly monthly payments than 30-year mortgages. Though you’ll ultimately save money, the payment may be too much for many prospective borrowers to reasonably afford.
30-year mortgages offer homebuyers lower monthly payments than many other options, at a catch: the total interest you’ll pay may come near equal the cost of your home itself.
40- and 50-year mortgages offer the lowest monthly payments for borrowers who can’t stretch their pocketbooks too far. However, that means that if you purchase a home at 20, you could be paying it off until you’re 70. Additionally, you will easily pay more than double the cost of your home due to all the interest over the years.
Ideally, you’ll be able to select a 15-year term (or shorter) and make extra payments to cut that time shorter. The smallest term you can take plus your ability to make larger payments will mean you pay the least amount for your home. This runs contrary to the common thinking that longer loans bring: that you should plan your financial life around your monthly payments. While this may seem good in the short-term, in the long-term you’ll pay more money and spend more time with that loan looming over your head.
Mortgage Costs Side-by-Side
Let’s give some examples of what some types of mortgage loans would cost for the same property over the lifetime of the loan. For each of these models, we’re going to assume the cost of the home is $200,000, and we are not including any taxes or additional/purchase fees.
Mortgage type: 30-year ARM
Mortgage conditions: 20% down; $160,000 remainder is financed with a 5/1 rate (five year fixed, 25 year adjustable); initial interest rate of 3.25%
Initial payment: $696/month for five years
Payment after five years: increases by .25% yearly
End-term payment: $990/month
Total cost of interest and fees: $147,962
Total cost of loan: $307,962
Mortgage type: 30-year FHA
Mortgage conditions: 3.5% down; remaining $193,000 is financed at 3.75% interest
Upfront MIP closing cost: $3,378
Monthly payment for lifetime of loan: $1,031
Principal plus interest: $894
MIP (does not count toward loan payment): $137
Total cost of interest and fees: $181,366
Total cost of loan: $374,366
Mortgage type: 30-year VA
Mortgage conditions: 0% down; 3.5% interest rate; $4,300 funding fee financed into the mortgage
Monthly payment for lifetime of loan: $917
Total cost of interest and fees: $130,263
Total cost of loan: $330,263
Mortgage type: 30-year fixed-rate conventional
Mortgage conditions: 5% down; remaining $190,000 financed at 3.875%; 0.5% PMI for less than 20 percent down
Monthly payment for lifetime of loan: $893/month
Additional PMI payment for initial 8.5 years: $79/month
Total cost of interest and fees: $139,779
Total cost of loan: $339,779
Mortgage type: 15-year fixed-rate conventional
Mortgage conditions: 20% down; remaining $160,000 financed at 3.125%
Monthly payment for lifetime of loan: $1,115
Total cost of interest and fees: $40,624
Total cost of loan: $240,624