Choosing the right home loan is one of the most important decisions a buyer will make throughout their journey to homeownership. Aspiring homeowners have many different mortgage options to choose from, and each alternative comes with its own benefits and processes. The right loan can open the door to better rates and repayment options, higher borrowing limits, and other benefits.
In this article, readers will learn about the different mortgage options available, such as fixed-rate mortgages or jumbo loans. It’ll also look at how to choose the best mortgage option based on financial situation and need.
Understanding different types of home loans
Here’s a breakdown of some of the most common loans available to homebuyers in the U.S.
Conforming loans
A conforming loan is a mortgage that’s backed by Fannie Mae, Freddie Mac, or by a private lender. Most mortgages issued in the U.S. are conforming mortgages. However, you can choose from different types of conforming loans, such as fixed-rate or adjustable-rate loans (ARMs), based on your specific needs.
Fixed-rate mortgages
A fixed-rate mortgage lets borrowers repay their principal and interest in consistent monthly payments. The interest rate remains the same for the life of the loan, ensuring predictable monthly payments.
- Pros: The key benefit of a fixed-rate mortgage is that your monthly payments are easier to budget around. Rising market interest rates won’t affect your mortgage payments. But if rates drop, you can always consider a refinance.
- Cons: On the other hand, you may pay a little more interest during the early years of your mortgage as you won’t have access to the low introductory rates that ARMs offer.
Adjustable-rate mortgage (ARM)
Adjustable-rate mortgages (also known as variable-rate mortgages or floating mortgages) are conventional mortgages with a variable interest rate. Mortgage borrowers can expect their interest to change a few times over the life of the loan.
How do adjustable-rate mortgages work?
An adjustable-rate mortgage has an interest rate tied to a specific market benchmark. Borrowers get a fixed rate for the first few years of the loan. This is known as the teaser rate and is usually lower than the fixed rate offered on comparable fixed-rate mortgages. However, after the introductory period ends, the rate changes based on the underlying benchmark.
- Pros: The teaser rate allows for lower payments in the initial years. A low monthly payment may enable you to make additional principal-only payments to amortize your loan faster. Additionally, if your ARM benchmark dips, you’ll benefit from lower interest rates even when the introductory low-rate period ends.
- Cons: The downside of an ARM is that it may leave you feeling uncertain about future rate adjustments. You won’t know exactly how much interest you’re paying beforehand, and your monthly payments could rise substantially over the life of the loan.
FHA loans
Administered by the Federal Housing Administration (FHA), FHA loans were created to offer more Americans the chance to be homeowners. FHA loans can be fixed- or variable-rate mortgages, though most borrowers choose a fixed-rate.
How do FHA loans work?
FHA loans are issued by lenders but guaranteed by the government, which means they pose a lower risk to lenders. FHA loans are an accessible choice for many low- to moderate-income borrowers since they’re designed to be affordable. FHA loans enable people with a credit score of at least 580 to borrow up to 96.5% of the value of their desired home. Borrowers with credit scores between 500 and 579 can get an FHA loan if they provide a down payment of 10% or more. In 2024, the FHA borrowing limit for single-family homes is $498,257 for low-cost areas and $1,149,825 for high-cost areas.
- Pros: FHA loans have low minimum down payment requirements compared to most conventional loans. You may pay as little as 3.5%. FHA loans may also accept applicants with lower credit scores.
- Cons: These loans require two types of mortgage insurance – an upfront and an annual mortgage premium. The FHA’s loan limits mean that the property you want may not qualify. These loans are only for people buying their primary residence (investment properties and second homes aren’t eligible).
VA loan
VA loans are a benefit offered to military veterans, service members, and their surviving spouses. This government-backed mortgage enables borrowers to secure an affordable mortgage when they buy a house or refinance their existing mortgage.
How do VA loans work?
A VA loan is usually offered by banks or other approved lenders and guaranteed by the U.S. Department of Veterans Affairs (VA). Qualifying borrowers don’t need a down payment or mortgage insurance but must pay a VA funding fee of around 1.25% to 3.3% of the loan.
- Pros: VA mortgage lenders offer competitive interest rates and have lower credit score requirements than other mortgages. Borrowers also benefit from not having to make a down payment or pay for mortgage insurance.
- Cons: VA loans are for primary residences only, so you can’t use one to finance a second home. The funding fee may pose a challenge for some borrowers. These loans aren’t available to everyone as they’re intended for veterans and active-duty service members.
USDA loan
The U.S. Department of Agriculture (USDA) offers home loans to encourage homeownership and community building in rural areas. Like FHA loans, these mortgages are intended for low- to medium-income borrowers.
How do USDA loans work?
A USDA loan is a mortgage backed by the U.S. government that offers competitive interest rates and a no-down payment benefit. You can choose from direct loans issued by the government or USDA-guaranteed loans issued by private lenders. USDA loans are fixed-rate loans with no ARM option available.
- Pros: USDA mortgage borrowers enjoy benefits such as low interest rates, flexible credit requirements, and no minimum down payment. Direct loans issued by the government for low-income borrowers may have interest rates as low as 1%.
- Cons: To be approved for a USDA loan, your home must be in an approved area on the USDA’s eligibility map, and you must demonstrate economic need. This means that if you earn more than the mortgage’s income limit, you’ll be ineligible.
Jumbo loans
A jumbo loan is a non-conforming mortgage that’s neither backed by the government nor by Fannie Mae or Freddie Mac. These loans exceed the Federal Housing Finance Agency (FHFA) loan limits and are usually used to purchase expensive properties such as luxury homes or homes in highly competitive real estate markets. Jumbo loans are riskier for lenders since they’re not backed by another entity.
What counts as a jumbo loan?
A jumbo mortgage is a home loan that exceeds $766,550, which is the conventional loan limit set by the FHFA. Jumbo mortgages can be fixed-rate or adjustable-rate mortgages, depending on the homebuyer’s needs.
- Pros: Jumbo loans make it possible to purchase homes that are too expensive for conforming mortgages. A jumbo loan can be used for a second home, such as a vacation home or investment property. It allows you to purchase even in pricey real estate markets such as tourist towns or upscale neighborhoods.
- Cons: These loans have much stricter approval criteria. Borrowers may need a high credit score, low DTI, high income, and cash reserves equal to about a year of mortgage payments. You may also need a larger down payment for a jumbo loan. Jumbo loans are also harder to find due to the risk they pose to lenders.
Factors to consider when choosing a home loan
When choosing a mortgage, you’ll need to consider several factors to ensure it fits your financial situation and long-term goals. Here’s where to start:
Financial situation
Your personal financial situation plays a significant role in determining which mortgage is right for you. Here’s what to evaluate:
- Income and Debt: Assess your debt-to-income ratio (DTI) and ability to make monthly payments. This will determine your eligibility for different loan types and the amount you can borrow. To calculate DTI, divide the sum of your monthly debt payments by your gross monthly income.
- Credit Score: Understand how your credit score affects your eligibility and interest rates for different loan types. While it’s known that higher scores typically qualify for better rates and terms, you may have to pre-qualify or talk to different lenders to understand minimum requirements.
- Down Payment: Evaluate your savings and ability to make a down payment (if required). Most loans will require a down payment, and the amount you put down can make a difference. For example, a down payment of 20% or more means you won’t have to pay for mortgage insurance.
Long-term goals
Knowing what you intend to do with the home beforehand can simplify the process of choosing a loan. For instance, if you’re buying an investment property, you’ll automatically rule out FHA and USDA loans.
- Homeownership Duration: Consider how long you plan to stay in the home and how loan terms align with your plans. If you plan to move out quickly, an ARM makes the most sense since you can benefit from the low introductory rate.
- Financial Stability: When you choose an ARM, you’re risking the possibility of rate increases in the years to come. It’s important to ensure that your income is stable or increasing so you can keep up with payments.
- Refinance plans: If you’re interested in taking advantage of lower home refinancing rates at a later date, you may choose a loan without putting as much importance on the current interest rate a lender offers.
Costs and fees
There’s more to a mortgage than monthly payments. Borrowers should take note of other costs embedded in their mortgage.
- Closing Costs: Closing costs don’t vary by loan type. They usually depend on your lender and home price, but your mortgage decisions may indirectly affect your closing costs. For example, if you choose an FHA loan to take advantage of the low down payment, your closing costs may be higher due to the cost of private mortgage insurance.
- Interest Rates: Research current interest rates and how they impact your monthly payments and overall loan cost. For instance, FHA rates may be lower than conventional mortgage rates, and ARM rates will change throughout the loan term.
Making a decision
When choosing the right home loan, it helps to compare offers, do your own research, and get professional advice.
Comparing loan offers
Apply for pre-approval where possible to get a clear picture of what mortgage terms you can get. Here are a few factors to consider when you’re comparing mortgages.
- Eligibility: Every lender has their own approval criteria such as credit score requirements, income requirements, DTI and more. Research your options to find your best fit.
- Loan Terms: Review and compare interest rates, loan amounts, and repayment terms from different lenders to find the most favorable terms.
- Lender Reputation: Consider the reputation and customer service of potential lenders. Look for reviews and testimonials online. You may also want to consider reaching out to friends and family who have used the lenders you’re considering.
Seeking professional advice
Making a mortgage decision can be overwhelming, especially as a first-time buyer. Don’t hesitate to get professional advice if you need it.
- Financial Advisor: Book an appointment with a financial advisor or mortgage specialist to discuss your options. These experts can present you with your mortgage options and help you identify the best prospect.
- Pre-Approval Process: Many lenders have a simple pre-approval process that gives you an insight into the rates and terms you can get without a hard credit check. Getting pre-approved may help you understand your borrowing capacity and streamline the homebuying process.
Disclaimer: Article content is intended for information only. It may not reflect the publisher nor employees’ views. Consult a mortgage professional before making financial decisions. Publishers or platforms may be compensated for access to third party websites.
