Mortgage Types Demystified Exploring Your Borrowing Options

Most people use the term “mortgage” as if it’s a single type of financial product. That’s understandable, because major media doesn’t talk about the various types like FHA, USDA, and VA, let alone mortgage types pros and cons.

Each loan type provides basic home financing but with its features and nuances. You may find one loan type preferable to another, either based on personal circumstances or financial goals.

Let’s take a look at the different major types of mortgages, and the pros and cons of each.

Conventional Loans

These mortgages are called conventional to distinguish them from government loans, like FHA, the Federal Housing Administration, and VA, or Veterans Affairs, mortgages. The loans themselves are funded by the Federal National Mortgage Association (FNMA, or “Fannie Mae”) and the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”).

But perhaps the biggest difference between conventional mortgages and government is the source of private mortgage insurance (PMI). While the PMI on FHA and VA loans is provided by government sources, it comes from private insurance companies on conventional mortgages.

PMI is required any time you either make a down payment of less than 20% of the purchase price on a home or have less than 20% equity in the case of a refinance.

Let’s look at the pros and cons of conventional mortgages:

Pros:

• More lenders offer conventional mortgages; not all participate in FHA or VA loans.
• Interest rates on conventional mortgages are often lower than they are under government loans.
• Conventional mortgage documentation requirements are generally lower than for government loans, especially if you have good credit and a large down payment.
• If PMI is required, you generally don’t have to make an upfront payment; PMI is collected only on a monthly basis.
• They can be used to purchase both second homes and investment properties; FHA and VA loans cannot.
• There’s generally a wider variety of loan types, such as Adjustable-Rate or Fixed-rate, and terms available than with government loans.

Cons:

• You generally have to have good credit to qualify.
• In many cases, at least 5% of the purchase price must come from the borrower’s own funds.
• Conventional mortgages are not assumable, meaning the outstanding loan and its terms cannot be transferred from the current owner to a buyer.

FHA Loans

These are mortgages that are insured by the Federal Housing Administration or FHA. The agency was created during the Great Depression to both standardize and liberalize mortgage financing. Over the years, FHA has made more generous loans to borrowers with less-than-perfect credit.

FHA mortgages are available in both fixed-rate and adjustable. Terms can be from 15 years to 30 years.

Pros:

• FHA loans tend to be more lenient when it comes to borrower credit.
• Relatively low down payments of just 3.5% of the purchase price.
• You can often get approved third-party financing or grants to cover the down payment.
• Higher seller paid closing cost limits – 6% of the loan amount, compared to just 3% on low down payment conventional loans, and 4% on VA loans.
• FHA mortgages are assumable.

Cons:

• FHA loans charge borrowers mortgage insurance in two ways – upfront and monthly. The upfront charge is 1.75% of the loan amount, though it can be financed through the mortgage.
• Sellers sometimes prefer to avoid buyers who need FHA loans, because of stricter property condition requirements.
• FHA loans are not frequently available for condominiums.

USDA loans

USDA loans are the least-known and perhaps most overlooked first-time homebuyer program

It offers zero down payment, lower mortgage insurance than FHA, and low rates.

However, you must be buying in a USDA-eligible area. The good news is that the eligibility map is quite generous, and you don’t have to buy a home in the wilderness to qualify. Many suburban areas are eligible.

Pros:

• Zero down.
• Low rates.
• Lower mortgage insurance than FHA.
• Easier qualification than conventional.

Cons:

• Must buy in a “rural” area as defined by USDA (some areas are quite suburban, though).
• Mortgage insurance remains for the life of the loan.
• Longer closing times, since USDA itself must approve the loan, not just the lender.
• Single-family homes only.

VA loans

VA loans are a benefit available to those who have served in the U.S. military. The minimum service required is usually around 2 years, but those who are on active duty can be eligible in as little as 90 days.

Pros:

• Zero down.
• No monthly mortgage insurance.
• Lower rates than most programs.

Cons:

• Need eligible military service.
• Stricter property standards than conventional loans require.
• Buyers pay a “funding fee” of (usually) 2.3% of the loan amount. This can be wrapped into the loan.
• May be harder to get an accepted offer when buying a home.

Fixed Rate vs. Adjustable Rate Mortgage (ARM)

Most of the major mortgage types offer both fixed-rate loans and adjustable rate mortgages, called ARMs. Fixed rates range from as little as 10 years up to 30 years. And naturally, 30-year loans are the most popular.

ARMs are typically for 30 years. They offer a fixed term for a limited amount of time, then the rate will periodically adjust to a new rate based on the market. On FHA and VA mortgages, ARMs have a five-year fixed term then adjust once per year thereafter.

Conventional mortgages offer initial fixed terms of three, five, seven, and 10 years. After the initial term, they typically become one-year adjustable-rate loans over the balance of the loan term.

For this reason, ARM loans are frequently referred to as 3/1, 5/1, 7/1 or 10/1 in the industry.

Some conventional ARMs adjust every six months, and those are called 3/6, 5/6 ARMs, and so forth.

There is another newer type of ARM, the 5/5. This means it’s fixed for five years then adjusts every five years thereafter.

ARMs typically have what is known as “rate caps”. For example, the initial rate adjustment may be limited to 2%. That means an initial rate of 3.5% cannot exceed 5.5% on the first adjustment. A 2% cap on subsequent adjustments is also typical. There’s also a lifetime cap of 5%, which would limit an initial rate of 4.5% to no more than 9.5% over the life of the loan.

Since fixed-rate mortgages are self-explanatory, let’s focus on the pros and cons of the ARMs.

ARM Pros:

• Lower initial rate than fixed-rate mortgages.
• Best for when you want to sell or refinance the home within the fixed rate term.
• ARMs don’t always rise during the adjustable period. They can fall with the market too. You don’t have to refinance to capture lower rates.

ARM Cons:

• Your future house payment is less certain.
• If interest rates rise, your house payment can increase substantially.
• Subsequent interest rate increases can more than double the initial rate on your loan.

Get started on the right program for you

Wherever you are financially, and whatever your goals may be, the right loan is out there. Choose the mortgage type that works best for you.