If you’re a first-time homebuyer, shopping for a mortgage can be scary. There are just so many options out there, and you may not understand what all the terminology means. Before you apply for a mortgage, you should be sure that you understand what’s available.
There are literally thousands of specific mortgage products on the market, for all sorts of different purposes. Some are tailored for first-time buyers. Some are tailored for high-income buyers, and a number of them are meant for buyers with bad credit. Others come from conventional banks, and still others are backed by the government.
We won’t go into every single mortgage product on the market. Instead, let’s look at the basic features that lenders combine to make those individual products. These include conventional versus government-insured, traditional versus fixer-upper, adjustable-rate versus fixed-rate, and jumbo versus conforming.
Conventional versus Government-Insured
Conventional home loans are made through banks or traditional lenders, and they aren’t backed in any way by the government.
Government-insured mortgages are not made through the government, but they’re backed by the government. Basically, if you default on your mortgage, the government agrees to pay the lender back. This results in less risk for the lender, which means those with less-than-ideal credit or income situations can often access government-insured loans. Many of them would have been unable to get a conventional loan otherwise.
The federal government insures several different types of loans, each targeted at different consumers or even housing areas. There are three primary types of government-insured loans: FHA, VA, and USDA/RHS.
- FHA Loans: These loans are backed by the Federal Housing Administration, and are managed by the Department of Housing and Urban Development (HUD). They are most often marketed to first-time buyers, though they’re available to a variety of borrowers. The advantage of an FHA mortgage is its low down payment requirement, and the ability for low-credit borrowers to access a mortgage.
You can put as little as 3.5% down on the purchase price of your home with an FHA mortgage. However, in exchange for this privilege, you’ll need to pay mortgage insurance for the life of your loan. To get out of this additional monthly payment, you’ll need to refinance your mortgage, which can be a hassle.
Still, if you’re ready to buy a home but don’t have an excellent credit score or a huge amount of money in savings, an FHA mortgage might be a good way to get into homeownership.
- VA Loans: These loans are administered through the U.S. Department of Veterans Affairs and are essentially a benefit offered to U.S. veterans, servicemembers, and some surviving spouses. Like the FHA loans, these loans require lower down payments — 0% down in some cases — and may not require private mortgage insurance.
To purchase a home using a VA loan, you’ll need to meet credit requirements. These may be lower than requirements from conventional lenders. You’ll also need to have sufficient income and get a Certificate of Eligibility.
- USDA Loans: These loans are similar to both FHA and VA loans in that they have lower down payment requirements than conventional loans. They may also involve lower credit and income requirements. These loans, administered through the U.S. Department of Agriculture, are specifically to be used in certain rural areas. They have income caps and are targeted at homebuyers who have steady income, but not enough income to qualify for a conventional loan.
USDA loans can be used for single family housing, multi-family housing, and even rural businesses. Each option has its own requirements, so be sure to check out the USDA website if you’re interested in purchasing a home in a rural area.
Conventional mortgage loans come with a variety of options, requirements, and rules. Some conventional lenders do offer low down payment options, and some cater to consumers with less-than-perfect credit. However, conventional lenders may be less flexible than those working with government-insured loans.
If your credit is middle-of-the-road and you have at least a 5% down payment saved, shopping around between conventional loans and government-insured loans to see which option is best suited for your needs.
Resource: Get a quick mortgage quote from Rocket Mortgage
Traditional versus Renovation Loans
Most mortgage loans are made for homes that are at least mostly finished. Sure, you might bargain with the seller for some cash at closing to take care of minor updates or repairs. But if you want to buy a real fixer-upper, you could be out of luck with a traditional loan.
This is where renovation loans come in. These types of loans are tailored to home buyers who want to purchase a home and immediately do some major repairs or renovations. There are a couple of good options for fixer-upper loans, including the FHA 203(k) loan and the Fannie Mae HomeStyle Loan.
The FHA 203(k) loan is similar to the FHA loan listed above, except that it allows the homebuyer to access funds above and beyond the home’s purchase price in order to renovate the home. Like other FHA loans, this one requires mortgage insurance, which can make it an expensive option. However, it also allows you to borrow against the future appraised value of your home to pay for your renovations.
For instance, say you find a home that needs some major updating. The purchase price is $40,000, but once it’s updated, the home would be worth closer to $100,000. The FHA 203(k) loan will let you take out a $90,000 mortgage (or even more, as it doesn’t require a large down payment). $40,000 will go towards purchasing the home, and you can put the remaining $50,000 towards home repairs.
The Fannie Mae HomeStyle loan works similarly, in that you borrow against your home’s future appraised value. Since it doesn’t require mortgage insurance, though, it’s a less expensive product if you have a decent down payment. However, the HomeStyle loan restricts how much of the total loan value can go towards renovations. This makes it a better option for more moderate renovations, as opposed to a huge overhaul of the home.
Adjustable-Rate versus Fixed-Rate Mortgage
Adjustable and fixed rates can apply to nearly any of the other distinct loan categories listed here. These terms refer to the APR you’ll pay on your loan.
In short, a fixed-rate mortgage gives you a fixed APR for the life of your loan. Your monthly payment will stay the same year after year, which makes these loans the more predictable option.
An adjustable-rate mortgage, on the other hand, will have a rate that changes on a set schedule. The rate is normally tied to some industry standard rate, and will adjust annually. Adjustable-rate mortgages (ARMs) can start out with much lower payments than similar fixed-rate mortgages. However, the payments can jump significantly over time, depending on how the market changes.
Other loans offer a hybrid option. For instance, a 5/1 ARM loan will have a fixed rate for the first five years of the mortgage, and then will have a rate that adjusts every year after that. These mortgages often carry a lower interest rate, and thus a lower payment, over the fixed-rate period than a completely fixed-rate loan would. But then the payments can be unpredictable, as the rate adjusts annually after this.
Adjustable-rate mortgage may be more expensive at the start, especially in a low interest rate environment. However, it can be difficult to predict how your payment will change over time, making it hard to plan financially. Too many consumers get caught in a mortgage payment they can’t afford because of adjustable-rate mortgages in a rising interest rate environment.
On the other hand, a fixed rate mortgage will keep the same rate and payment in a falling interest rate environment, where an adjustable-rate mortgage would have had a lower rate and payment. With a fixed-rate mortgage, you’ll have to refinance to take advantage of rates that change in your interest.
There’s no right way to choose which of these mortgage options will work best for your needs. If you need a predictable payment and can’t handle financial volatility, a fixed-rate mortgage is normally your better option. However, a ARM can be a good option if you expect interest rates to fall, or if you plan to sell your home shortly after buying it.
For instance, a 5/1 ARM can be a great deal if you lock in a lower interest rate and payment for five years, put a bit of extra towards your mortgage’s principal, and then sell before the rate adjusts. Of course, you always risk being unable to sell and getting locked into a higher, less affordable interest rate when your five years is up!
Ultimately, you’ll need to do your research and shop around when choosing between fixed- and adjustable-rate mortgages. And, of course, check out which options are available to you based on your credit history, income, and other circumstances.
Resource: Get multiple quotes from mortgage brokers competing for your business at Lending Tree
Jumbo versus Conforming Mortgages
As you might guess, this distinction has to do with the size of a loan. A conforming loan is one that meets Fannie Mae or Freddie Mac’s underwriting guidelines. Basically, one of these organizations can purchase and sell mortgage-backed securities (MBS) on a conforming loan. They will not buy and sell MBS on jumbo loans, which are non-conforming.
Loan limits change annually, and are different for different areas of the country. For 2016, a mortgage on a single-unit home is considered conforming if its original principal balance is at or below $417,000. This figure rises to $625,000 for homes bought in Alaska, Guam, Hawaii, and the U.S. Virgin Islands, as well as certain other areas considered high-cost.
Conforming loans typically come with lower interest rates than jumbo loans. Plus, to get a jumbo loan, you’ll need to have great credit and a big enough income to cover the jumbo mortgage payments.
So which works best for you?
As we noted above, you can combine these loans in many different combinations. For instance, you could opt for a fixed-rate, conforming FHA loan. Or you could get an adjustable-rate jumbo loan.
As with any financial product, shopping for a mortgage is about figuring out which combination of options works best for your particular needs. If you have relatively low credit and not a huge amount saved for a down payment, a government-insured loan may be your best option. If you know you’ll sell your home within a few years, an ARM could actually save you money. And if you’re a high-earner with excellent credit and large housing needs, a jumbo loan may be the way to go.
The key to deciding is to figure out what you qualify for, and then to figure out which of those options is most affordable and will best meet your needs.