4 Types of mortgage your clients can choose from

It is important to know which type of mortgage you can qualify for so that you know which type of home you can buy. Are you looking for a conventional loan? What is the difference between a fixed-rate mortgage and an adjustable-rate mortgage? What about if you want to build a home from scratch?

There are many things to consider. But don’t worry. We have the answers to these questions and more. Here is everything you need to know about the different types of mortgage. We are running this as part of our client education series, so all mortgage professionals out there are encouraged to share this with their clients early in the process.

What is a mortgage loan?

A mortgage is a type of loan that you use to buy or maintain a house or other types of real estate. You, the borrower, enter into an agreement to repay the lender over a loan term, usually as monthly payments that go toward the principal and the interest. To secure the loan, the home serves as collateral with the lender.

To find the right mortgage for you, it is important to understand the loans you may qualify for. Here are some factors that can influence which mortgages will be available to you:

• Down payment. Lenders use the size of your down payment to help determine the mortgage rate they will give.
• Monthly mortgage payment. Lenders review your assets and your income to decide on the loan amount you will be able to repay. Therefore, you should consider the principal amount, interest and taxes, utilities, mortgage insurance, and any homeowner’s fees when settling on a budget for your monthly mortgage payment.
• Credit score. The interest rate on your loan will be determined, in large part, by your credit score.

What are the various types of mortgage?

The good news is that there are many types of mortgage options available to you. While the specific loan types may depend on where you live—and the government-backed mortgages on the market—there are generally four types of mortgage.

Here are the four types of mortgages we will be looking at:

1. Conventional loan
2. Jumbo loan
3. Fixed-rate mortgage
4. Adjustable-rate mortgage

To help you decide which type of mortgage may be the best for your situation, here is a closer look at each:

1: Conventional loan

Conventional loans are the most common mortgage type and are offered by almost every mortgage lender. This type of loan is not government-backed and is usually a great option if you have documented employment history and a stable income.

If, however, your credit score is under 620, you usually will not be able to qualify for a conventional loan. Lenders will also scrutinize your debt-to-income ratio (DTI). You may not qualify for a conventional mortgage if more than 36% of your monthly income is tied up in debt payments.

Previously, lenders required borrowers to make a 20% down payment. But now, most lenders will allow less if you have a solid income and great credit. For a conventional mortgage, you can now make a down payment for as little as 3%. Paying less than 20%, however, will require you to pay private mortgage insurance (PMI), at least until the balance of your mortgage is 80% or under the value of the property.

Read more: PMI: Back to Basics for Private Mortgage Insurance... or Not

If you make a lower down payment, you could also wind up paying a higher interest rate. Since paying PMI and more on the interest rate will mean you pay more on the overall cost of the loan, you will have to decide whether paying a smaller down payment is worth it.

2: Jumbo loan

Conventional loans generally break down into conforming and non-conforming loans. A conforming loan means it conforms to government limits that are designed to stabilize the housing market. Non-conforming loans—or jumbo loans—exceed those limits.

What qualifies as a jumbo loan, however, differs depending on the market. This is because the cost of housing in some markets is simply more on average than in other markets.

So, what is a jumbo loan exactly? It is essentially a large mortgage loan for an expensive property. Jumbo loans will make the most sense if you have a high income and can easily make large loan payments. Because of this, criteria for jumbo loans is stricter than it is for conventional loans, with a credit score of at least 700 required by most lenders and six-to-12 months of payments in your bank accounts. To secure the jumbo loan, you will likely have to put down 15% to 30%.

3: Fixed-rate mortgage

A fixed-rate mortgage means you have the same interest rate and payment amount for the duration of the loan. While changes in insurance rates and property taxes may mean your monthly payments fluctuate, fixed-rate mortgage are likely to offer you predictable, consistent monthly payments.

If you are living in your forever home—the home you plan to stay in the longest—a fixed-rate mortgage might be your best option since it provides you a better idea of how much you will pay every month. This is especially convenient because it will help you budget in the long term.

If, however, interest rates are high in your area, you might want to forgo a fixed-rate mortgage because you will be stuck with the interest rate for the life of the loan—unless you refinance. You may end up overpaying thousands of dollars in interest if interest rates are high when you lock in.

4: Adjustable-rate mortgage

An adjustable-rate mortgage (ARM) is the opposite of a fixed-rate mortgage. An adjustable-rate mortgage is a 30-year loan with interest rates that fluctuate along with market rates.

When you secure an ARM, you agree to an introductory period of fixed interest which is usually five, seven, or 10 years. During the introductory period you pay a fixed interest rate that is typically less than 30-year fixed rates.

Your interest rate changes after the introductory period ends to match market interest rates. To calculate how rates are shifting, your lender will refer to a predetermined index. If the market rates on the index rise, your rate will rise, and your rate will go down if the index’s market rates go down.

Learn how mortgage rates are calculated in the USA, factors that help determine your mortgage interest rate here.

Rate cap

Adjustable-rate mortgages do, however, include a rate cap that will limit how much your interest rate can fluctuate over the life of your loan. These rate caps are designed to protect you from interest rates that rise too fast.

For example, your loan will hit its rate cap and not continue to climb even if interest rates continue rising. Note, however, that rate caps can function in the opposite way: i.e., they can limit the amount your interest can decrease.

ARM benefits

If you purchase a starter property prior to moving into your “forever home”, then adjustable-rate mortgage may be your best option, since you can benefit—and save money—by not living in the house throughout the entire life of the loan.

ARMs will also work for you if you pay more toward the mortgage in the early states, since they provide extra money to pay toward your principal. You can potentially save thousands of dollars in the long run if you pay extra on your loan at the beginning.

What is the most common type of mortgage?

The most common type of mortgage is called a conventional loan. Conventional loans are not government-backed and come in two forms, which include:

• Conforming loans
• Non-conforming loans

The difference between a conforming loan and a non-conforming loan is simple:

• Conforming loans literally conform to a set of governmental standards put in place that include criteria for credit, debt, and loan size.
• Non-conforming loans, on the other hand, cater to borrowers who want to buy more expensive homes or for people with unique credit profiles.

If you can afford to make a significant down payment and have a solid credit score, then a conventional mortgage may be your best option. In fact, the most popular choice for homebuyers is the 30-year-fixed rate conventional mortgage.

But here are some things worth considering before you commit. 

Advantages of conventional loans

• Flexibility. One of the major advantages of a conventional loan is its flexibility. You can use this loan for your primary home, secondary home, or investment property.
• Lower borrowing costs. Your borrowing costs for a conventional loan are usually lower overall than other types of mortgages, despite interest rates generally being slightly higher.
• Private mortgage insurance (PMI). After you have reached 20% equity, or refinance to remove it, you can request that your lender cancel your PMI.
• Down payment. In certain scenarios, you can pay as little as 3% down.
• Closing costs. Sellers can contribute to closing costs on most conventional loans.

Read more: Closing costs: What are they and how are they estimated?

Disadvantages of conventional loans

• Minimum credit score. Usually, lenders require a minimum credit score of 620 or higher for most conventional loans, as well as refinancing them.
• Higher down payment. Down payments for conventional loans can be much higher than government-backed loans.
• Debt-to-income ratio (DTI). To qualify for a conventional loan, you will have to have a debt-to-income ratio of less than 43%. In some cases, that number is 50%.
• PMI vs. down payment. If your down payment is less than 20% of the sales price, you will likely have to pay private mortgage insurance—which can be costly.
• Documentation. To verify your employment, income, assets, and down payment, you will be required to provide significant documentation.

What is the best loan term for a mortgage?

The answer to this question depends on what you are looking for, but generally the most common loans come in 30-year or 15-year terms. The choice you make on your loan term will impact the following:

• Monthly principal and interest payment
• Interest rate
• Interest you will pay over the life of your loan

Here is how longer and shorter loan terms will impact each:

Longer term (30-year)

• Lower monthly payments
• Higher total cost
• Higher interest rates

Shorter term (15-year)

• Higher monthly payments
• Lower total cost
• Lower interest rates

Generally, you will pay more interest on a longer loan term. Shorter-term loans typically have lower interest costs but higher monthly payments, comparatively. However, the difference in interest and monthly payments depends on your loan term and the interest rate.

If you choose a shorter loan term, you are likely to save more money overall, even though you will have higher monthly payments.

How does a shorter loan term save you money? Here are a couple reasons:

1. Typically, the interest rate is lower, sometimes by as much as one percentage point
2. You will be paying interest and borrowing money for less time

What are other (less common) types of mortgages?

Aside from the more common types of mortgages already mentioned—conventional, jumbo, fixed-rate, and adjustable-rate—there are other options available to you. When shopping around for a home loan, you might also find:

• Construction loans
• Interest-only mortgages
• Piggyback loans
• Balloon mortgages

Here is what we mean by each:

Construction loans

A construction loan may be your best bet if you want to build a home. This even gives you the option to get a separate construction loan for your project and a separate mortgage to pay off that loan.

Another option is a construction-to-permanent loan, which combines financing and construction costs into one loan product. Either way, you will be required to make a higher down payment and provide proof that you will be able to make the monthly payments.

Interest-only mortgages

In this case, you would make interest-only payments for a pre-set period, typically between five and seven years. After this initial period, you will have to make payments on both the interest and the principal.

Interest-only mortgages are not the best option for building equity, since initially you only pay interest. However, if you know you can sell or refinance—or expect to afford higher monthly payments further down the line—this is a good option.

Piggyback loans

Piggyback loans involve two loans: one for 80% of the home price and the other for 10%. For the remaining 10%, you will make a down payment. This loan is designed to help you avoid paying mortgage insurance. However, piggyback loans also mean you pay two sets of closing costs and accrue interest on two loans. It is important that you do the math first, to decide whether it makes sense for you.

Balloon mortgages

In this arrangement you must make a large payment at the end of your loan term. For instance, you will make payments based on a 30-year term but for a shorter period, such as seven years. After the loan term ends, you pay the outstanding balance. Be sure, ahead of time, that you can manage that large payment.

Have experience with the different types of mortgage? Let us know in the comment section below.