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Mortgage 101: Types and How to Compare
The homebuying process can get complicated quickly, and this complexity usually starts with determining the type of mortgage you’d like to apply for. There are a number of options, and the choice you make can affect everything from the down payment requirement to what area you’re allowed to buy in.
In order to make the right decision, you need to have a general understanding of what’s available. Read on for a comprehensive breakdown of the different mortgage types.
How to Compare Mortgages
There are so many different factors to consider when taking out a mortgage. Here are the most important things to look at:
The term length is how long the repayment period lasts. The most common term lengths for mortgages are 15 and 30 years, although 10 and 20-year loans are also an option.
Lenders charge higher interest rates for longer terms and lower interest rates for shorter terms. Payments will be highest for shorter terms and lowest for longer terms.
Fixed vs. Variable Rate Loans
When you apply for a mortgage, you can choose between a fixed interest rate and a variable interest rate. A fixed-rate mortgage is the most common option. With a fixed-rate loan, the interest rate will remain steady the entire time, no matter what happens with overall market interest rates.
Your monthly payment will also mostly stay the same, though you may see changes due to property tax rates increasing or homeowners insurance rates increasing.
An adjustable-rate mortgage (ARM) is a mortgage that combines aspects of a variable-rate loan and a fixed-rate loan. The most common type is a 5/1 ARM. Here’s how it works. For the first five years, the rate and the monthly payment will be fixed. After the five years are up, the mortgage will switch to a variable-rate loan. The interest rate will likely increase and result in higher monthly payments.
Borrowers often choose an ARM because it has a lower initial interest rate than a fixed-rate loan. The interest rate on an ARM will usually change once a year. If you’re only planning on staying in the home for a few years, you may pay less interest with an ARM.
But if you plan to stay in the home longer than the initial fixed-rate period, you may be better off with a fixed-rate loan. Payments can swing wildly with an ARM, catching many borrowers off-guard. Borrowers with an ARM can refinance once the variable rate kicks in if they can’t afford the payments.
Types of Mortgages
There are several different kinds of mortgages you can choose from. Here are the most common options:
A conventional mortgage is the most common type. Conventional loans have lower interest rates than FHA loans, but higher down payment requirements. The minimum down payment for a conventional loan is 5%. In rare cases, you may be able to find a lender who only requires a 3% down payment for a conventional loan.
If you put down less than 20%, you’ll have to pay Private Mortgage Insurance (PMI) every month. PMI is a type of insurance that protects the lender in case you default.
The minimum credit score requirement for a conventional mortgage is 620, but if you want to qualify for the lowest interest rates advertised, you’ll need to have a score in the 700s or higher.
An FHA loan is backed by the Federal Housing Authority (FHA), and exists to make homebuying more affordable.
The minimum down payment for an FHA loan is only 3.5%, making this a great option for first-time homebuyers. This is the lowest down payment requirement available to the vast majority of borrowers.
Borrowers who put down less than 20% will have to pay a Mortgage Insurance Premium (MIP), which is similar to PMI. MIP ranges from .45% to 1.05%, depending on your down payment, loan amount and repayment term. FHA loans also come with an upfront fee that is 1.75% of the loan amount.
Credit score requirements are lower for FHA loans, which is another reason why they’re popular with borrowers. To qualify for an FHA loan, you only need a credit score of 580 or higher. You can still qualify with a credit score between 500 and 579, but you’ll have to make a 10% down payment. Borrowers with scores below 500 won’t be eligible for an FHA loan.
FHA loans accept cosigners. If you’re having trouble meeting the income requirements, adding a cosigner can help you qualify.
A VA loan is available to both current and former service members, as long as they were honorably discharged. VA loans are popular because they don’t have a down payment requirement. And unlike other loans with low or no down payment requirements, VA loans don’t charge PMI or MIP if you put down less than 20%.
Borrowers also have access to low interest rates, despite not making a down payment. The minimum credit score for a VA loan is usually around 620, but it depends on the lender.
A USDA loan is a rare kind of mortgage, because it has a specific geographic limit. To qualify for a USDA mortgage, you have to live in a certain region, usually a rural area. Some suburban neighborhoods may also qualify. You can find the current limits here.
Like VA loans, USDA loans have a 0% down payment. This is designed to motivate potential buyers to move to rural areas.
To qualify for a USDA loan, you must have a credit score of 640 or higher. Unlike other types of loans, USDA mortgages have an income limit and a loan amount limit that both depend on the specific area.
Conventional loans have a loan amount limit of $647,200 in most areas, but up to $970,800 for high cost-of-living places like the Bay Area or New York City.
If you want to buy a more expensive property with a jumbo loan, you’ll need a credit score of 680 or higher. Many lenders also have higher down payment minimums, often around 20%.
Related Credit Insights
Originally featured in Scotsman Guide, Hidden in Plain Sight. Nudging a credit score upward, could be the difference between owning a home or not. Every applicant is more important than ever. The truth is that 71% of mortgage applicants with scores below 760 could better their score by at least one 20-point credit band within 30 days, allowing many to qualify for a mortgage. That’s what CreditXpert discovered when examining 24 mil- lion mid-score credit inquiries. It’s surprising how many prospective mortgage borrowers are hiding in plain sight, shielded by a credit score that is far below its potential.
We’re often asked how mortgage inquiries impact a borrower’s credit score. Rosa Mumm, our product support manager and “Xpert Insights” guru, shares the details in Scotsman Guide’s August issue.