Homebuyers should be aware that most mortgages are classified as either government-insured loans or conventional home loans. While government-insured loans are insured by the federal government, conventional home loans are not – making them slightly riskier for the lender. This means homebuyers seeking a conventional home loan will likely need excellent credit. In addition, home loans can be characterized by their size. Most are either conforming loans or jumbo loans. In addition to a loan’s insurance source and size, a third key characteristic of a home loan is how its interest rate is structured. Mortgages are typically classified as either fixed-rate mortgages, meaning that the interest rate doesn’t change, or adjustable-rate mortgages, meaning that the interest rate changes and adjusts over time depending on market conditions. This interest structure affects how much a borrower pays on a monthly basis and throughout the life of the loan.
A conventional home loan is one of the most common types of mortgages available to homebuyers. These loans are not insured by the federal government. Instead, they are insured by private insurers such as Fannie Mae and Freddie Mac. According to LendingTree, though these two entities are “government-sponsored,” they are not government-owned. A conventional mortgage that meets Fannie Mae or Freddie Mac’s standards is considered a conforming home loan. A conventional mortgage that is outside of federal loan limits is considered a non-conforming home loan. The most common type of non-conforming home loan is a jumbo home loan, which is used when “home prices exceed federal loan limits,” according to bankrate.com. These types of loans are typically needed in expensive places where homes prices are particularly high.
Since conventional loans are not government-backed, there’s no guarantee that they will be paid back by the borrower, making them riskier for the lender. For this reason, borrowers of a conventional home loan must typically earn a high income, have a good credit history and have a limited amount of debt. While it is difficult to qualify for a conventional mortgage, there are certain advantages for the homebuyers who do. Those with a conventional mortgage who make a down payment of at least 20 percent won’t have to pay private mortgage insurance (PMI). They also have the freedom to purchase a primary residence, a vacation home or investment property with a conventional mortgage.
A popular alternative to a conventional mortgage is a government-backed home loan. These loans are insured by three different government agencies including the Federal Housing Administration (FHA), the U.S. Department of Veteran Affairs (VA) and the U.S Department of Agriculture (USDA). Here’s a quick rundown on these three government-insured mortgage options.
- FHA loans – FHA mortgages are often considered the easiest loans for homebuyers to obtain. The reason? Lenders are more likely to take a risk on less-than-perfect borrowers because the FHA will cover the borrower if they fall behind on payments. FHA loans do not require a large down payment. In fact, those using an FHA loan to buy a home may only have to put down as little as 3.5 percent of the purchase price. In addition, homebuyers do not need a high credit score to obtain an FHA loan. However, there are a few downsides for homebuyers with an FHA loan. First, homebuyers can only purchase a primary residence with an FHA loan – not a secondary residence or investment property. Second, homebuyers must also pay hefty mortgage insurance premiums, which can raise the cost of the mortgage.
- VA loans – VA loans are another good alternative to a conventional mortgage. However, to qualify, homebuyers must either be veterans of the U.S. military or active members of the U.S. military. Service members who qualify can obtain a mortgage without having to make a down payment or pay mortgage insurance. According to bankrate.com, closing costs are often capped and paid by the seller as well. While VA loans are certainly an affordable alternative to a conventional mortgage, they do have a few downsides. For starters, the pool of buyers who qualify for this type of home loan is limited. Second, there are restrictions on the types of properties that can be purchased using a VA loan. For instance, these loans cannot be used to purchase a rental property. Third, homebuyers who purchase a home with a VA loan will be charged a funding fee, which can be anywhere from 1.25 percent to 3.3 percent of the amount borrowed.
- USDA loans – USDA loans are designed for low-income homebuyers looking to purchase a property in certain designated rural areas. Before seeking a USDA loan, homebuyers will need to check whether or not their address qualifies as one of these rural areas. With USDA loans, no down payment is necessary, credit scores do not need to be high and mortgage interest rates are low. However, the downside is that borrowers must be moderate to low income earners. Benefits of this loan also vary depending on how much the borrower makes. In addition, homebuyers can only qualify for the loan when they purchase a home in a USDA designated rural area.
For homebuyers who like stability and predictability, a fixed-rate mortgage is probably a good bet. Those that choose a fixed-rate home loan will pay the same monthly mortgage payment throughout the life of the loan, no matter how much average interest rates rise or fall in the U.S. The lifetime of a fixed-rate loan is typically either 15, 20 or 30 years. For homeowners, knowing that their monthly mortgage payments will stay the same no matter what allows them to budget their expenses accordingly. However, this could also make building equity in the home a slow process. In addition, interest rates are typically higher for fixed-rate mortgages. For this reason, a fixed-rate mortgage may not be the right fit for borrowers who don’t plan on staying in their home for long.
Adjustable-rate mortgages (or ARMs, as they’re often called) offer interest rates that are not fixed. Instead, they fluctuate and change based on market conditions. This means homeowners with an ARM loan may be able to pay lower monthly mortgage payments for a certain period of time. However, these payments are subject to change after a certain number of years, making them unpredictable for those who plan to stay in their home for a long period of time. For instance, homeowners with a 5/1 ARM may get an excellent rate for five years but after that, the monthly rate could increase based on market conditions each subsequent year. While this type of loan may be ideal for short-term homeowners, it can be a risky move for those who plan to live in the same home for many years.
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