Getting a mortgage is overwhelming.
You have seemingly endless loan options, all of which read like a foreign language. And each type of mortgage comes with its own separate set of rules, which add even more confusion.
If you’ve never taken out a mortgage loan before, start with the following high level overview of your options.
Fixed-Interest vs. Adjustable-Rate Mortgage Loans
Most homeowner mortgages come with loan terms of either 15 or 30 years, and your interest rate could remain fixed for that term or it could vary over time.
Fixed interest rates are exactly what they sound like: you agree to a specific interest rate when you take out the loan, and that interest rate remains the same for the entire life of your loan. For example, you borrow a 30-year mortgage at 4% interest, and it doesn’t matter if interest rates fall or rise in the coming decades, your interest rate stays fixed at 4%.
The Skinny on ARMs
Adjustable-rate mortgages (ARMs) allow the interest rate to shift up or down along with some baseline index. Most ARMs use either the Fed Funds Rate or the LIBOR (London Interbank Offered Rate) as the index, plus a margin on top of the index rate.
For instance, your loan could be priced at the Fed Funds Rate plus a margin of 4%, so if the Fed Funds Rate is 0.5%, you would pay 4.5% for that month’s mortgage interest rate.
Usually ARMs come with a set number of years with a fixed interest rate before the rate starts adjusting. You’ll see this written as two numbers, the first representing the number of years at the introductory fixed rate, and the second the interval over which the interest rate resets. For example, a 5/1 ARM starts with five years of a fixed introductory rate, and then the interest rate adjusts once per year thereafter, based on the index rate.
In the 21st century, interest rates have largely remained low, so it has made more sense for borrowers to take out fixed-interest loans. If interest rates were high, and you believed they would drop in the coming years, an ARM would make sense.
However in practice, lenders offer ARMs more as a subprime loan option to borrowers with weak credit. The sales pitch goes like this: “Well, you could borrow a 30-year fixed loan at 6%… or you could take out a 5/1 ARM at 4% interest for the first five years. What do you think?”
What they don’t tell you is that after those first five years, the interest rate will skyrocket because the margin is so high. If you push back with that argument, they then reply “But you’re going to improve your credit between now and then, right? So you’ll be able to refinance for a cheap fixed-interest loan. Maybe you’ll even be able to pull some equity out as cash!”
Which is precisely what they want you to do: refinance your loan and pay them another set of closing costs, and restart your interest payments from the beginning.
Conventional Mortgage Loans
Conventional mortgages meet specific loan program guidelines set out by Fannie Mae or Freddie Mac. These government-sponsored entities are private companies backed by the U.S. government, and they buy or guarantee mortgage loans that meet their loan program criteria.
In most cases, the lender you work with to borrow a mortgage won’t actually hold your loan very long. They turn around and sell your loan almost immediately after you close on a property. And in order to sell your loan to a long-term institutional lender, the loan must conform to a specific Fannie Mae or Freddie Mac program, so that they’ll guarantee it against your default.
If you borrow more than 80% of the property’s value — a loan-to-value ratio (LTV) over 80% — you must pay a monthly surcharge for private mortgage insurance (PMI). Expect it to add $50 to $250 per month to your loan payment, depending on your loan amount.
Pros of Conventional Mortgages
Conventional mortgages work best for borrowers with strong credit. You can borrow money at a fixed low interest rate, and avoid paying up-front fees for mortgage insurance (more on that shortly).
A few of the advantages of conventional mortgages include:
- You can remove PMI: Even if you borrow more than 80% LTV, you can remove PMI from your monthly payment once you pay your loan balance down below 80% of your home’s value. That’s a good day indeed, when you kiss those extra monthly fees goodbye.
- No upfront PMI fee: Unlike government-insured mortgages, conventional loans don’t charge an upfront fee at closing for mortgage insurance.
- Flexibility: There are plenty of loan programs available for unique needs. For example, you can find 10-year loan programs rather than the standard 15 or 30 if you prefer.
- Faster, easier settlement: Conventional mortgages also don’t come with quite as many rules and regulatory hoops to jump through as government-issued loans. That makes them more likely to actually close on time, and reduces your paperwork headaches along the way.
- Escrow optional: You can also choose whether you want your property taxes and insurance escrowed. The mortgage lender collects your property taxes and insurance premium costs from you as part of your monthly payment, and pays them on your behalf. If you opt out, they often charge you a higher interest rate however.
Cons of Conventional Mortgages
Conventional loans aren’t for everybody. Watch out for the following downsides as well.
- Higher credit requirements. Conventional mortgages are not (usually) subsidized by the government — they’re market-driven loans and work best for strong borrowers.
- Higher down payments and costs for borrowers with bad credit. Similarly, if you have weak credit, you can expect to cough up more cash for both your down payment and fees and interest.
- Higher income requirements: Conventional loans allow a front-end debt-to-income (DTI) ratio of 28%, meaning borrowers can qualify for a loan with monthly payments of up to 28% of their gross income. They also have a maximum back-end DTI of 36%, meaning the total of the borrower’s monthly debt payments — including car loans, credit card payments, etc. — can’t exceed 36% of their gross income.
- Higher annual PMI costs: Borrowers with PMI typically pay 1.65% of the loan amount per year, until they reach 80% LTV and can remove PMI. That annual rate is higher than government-insured mortgages.
- Cash reserve requirements: Lenders typically require borrowers to have a certain number of months’ worth of payments set aside in cash at the time of settlement. In other words, they require borrowers to have an emergency fund.
You Should Get a Conventional Mortgage If…
If you have strong credit and you can easily document your income, get a conventional mortgage. Stick with fixed-interest loans, and avoid sleazy loan officers trying to pitch you on an ARM.
Consider putting down 20% and avoiding PMI altogether. If you can’t do that, at least you can remove it once you pay down your balance below 80% of your home’s value.
Government-Insured Mortgage Loans
The federal government subsidizes mortgage loans for certain groups of people by offering special loan programs for them.
They each come with their own rules, and their own pros and cons. Make sure you understand them fully before committing to a decades-long loan.
The broadest government loan program that most Americans qualify for is the Federal Housing Administration’s program.
Designed to help Americans buy their first home — and particularly homebuyers with bad credit or lower incomes — FHA loans allow you to buy a home with only 3.5% down if your credit score is 580 or higher. Even borrowers with credit scores between 500 and 579 qualify for a 10% down payment.
Of course, just because you can doesn’t mean you should buy a home with bad credit. Contrary to popular belief, homeownership isn’t for everyone and doesn’t always make financial sense. Despite being a landlord and real estate investor, I myself rent my primary residence, for example. But I digress.
Pros of FHA Loans
For a certain type of borrower, FHA loans come with some impress advantages:
- Low down payment: As noted above, borrowers with a credit score of 580 or higher can put down just 3.5% of the home’s purchase price.
- Lower income requirements: Borrowers can qualify for a monthly payment of up to 31% of their gross income: a front-end debt-to-income ratio of 31%. The maximum back-end DTI ratio is 43%. These represent more generous limits than conventional loans, which cap borrowers at 28% and 36% on the front-end and back-end ratios, respectively.
- No income limit: Higher-income borrowers can also take out FHA loans.
Cons of FHA Loans
These generous loan rules outlined above come at a cost.
- Permanent mortgage insurance: FHA loans require borrowers to pay mortgage insurance (called MIP for FHA loans) for the entire life of the loan, regardless of how far down you pay the balance. Borrowers pay 1.75% of the loan amount upfront at closing for MIP, plus ongoing payments ranging between 0.8% and 1.05% of your loan amount each year, depending on your loan amount and down payment.
- More red tape, slower settlements: Expect more paperwork requirements, more underwriting, and more delays.
- Lower loan limits: The FHA sets loan limits by county, and in high-income areas they often come in too low to be useful.
- Less flexibility: While the FHA does have a specific program for fixer-uppers (the 203K loan program), expect less flexibility to buy a run-down-but-livable house.
- Primary residences only: You may only buy a primary residence with an FHA loan. However you can house hack a property with up to four units.
VA Mortgage Loans
Military service members qualify for a special loan program insured by the Department of Veteran Affairs (VA). In fact, it’s a specific benefit of joining the armed services.
Pros of VA Loans
You’ll be hard pressed to find a better loan program than VA loans — if you’re a veteran.
- Low down payments: These loans come with extremely low down payments, and some borrowers qualify for 0% down. You read that correctly: no down payment at all.
- More flexibility on income: As another perk, VA loans offer a higher DTI limit than conventional loans. They don’t impose a front-end ratio limit at all, and cap the back-end ratio at 41%.
- Lower interest rates: Because VA loans are subsidized by the federal government as a military employment benefit, they usually come with lower interest rates than conventional or FHA loans.
- No mortgage insurance: VA loans don’t come with mortgage insurance. They do come with an upfront “VA Funding Fee” however — more on that below.
- Built-in appraisal contingency: The “VA Amendment to Contract” guarantees that buyers using VA financing can get their earnest money deposit refunded if the property’s appraised value comes in lower than the purchase price.
- Assumability: Subsequent buyers can assume VA loans, rather than having to pay them off in full upon purchase. For example, if you use a VA loan to buy a home, and you can later sell the property to your daughter and have her take over your low-interest mortgage rather than borrowing her own new loan.
Cons of VA Loans
These loans don’t come with many cons. For borrowers who qualify, that is.
- VA Funding Fee: While VA loans don’t come with mortgage insurance, they do come with a one-time fee at closing called the VA Funding Fee. It serves a similar purpose of funding the program and covering losses from defaults. This fee ranges between 1.4% to 3.6% of the loan amount, depending on whether you’ve taken out a VA loan before and the amount you put down (view details at the VA website). Some borrowers can roll it into the loan, and borrowers with disabilities or Purple Hearts, plus surviving spouses, are exempt from paying it.
- Primary residences only: Like FHA loans, VA loans only allow you to take them out for your primary residence. But also like FHA loans, you can buy a multifamily property with them, up to four units.
- Less flexibility to buy fixer-uppers: VA loan appraisers come under more scrutiny from federal regulators, similar to FHA loan appraisers. They have less leeway to pass properties that need repairs as “habitable.”
- Friction with sellers or real estate agents: If your agent doesn’t know VA loans, they can’t save you wasted time making offers on properties that won’t pass VA appraisals. Sellers may also balk at the VA Amendment to Contract contingency, which forces them to refund earnest money deposits if the property fails to pass a VA loan appraisal.
USDA Mortgage Loans
A subsidized loan program designed initially to support farmers, U.S. Department of Agriculture (USDA) loans aim to stabilize lower-income borrowers in rural areas and smaller towns.
Note that all USDA loans are fixed-rate mortgages — the program doesn’t allow ARMs.
Pros of USDA Loans
Like other government-insured loans, these come with some advantages over more market-based conventional loans.
- Low down payments: USDA offers the only other loan program with as little as 0% down.
- No cash reserve requirements: Unlike conventional loans, USDA loans don’t require borrowers to have a cash emergency fund at settlement.
- Low interest rates: As a subsidized loan, the interest rates tend to be lower than conventional loans, all else being equal.
- Finance closing costs: In some cases, borrowers can even roll their closing costs into the loan amount, borrowing more than 100% of the purchase price.
- Flexibility for repairs or construction: Borrowers can finance major renovations or even new construction with USDA loans.
- Lower mortgage insurance: USDA loans charge 1% of the loan amount upfront for mortgage insurance, and annual mortgage insurance of 0.35% per year. That’s significantly lower than FHA loans’ MIP.
Cons of USDA Loans
For all those advantages, USDA loans come with their share of drawbacks.
- Geographic restrictions. Most obviously, you can only take out a USDA loan in certain prescribed areas. View USDA’s eligibility map for more information.
- Higher credit score requirement. To qualify for a USDA loan, borrowers must have a credit score of 640 or higher.
- Mortgage insurance for the life of the loan. Similar to FHA loans, borrowers can’t remove mortgage insurance on USDA loans, even when they pay the loan balance below 80% of the home’s value.
- Income limits: Because USDA loans are designed for low-income borrowers, they cap incomes at 15% over the local median income. In some particularly low-income counties, that makes for low caps on eligible incomes.
- Single-family homes only: Unlike other types of government-insured mortgages, you can only take out a USDA loan on single-family homes.
You Should Get a Government-Insured Mortgage If…
As you can see, not all government-insured loans are created equal.
Consider taking out an FHA loan if you have weaker credit or lower income, and it’s the only way you can afford to buy your first home.
For veterans and military spouses, VA loans generally make for the best option if you qualify for them. But compare the life-of-loan interest and fees for your own VA loan and conventional loan quotes for a personalized analysis. You can run these numbers using a free online mortgage calculator such as MortgageCalculator.org.
Like VA loans, USDA loans tend to cost less over the life of the loan than their conventional counterparts. Still run the numbers for your own loan quotes before deciding however.
Conventional loans come with a limit imposed by Fannie Mae and Freddie Mac. In most counties, the limit for “conforming” loans is $548,250 in 2021, rising to $625,000 in 2022.
Higher-income borrowers may need to take out a “jumbo” loan rather than a conforming loan. Jumbo loans typically require higher credit scores and down payments, and lenders tighten the underwriting requirements. In other words, prepare for stricter rules if you want to borrow more money.
As a general rule, stronger borrowers should take out conventional home loans, while borrowers with weaker credit and cash-strapped first-time homebuyers can explore FHA loans. But if you qualify for a VA or USDA loan, look there first.