If you’re looking for a home loan, you probably know that mortgages have different terms (such as 15 years versus 30 years) and that you should compare interest rates among lenders. However, lenders usually offer various loan programs, and choosing the right one can impact your overall costs.
Conventional, HELOC, jumbo loans… your lender or broker may discuss different types of home loans with you. And while you don’t have to be an expert (that’s what the lender/broker is for!), it helps to know what options are available and why you might choose one over another.
Conventional Loans
According to Census Bureau data, more than 70% of homes purchased in the U.S. are financed by conventional loans. Conventional loans are not insured or guaranteed by the government and can be originated by banks, credit unions, mortgage companies, or private lenders.
Conventional loans fall into one of two categories: conforming or non-conforming. Conforming loans meet the underwriting requirements to be sold to Fannie Mae or Freddie Mac, which are two government-sponsored enterprises. Both agencies have income, debt, credit score, and down payment requirements. A conventional loan might be your best option if you have good credit and a stable income.
Conventional loans can be either fixed-rate or adjustable-rate. If the loan is fixed-rate, your interest will not change over the life of the loan. If it’s adjustable, your interest rate can fluctuate, though there is often a cap on how much it can adjust (both high and low, also known as ceiling and floor).
If you’re buying a home, Fannie Mae has down payment requirements of as little as 3%, though this option has some additional criteria. If your down payment is below 20%, your lender will require private mortgage insurance (PMI), which is a premium you’ll pay every month. PMI protects the lender against losses if, for some reason, you’re not able to make your mortgage payments.
FHA Loans
FHA loans are government loans (therefore non-conventional loans) insured by the Federal Housing Administration (FHA). FHA loans have less stringent underwriting requirements, so they help borrowers with lower incomes, lower credit scores, and smaller down payments.
FHA loans are good for first-time homebuyers and borrowers who want to refinance but don’t meet the criteria for a conventional loan. They require a minimum down payment of 3.5%, but some states also have down payment assistance programs.
FHA loans also have a special type of mortgage insurance called a mortgage insurance premium (MIP). You’ll pay an upfront MIP equal to 1.75% of your loan. You’ll also make annual MIP payments, which vary depending on factors like the amount of your down payment and the term of your loan.
You can only get an FHA loan for your primary residence (your home). If you want to purchase or refinance an investment property, you’ll need a different type of loan.
VA Loans
Another type of government loan is a VA loan from the Department of Veterans Affairs. VA loans provide affordable options for eligible military members, veterans, and surviving spouses.
VA loans don’t require a down payment, which means borrowers can finance 100% of the home’s purchase price. Unlike their conventional loan counterparts, VA loans don’t require PMI, and interest rates are typically lower for VA loans.
If you’re eligible for a VA loan, you’ll have to pay a one-time VA funding fee. This fee is waived for certain borrowers, such as those with a service-related disability. You can either pay the fee when you close the loan or roll the fee into the loan amount. The fee ranges from 0.5% to 3.3% of the loan amount, depending on the type of VA loan and the amount of your down payment.
Jumbo Loans
Fannie Mae and Freddie Mac have maximum loan amounts set by the Federal Housing Finance Authority (FHFA). The maximum loan amount is $766,550 for most areas, but can go up to $1,149,825, based on where you live. If you need a loan over these limits, you’ll need to get a jumbo loan. Jumbo loans are conventional, but they are non-conforming loans because they aren’t eligible to be sold to Fannie Mae or Freddie Mac.
Jumbo loans have stricter underwriting requirements. You’ll typically need a higher credit score, higher income, lower debt, and a larger down payment. However, a jumbo loan may be your only option if you’re in the market for a higher-priced property.
Interest-Only Loans
The monthly payments on most loans are a combination of principal and interest. Your principal reduces the amount you owe, and the interest is the cost of borrowing money.
However, you can also get an interest-only loan, which only requires monthly interest payments for a period of time, rather than principal and interest. During this interest-only phase, which can be 5-10 years, your payments don’t reduce the amount you borrowed at all. At the end of the interest-only period, you’ll need to start making monthly payments of principal and interest, or the lender may require you to pay off the remaining balance in full.
Most interest-only loans have a fixed interest rate during the interest-only period, and then the interest rate adjusts once you start making principal and interest payments.
Interest-only loans keep your monthly payment low and can be great for borrowers with fluctuating incomes. However, they come with risks. Your payment will be substantially higher after the interest-only period, or you need to pay off the entire balance (though if you plan to sell the property, this isn’t as much of an issue).
You’re also less likely to build equity. Equity typically comes from making principal payments, which reduce the amount you owe compared to your home’s value. With interest-only loans, the only way to build equity is if your home’s value increases.
Home Equity Loans and HELOCs
As you make payments on your mortgage, you’ll start building equity in your home. Equity is the difference between your loan balance and the value of your home. For example, if you have a home worth $400,000 and your loan balance is $300,000, you have $100,000 in equity. Lenders will allow you to “tap into” your equity with a home equity loan or home equity line of credit (HELOC).
A home equity loan is structured similarly to your primary loan on your home. It will have a specific loan amount, interest rate, and term. When you close on your home equity loan, the lender will give you the loan amount in cash, and you’ll make monthly principal and interest payments to repay it.
A HELOC functions more like a credit card. Your lender will give you a maximum loan amount, and you can draw from the loan as you’d like. You could draw $10,000, pay it all back over a few months, and then draw $10,000 again. Unlike a home equity loan, a HELOC doesn’t have fixed monthly payments. You’ll have a draw period, in which you can draw funds from the loan and only need to pay back the interest due. After the draw period, you’ll have a repayment period where you can’t draw on the loan anymore and have to repay the balance owed. HELOCs are adjustable-rate loans.
For both home equity loans and HELOCs, lenders will have a maximum amount you can borrow, such as 90% of your home’s value. In the $400,000 home example, the maximum loan amount would be $360,000. Since you already owe $300,000, you could get a home equity loan or HELOC for $60,000 (minus any closing fees).
Home equity loans and HELOCs are great for financing home improvements or consolidating debt. You can also use them as an emergency fund, particularly a HELOC, since you can draw funds as needed.
Reverse Mortgages
Older homeowners often accumulate substantial equity in their homes or may even have their home loans paid off entirely. A reverse mortgage allows homeowners over the age of 62 to convert their equity into cash. These loans can be valuable for seniors looking to supplement their retirement income.
Reverse mortgages can be structured to give the borrowers a lump sum, monthly cash payments, or a line of credit. Borrowers do not need to make any monthly payments. The loan becomes due in full, including any interest and fees, when the borrower dies, sells the home, or permanently moves out. Loan amounts vary depending on the value of the home, their age, and interest rates but typically are 40% to 60% of the home’s value.
Borrowers retain ownership of the home and need to keep paying property taxes and insurance. If the borrower dies, heirs need to pay the balance due. If the home is sold, the heirs will keep the equity — the difference between the sale price and what’s owed on the reverse mortgage.
The Right Type of Home Loan for Your Financial Situation
Your personal financial situation plays an important role in finding the right type of home loan. You may want the lowest payment possible or want to buy a high-end property. Your income, credit score, equity, and other debt factor into the loans you qualify for, in some cases giving you more or fewer options.
While the criteria for each type of loan goes beyond what was covered here, a knowledgeable mortgage professional can walk you through different types of loans. You shouldn’t have to figure out the nuances of each loan program on your own, since there are so many variables and requirements. Work with someone you trust to guide you through the process and help you make the right decision.