5 Types Of Home Loans Home Buyers Should Consider

If you’re buying a home, chances are that you’ll need to take out a mortgage. After all, most people can’t afford to buy a home in cash. And considering you’re likely to spend decades paying off the loan, it’s important to choose the right one.

There are several different types of home loans to choose from, each of which has both pros and cons and may be best suited to a certain type of borrower. Before you buy a home, be sure to learn about your mortgage options and identify the best type of loan for you.

5 Types Of Mortgage Loans To Consider

When you’re shopping around for a home loan, you’ll find that you have many options to choose from. The following are the five common types of mortgage loans.

1. Conventional Loans

A conventional loan is the most popular type of loan on the market. The term conventional loan refers to any loan that isn’t backed by a government agency.

Most conventional mortgages are also conforming loans (though they don’t necessarily have to be). A conforming loan is one that complies with the Federal Housing Finance Authority’s (FHFA) conforming loan limits and is eligible to be purchased by Fannie Mae and Freddie Mac.

Pros Of Conventional Loans

• Low down payment: Conventional loans only require a down payment of 3% in many cases, which is lower than the amount required for some other loans.
• Flexible borrowing limits: There are few restrictions on the amount you can borrow with a conventional loan. These loans can be either conforming or non-conforming, meaning they don’t necessarily have to meet the FHFA loan limits.
• Choice of loan types and terms: When you get a conventional loan, you can choose between a variety of loan terms and interest rate types.
• Few property restrictions: There aren’t as many standards imposed on the type of property you can buy with a conventional loan as there are with government loans.

Cons Of Conventional Loans

• Higher credit score requirement: Conventional loans require borrowers to have a credit score of 620, which is higher than the requirement for many other mortgages.
• PMI with small down payments: If your down payment is less than 20%, you’ll be required to pay private mortgage insurance (PMI).
• Higher interest rates: Conventional loans have higher interest rates than some government loans, especially for borrowers with fair credit.

Who This Loan Type Might Benefit

A conventional loan is a good choice for most borrowers. Consider this type of loan if you meet the credit score and debt-to-income ratio requirements and can qualify for a decent interest rate. You can also use this type of loan if you don’t qualify for a VA loan or another that offers special benefits.

2. Fixed-Rate Mortgages

A fixed-rate mortgage is one that has the same interest rate for the entire loan term. For example, if you’re approved for a mortgage at a rate of 5%, you’ll pay 5% until your loan is repaid or refinanced.

Because fixed-rate mortgages don’t fluctuate, neither do the monthly principal and interest payments on these loans. This is advantageous for borrowers who want stability in their mortgage payments. However, they also have higher starting interest rates than adjustable-rate loans.

Pros Of Fixed-Rate Mortgages

• Not vulnerable to market changes: When you have a fixed-rate loan, you don’t have to worry about changes in the market increasing your interest rate.
• Stable monthly payments: Fixed-rate loans also have fixed monthly payments, which makes budgeting easier and more predictable.

Cons Of Fixed-Rate Mortgages

• Higher starting interest rates: Fixed-rate mortgages have higher starting interest rates than adjustable-rate loans, making them more expensive at first.
• More expensive for short-term homeowners: If you plan to stay in a home for a short time, a fixed-rate loan will be more expensive than an adjustable-rate one.

Who This Loan Type Might Benefit

This type of mortgage is ideal for borrowers who want predictability in their mortgage payments. When you have a fixed-rate loan, you don’t have to worry about your payment suddenly spiking because there was a change in the market. Additionally, this type of payment is best for borrowers who don’t have the wiggle room in their budgets to accommodate a large increase.

Fixed-rate mortgages are also a good choice for people who plan to stay in their homes for a long time. While fixed-rate loans tend to be more expensive for short-term homeowners, they are more beneficial for long-term homeowners.

3. Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) is one whose interest rate can fluctuate over the loan term. These loans usually have a low interest rate to start for a certain fixed period. Once that fixed period ends, the interest rate can increase or decrease at predetermined intervals up to a certain amount.

Some examples of ARMs include 5/1 ARMs, 5/6 ARMs, 7/1 ARMs, 7/6 ARMs, and 10/1 ARMs. The first number is the initial fixed interest period, while the second number is how often the interest rate can adjust after that. If the second number is one, the rate can change once per year. If the second number is six, the rate can change once every 6 months.

ARMs also have some interest rate caps. They have an initial cap, which is the maximum the interest rate can increase by at the first adjustment. There’s also a periodic cap for future adjustments and a lifetime cap to limit the total interest rate increase.

Pros Of Adjustable-Rate Mortgages

• Lower starting interest rate: ARMs have lower starting interest rates than fixed-rate loans, making them cheaper in the early years.
• Flexible loan terms: There are several options for ARM terms, giving you some control over your fixed-rate period and rate adjustments.
• Potential for a lower payment in the future: If a change in the market causes interest rates to fall, your mortgage payment could be reduced.

Cons Of Adjustable-Rate Mortgages

• Lack of stability: ARMs offer little stability for your interest rate and payment, and you could see both increase due to market events.
• Payment could become unaffordable: If interest rates rise and your payment spikes, you may find that your mortgage payment becomes unaffordable.
• Possible prepayment penalties: ARMs are more likely than fixed-rate loans to have prepayment penalties, which penalize you if you pay off your loan early.

Who This Loan Type Might Benefit

An ARM is a good option for borrowers who plan to stay in their home for a short period – ideally, less than the initial fixed-rate period on their loan. As long as you sell the home before your first interest rate adjustment, you’ll pay less overall than you would with a fixed-rate loan.

An ARM could also be a good option for someone who wants to stretch their budget a bit. Because of the lower monthly payment in the initial period, you may qualify for slightly more with an ARM than you would with a fixed-rate mortgage.

4. Government-Backed Mortgages

A government-backed mortgage is one that’s insured by a federal government agency such as the Federal Housing Administration (FHA), Department of Agriculture (USDA) or Department of Veterans Affairs (VA). These loans have protections for lenders, so that if a borrower doesn’t repay the loan, the backing government agency will compensate them for their losses.

There are three primary types of government-backed mortgages:

• FHA loans: An FHA loan has flexible credit score and closing cost requirements, helping borrowers with low credit and/or low to moderate incomes buy homes.
• USDA loans: A USDA loan helps low- to moderate-income borrowers buy homes in designated rural areas with no down payment and no mortgage insurance.
• VA loans: A VA loan is available to current and former service members, as well as qualifying surviving spouses, these loans require no down payment and no mortgage insurance.

Pros Of Government-Backed Mortgages

• Flexible requirements: Government-backed loans often have flexible borrower requirements, such as low credit scores and high debt-to-income ratios.
• Potential for no down payment: USDA loans and VA loans don’t require down payments (though FHA loans do).
• Low or no mortgage insurance: Depending on the type of loan, you could end up paying lower mortgage insurance or even none at all.
• Competitive interest rates: Government-backed loans have competitive interest rates, even for borrowers without the best credit scores.

Cons Of Government-Backed Mortgages

• Imposes certain housing standards: When you apply for a government-backed loan, the home you purchase must meet certain safety and livability standards and, in the case of USDA loans, location limitations.
• May have eligibility requirements: USDA loans have income caps and are only available to borrowers in rural areas. Meanwhile, VA loans are only available to current and former military service members and surviving spouses.
• Potentially higher costs: In some situations, government-backed loans could end up being more expensive (such as if you have to pay mortgage insurance on your FHA loan).
• Not offered everywhere: Some of these loans may not be offered by all lenders. For example, our sister company, Rocket Mortgage^® does not offer USDA loans at this time.

Who This Loan Type Might Benefit

Each type of government-backed loan is best suited to a different type of borrower. First, an FHA loan might be a good fit for a borrower with a fair or poor credit score who can’t qualify for a conventional loan. Next, a USDA loan is a good option for low- and moderate-income borrowers in rural areas. Finally, a VA loan can help you save money if you’re a current or former military servicemember or surviving spouse.

5. Jumbo Loans

A jumbo loan is one that exceeds the borrowing limits set by the FHFA, meaning it's too large to be purchased by Fannie Mae and Freddie Mac. Like other conventional loans, jumbo loans can have either fixed or adjustable interest rates. However, because of the increased risk to the lender, they may have higher interest rates in general.

Jumbo loans may also have stricter borrowing standards, including higher credit scores, lower debt-to-income ratios and higher cash reserves. Jumbo loans may also require down payments that are higher than the 3% typically required for conventional loans. In fact, you may be required to put down 10% or more.

Pros Of Jumbo Loans

• Higher loan amounts: The key advantage of a jumbo loan is you can borrow more than the FHFA limits, which is good for luxury home buyers or people in high-cost-of-living areas.
• Loan flexibility: Because jumbo loans can’t be purchased by Fannie Mae or Freddie Mac, they also aren’t subject to their requirements. As a result, lenders may offer more flexibility in some areas.
• Competitive interest rates: Historically, jumbo loans have had higher interest rates. But more recently, their rates have been competitive with conforming loans.

Cons Of Jumbo Loans

• Higher credit score: To qualify for a jumbo loan, you’ll typically need a higher credit score than you’d need to qualify for a conforming conventional loan.
• Increased risk: Because jumbo loans are larger, there may be an increased risk of not being able to make your mortgage payments.
• Higher cash requirements: Jumbo loans often have stricter requirements when it comes to your income, your down payment and your amount of cash reserves.

Who This Loan Type Might Benefit

A jumbo loan is a great option for any borrower who wants to spend more on their home than the FHFA limits allow. In some cases, this could apply to wealthy borrowers who want to purchase luxury homes. However, it could apply to people in high-cost-of-living areas. Even though people in high-cost areas have a higher FHFA limit, that limit is still lower than the average home price in certain cities, making it challenging to buy a home without a jumbo loan.

Conforming Vs. Non-Conforming Loans

One of the biggest characteristics of any loan is whether it’s conforming or non-conforming, and it’s important to know which you’re applying for upfront.

Conforming loans are those that comply with the FHFA loan requirements. Most conventional loans are also conforming loans, meaning they’re eligible to be purchased by Fannie Mae and Freddie Mac. Government-backed loans can also be conforming loans.

In 2023, a conforming loan for most areas is one valued at $726,200 or lower. However, for high-cost areas, the limit is 150% of the standard limit, or $1,089,300.

A non-conforming loan is one that doesn’t meet the requirements to be purchased by Fannie Mae and Freddie Mac. Jumbo loans are non-conforming loans because they don’t meet the FHFA conforming loan limits. However, a loan could also be non-conforming if it doesn’t meet other Fannie Mae and Freddie Mac requirements, such as those relating to credit scores or debt-to-income ratio.

Additional Steps To Take In The Home Buying Process

Deciding what type of mortgage to get is an important part of the home buying process, but it’s far from the only one. Here are some other steps you’ll need to take before buying a home:

• Check your credit score: Knowing your credit score upfront is important when buying a house, as it helps to determine what type of loan you’ll qualify for. If you have a low credit score, you should also spend some time trying to increase it before applying for a mortgage.
• Save for your down payment: Most mortgages require a down payment. Conventional loans require at least 3%, while FHA loans require either 3.5% or 10%, depending on your credit score.
• Shop around for a lender: Compare loan types, interest rates and other features from various lenders to help you choose a mortgage lender.
• Get preapproved: Preapproval can help streamline the mortgage process by improving your chances of having your offer approved and giving you a head start on your final approval once you apply for a loan.

The Bottom Line

There are five primary types of home loans to choose from when you’re buying a house. Each one has different features, pros and cons and may cater to different types of borrower. When you’re ready to choose a home loan, start the mortgage approval process today.