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What are the different types of mortgage loans available today? How do they work? Which type of home loan is best for a first-time home buyer?
These are just a few of the questions we receive from our readers every month. Instead of answering them one at a time, I thought it would be easier to create an all-inclusive guide. This article explains the different types of home loans that are available in 2014.
7 Different Types of Mortgage Loans, Explained
First the good news. Most of the high-risk “exotic” mortgage products of the housing-boom era have disappeared. For instance, payment option ARM loans and interest-only mortgage payments are all but extinct. This is partly the result of new government restrictions, and partly due to the more conservative lending practices we are seeing among lenders today.
In 2014, borrowers will have fewer financing options, and fewer types of mortgage loans to choose from. Here are the primary choices:
1. Fixed-Rate Mortgage Loans
This is the most popular type of mortgage loan among home buyers, because it offers the most stability and predictability over time.
With this type of loan, the interest rate and the monthly payments stay the same for the entire term. This is true even for borrowers who keep their loans for 10, 20 or 30 years. The benefit here is that you always know what your interest rate and monthly payments will be. There are no surprises with the fixed-rate home loan — no adjustments or variables.
The downside of using this type of mortgage is that you’ll pay a premium in exchange for the predictability. It comes in the form of a higher interest rate. With all other things being equal, fixed-rate mortgages typically have higher interest rates than adjustable loans (which are defined below). So there is a trade-off to consider here.
The fixed-rate type of home loan is available in different terms. The “term,” in this context, is simply the length of the repayment period. They are also available in both FHA (government-insured) and conventional (non-government-insured) forms. So the fixed rate is basically a class or category that can be applied to many different mortgage products and programs.
2. Adjustable-Rate Mortgage Loans
This type of home loan is popular among borrowers who only plan to hold the loan for a few years, before either refinancing or selling the home. An adjustable-rate mortgage (ARM) loan has an interest rate that changes or adjusts over time.
Most ARMs are actually “hybrid” products that combine the qualities of both a fixed and adjustable-rate loan. This product starts off with a fixed interest rate for a certain number of years, after which the rate begins to adjust annually. That’s what makes it a hybrid, or combination, mortgage product.
ARM loans typically have lower interest rates than their fixed-rate counterparts, with all other things being equal. That’s the primary advantage of using this type of home loan.
But there’s an obvious downside as well. This product is less predictable over the long term, and is therefore a riskier option for the borrower. You know your interest rate will eventually begin adjusting, or changing, every year. You just don’t know exactly how it will adjust — or how your monthly payments will change over time.
3. Conventional Home Loans
As a borrower, you will have to choose between the fixed and adjustable mortgage types described above. You’ll also have to choose between conventional or government-insured financing. A conventional loan is one that is not insured or backed by the federal government. This distinguishes it from other types of home loans that are insured by the government in some way, such as VA and FHA loans (described below).
Conventional home loans might be insured by a private mortgage insurance (PMI) company. But they are not insured by the government.
Qualification standards are typically stricter for conventional loans, when compared to government-backed financing. That’s why a lot of borrowers flock to the government programs, such as the FHA loan. Generally speaking, the government-insured products are easier to obtain — especially for borrowers with smaller down payments and/or credit problems.
4. FHA Home Loans
If you’ve been researching your mortgage options online, you’ve probably already heard about FHA loans. They are one of the most popular types of mortgages among home buyers these days, particularly first-time buyers. This is one of the government-backed programs we talked about earlier. This program falls under the Department of Housing and Urban Development (HUD), and is administered by the Federal Housing Administration (FHA).
There are different types of FHA loans available today. For instance, you could take out an FHA-insured mortgage with a 30-year term and a fixed interest rate. You could also get a 5-year hybrid adjustable-rate mortgage (ARM) that is backed by the FHA.
So here again, we have a broad category that can be applied to several different types of home loans. You can start to see how these different categories can be combined to create a specific product with specific features and characteristics.
5. VA Home Loans
The VA loan program is another example of government-backed mortgage financing. These loans are generated in the private sector by regular lenders, but they are guaranteed by the Veterans Administration (at least in part). They are generally limited to military service members and their families.
The primary advantage of this program is that it offers 100% financing. Qualified borrowers who use a VA loan to buy a house can finance 100% of the purchase, with no down payment whatsoever. That makes the VA program unique among the different types of mortgages covered in this tutorial. Along with the USDA program mentioned below, this is one of the only options for 100% financing.
6. USDA Loan Program
USDA loans also provide 100% for qualified borrowers. But they are limited to a very select group. This type of mortgage is only offered to low- and moderate-income borrowers in designated rural areas.
The full name of this program is a mouthful. It’s officially known as the USDA Rural Development Single-Family Housing Guaranteed Loan Program. They are also referred to as rural housing loans, or Section 502 mortgage loans.
According to a HUD fact sheet, this program “is designed to serve rural residents who have a steady, low or modest income, and yet are unable to obtain adequate housing through conventional financing.”
Eligible borrowers can use this type of home loan to “acquire modestly priced housing for their own use as a residence through the purchase of a new or existing dwelling or the purchase of a new manufactured home.”
You can learn more about this program on the USDA website:
7. The Qualified Mortgage (QM) Rule
In January 2013, the Consumer Financial Protection Bureau (CFPB) introduced a new rule designed to eliminate the types of risky mortgage loans that were common during the housing boom. The Qualified Mortgage (QM) rule, as it is known, prohibits a wide variety of loan products and features.
This rule can be applied to many different types of mortgage products and programs. I wanted to mention it briefly in this article, because you will almost certainly encounter it again – especially after January 2014, when the rule takes effect. It will essentially set the bar for lending standards in the U.S.
The QM rule actually eliminates different types of home loans that were used during the housing boom. For instance, it prohibits interest-only payments and negative-amortization scenarios. Among other things, this rule is intended to prevent borrowers from taking on mortgage obligations they cannot realistically afford.
Choosing the Best Financing Option for You
All of the different types of home loans explained above have certain pros and cons associated with them. As a borrower, you must thoroughly research the advantages and disadvantages of each option. As you consider the pros and cons, you will eventually get a sense of which product or program is best suited for your situation.
For example, borrowers who plan to stay in a house for a long period of time are generally better off with a fixed-rate mortgage. Borrowers who only plan to be in a house for a few years may be able to use an ARM loan to their advantage. Borrowers with limited funds for a down payment might choose the FHA loan program due to the 3.5% down payment it allows.
My goal with this article is to introduce the different types of mortgage loans, products, and options that are available to you in 2014. Your job, as a responsible borrower, is to research all of these options to make an informed decision.