Trying to decipher all the different types of home mortgages can feel a little like attempting to solve a Rubik's Cube -- it's frustrating, time-consuming, and often head-scratching. But when you're buying a home, there's a lot at stake, so it's smart to shop around, compare interest rates, carefully consider all your options, do a loan comparison, and come to a conclusion about what's best for you -- and your budget.
Here is a rundown of all the different types of loans and financing options you may encounter when deciding how, exactly, to buy your home.
Home loan options
There are many types of home loans out there that cater to different financing needs. We start with the most conventional loan types (fixed- and adjustable-rate) and then move into some more unconventional options.
Fixed-rate mortgage. A fixed-rate mortgage lets you lock in your interest rate so that your monthly payment will remain the same over the life of the loan (assuming your property tax and homeowners insurance costs don't increase). If you have trouble budgeting or prefer a set payment you can anticipate every month, a fixed-rate mortgage might be your best option.
The downside? You'll probably need to pay a higher interest rate on a fixed-rate mortgage than you would with an adjustable-rate mortgage (ARM). "If you want certainty, you're going to pay for it," says Heather McRae, a senior loan officer at Chicago Financial Services Inc. Lengths on these types of loans vary, but the two most popular are 15-year and 30-year fixed mortgages.
Adjustable-rate mortgage. An adjustable-rate mortgage offers a lower interest rate and payment than a fixed-rate mortgage, but the rate is good only for an initial period -- say, three or five years -- and can then change every year depending on market conditions. (In most cases, "change" means increase.) Since the monthly payment on an ARM has the potential to go up.
FHA loan. Federal Housing Administration, or FHA, loans, which were established during the Great Depression, enable you to qualify for a mortgage with a down payment as low as 3.5%. You can also get approved with a lackluster credit score (think low to mid-600s). But since the federal government insures these loans, borrowers pay a mortgage insurance premium (MIP). This premium on FHA loans currently costs borrowers 1.75% upfront with an ongoing monthly fee of 0.85% for a mortgage of 15 years or more with a loan-to-value ratio of more than 95.01%.
VA loan. The U.S. Department of Veterans Affairs' loan program gives active or retired military -- or a veteran's surviving spouse -- the opportunity to purchase a home using a 0% down payment. VA-backed loans typically offer attractive interest rates, says Todd Sheinin, mortgage lender and chief operating officer at New America Financial in Gaithersburg, MD. The icing on the cake: You don't have to pay private mortgage insurance (PMI) on the loan. Given the perks of a VA loan, it's often your best mortgage option if you can qualify.
USDA loan. U.S. Department of Agriculture Rural Development loans are offered in areas typically defined as having populations of 10,000 or less. You can use the USDA's website to see if your location is eligible. USDA loans typically have lower interest rates than non-USDA loans since the U.S. government assures the lender that any financial loss resulting from servicing the loan will be reimbursed in full up to an amount not exceeding 90% of the original loan amount.
USDA loans also carry a mortgage insurance fee of 2% of the loan amount (collected at closing), plus a monthly mortgage insurance premium of 0.5%, which can be lower than the traditional cost of private mortgage insurance. Since borrowers can put as little as 0% down on these loans, they open up mortgage opportunities for many people who wouldn't have been able to purchase homes otherwise, says Gutierrez. Only certain mortgage companies can accept USDA mortgage applications, so check the government's list of approved lenders if you're considering this type of loan.
Conforming vs. jumbo loans
You may have heard about something called a jumbo loan and wondered what the heck it is. Your mortgage becomes a "jumbo" loan if the amount you're borrowing exceeds conventional conforming loan limits. The limit on conforming loans in "general" areas of the United States is $417,000; in high-cost areas, such as New York, NY, Los Angeles, CA, and San Francisco, CA, the limit is $625,500 for a single-unit home. Jumbo loans generally require you to make a higher down payment (anywhere from 15% to 30% down for some lenders) and have at least a 680 credit score.
What's the deal with points?
You may encounter two types of points in the home loan process: origination points and discount points. Since both can impact your mortgage's terms, it's important to understand the difference.
Origination points. These points are used to pay the mortgage lender's administrative costs for processing the loan. How many origination points you need to pay is based largely on your credit score, but the average buyer pays one point, which is 1% of the loan amount. Although discount points are tax-deductible since they cover the interest on your loan, origination points are deductible only if they were used to obtain the mortgage. In other words, if you used points to cover other closing costs, you won't be able to get a tax deduction from Uncle Sam.
Discount points. Discount points are essentially a way of prepaying the interest on your loan, since they're fees you pay the lender at settlement in exchange for a lower interest rate. One point equates to 1% of the loan amount. As the borrower, you have the option of paying these additional points to reduce your monthly mortgage payment. Discount points are also tax-deductible.
It's up to you to decide if you should purchase discount points. Your lender will require you to pay at least some amount of money for an origination fee, but you may be able to negotiate how much. With discount points, you have the option of whether or not you wish to purchase any; your decision should rest largely on how long you plan to stay in the home. You'll want to calculate your break-even point so that you can determine when you'll begin to recoup the money you paid upfront for the points. If it's longer than you plan on staying in the home, you're probably better off going without them. It's also important to consider whether your money would be better spent on a larger down payment to reduce or eliminate your monthly private mortgage insurance.
Should you consider a mortgage broker?
You have two options when choosing a lender. You can use either a bank or a mortgage broker; each option comes with advantages and disadvantages. You probably do most of your banking -- including maintaining your checking, savings, and credit card accounts -- at one financial institution. If that's the case, the main benefit to getting your mortgage from your current bank is that all your financial accounts and products will be consolidated in one place, which can make managing your money easier. But loan officers at large banks tend to work only 9 to 5, which could leave you stranded if you have pressing questions or issues on nights or weekends. Also, if your loan officer is tied to using the bank's products, you may not get the best mortgage for your specific needs.
Using a local mortgage broker can sometimes get you a lower interest rate and more favorable loan terms, since local brokers typically survey the total marketplace instead of being limited to a set suite of products. Also, because most mortgage brokers do all their work in-house (unlike many big banks), origination, processing, underwriting, and closing is usually a smoother process from start to finish -- with fewer delays and better communication. The main caveat: Some brokers are biased toward certain lenders, since they often get paid a fee from the lender for bringing in business.
Financing options down the line
Once you've decided on your loan, closed on your home, and moved into your new abode, you still may wonder about additional financing options, especially if you decide to remodel or refinance. Here are a few terms you may need to know.
HELOC. A home equity line of credit (HELOC) acts almost like a piggy-bank loan in the sense that it lets you borrow money -- typically at low interest rates -- against the value of your home for improvements, emergencies, and other expenditures.
Refi. Short for a "home mortgage refinance," a refi enables homeowners to get a lower interest rate on the amount they now owe on their home. If you're planning to stay in your home for several more years, a small reduction in your interest rate can make a big difference in your monthly payment.
Since you're not required to use your original lender when you refinance, you'll want to shop around and compare rates to make sure you're getting the best deal. However, "many lenders will offer a discount on closing costs to retain customers," says Gutierrez.
Once you've decided on a lender and secured your financing, you're ready to sign on the dotted line -- your home closing is within reach.
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