The type of mortgage loan you choose is very important when buying a home. You are faced with quite a number of choices. Therefore, it might become really hard to make a perfect choice. In this article, we will talk about the different types of mortgage loans and provide you with tips on how to choose which will be suitable for your financial situation.
Mortgage loans are available in many different forms, and they each have their own pros and cons attached to them. Selecting the correct type of mortgage loan may not only save you money in the future but also guarantee that your monthly payments will be affordable.
Now, we are going to discuss different types of mortgage loans and how interest on loans works.
Types of mortgage loans: Which one is better for you?
- Fixed-rate Mortgage
- Adjustable-rate Mortgage (ARM)
- Interest-only Mortgage Loans
- FHA Loans
- USDA Loan
- Jumbo Loan
1. Fixed-rate Mortgage
A fixed-rate mortgage is a type of home loan where the interest rate stays the same throughout the length of the loan, usually 15 or 30 years.
Under a variable-rate mortgage agreement, borrowers get the advantage of being assured that their monthly payments will remain unchanged. Such predictability makes planning safer and protects against increasing interest rates.
The initial interest rate is agreed upon at the start of the loan and does not change, irrespective of fluctuations in the economy or in the lending market.
Pros:
Predictable Payments: Borrowers are able to budget with precision, knowing exactly what their monthly payments will be.
Protection Against Interest Rate Increases: Regardless of market circumstances, the interest rate remains stable, thus giving borrowers security against rising interest rates.
Simplified Budgeting: With the monthly payment fixed, it becomes easier and more predictable to budget one’s finances.
Cons:
Higher Initial Interest Rates: Fixed-rate mortgages typically have higher interest rates in the beginning, while adjustable-rate mortgages (ARMs) begin with lower rates.
Limited Flexibility: However, after securing a fixed rate, borrowers are unable to benefit from declining rates unless they are willing to refinance, which is a costly and time-consuming process.
The specific FICO score needed to be approved for a fixed-rate mortgage could vary depending on the particular lender and other factors; however, to qualify, one needs a credit score of 620 and above.
When it comes to APR (Annual Percentage Rate), it includes not only the interest rate but also other fees and expenses connected to the loan, for instance, the origination fee and points.
The creditworthiness, amount of the loan, and market conditions will determine the APR that borrowers will be offered.
Fixed-rate mortgages are a good recommendation for those who plan to occupy their homes for a long time or are risk-averse.
2. Adjustable-rate Mortgage (ARM)
Adjustable-rate mortgages (ARMs) are loans where the interest rate may vary over the duration of the loan and typically will adjust in response to changes in a benchmark rate such as the prime rate or Treasury bill rate.
ARM loans usually go along with a fixed rate duration ranging from 5, 7, or 10 years, during which the interest rate remains constant.
Following the first period, this rate changes occasionally, usually on an annual basis. The adjustment is done by using the index rate plus a margin, which depends on the lender.
Pros:
Lower Initial Rates: ARMs usually open with lower interest rates as compared to fixed-rate mortgages, and because of this, payments are initially easier to make.
Potential Savings: If the interest rates decrease over time, one of the benefits for the borrowers will be the lower monthly payments they have to make.
Short-term Solution: Preferable for those who are going to be in a property for a limited duration, as the lower introductory rate can help save money during the initial term.
Cons:
Rate Fluctuations: If interest rates rise, monthly payments may rise, which might create troubles for a borrower.
Uncertainty: Budgeting becomes a struggle because of the unstable rate changes.
Risk of Negative Amortization: In certain circumstances, the monthly payments may not cover the interest accumulated, which will consequently raise the loan burden.
The ones with credit scores above 620 (FICO scores) have higher chances of getting good terms. The APR (Annual Percentage Rate) for ARMs fluctuates in accordance with market conditions and the terms of the loan but mostly begins lower than fixed-rate mortgages.
While more cost benefits might appear attractive to borrowers, it’s always important to evaluate their financial situation and future plans before going for an ARM.
3. Interest-only Mortgage Loans
An interest-only mortgage is a loan in which every interest payment is made for a certain period of time, usually 5–10 years, while the principal payment is deferred before switching to regular payments of both principal and interest.
Pros:
Lower initial payments: As you only bear an interest charge, your initial payments are low, which can be a good way to deal with cash flow issues or an investment, for example.
Flexibility: In the interest-only period, you have the option of using the saved money for other investing opportunities.
Potential for tax benefits: In certain instances, the interest payments may be tax-deductible.
Cons:
Higher long-term costs: When the interest-only period ends, your monthly payment rate also increases since you have to pay both principal and interest now.
Risk of negative equity: If property values decline, you may find that you owe more than the property is worth by the time the interest-only period ends.
Limited availability: Interest-only mortgages are not so widely used and may be difficult to find.
Best suited for:
- Borrowers who might have an income that is unstable or expect exceptional financial growth in the future.
- Those intending to sell or refinance their mortgages before the end of the interest-only period.
FICO score and APR: Applicants for interest-only mortgages generally need to have higher credit scores, with the majority of them being at least 720, to be able to enjoy good terms.
4. FHA Loans
FHA (Federal Housing Administration) loans are mortgages underwritten by the government that make it possible for individuals with lower credit scores and low incomes to buy a home.
The main feature of FHA loans is their low down payment requirement, typically not higher than 3.5%, which makes them a good choice for first-time homebuyers and people with limited savings.
Pros:
Low down payment requirement: As mentioned, FHA loans have a low down payment option, and that makes it possible for buyers to be in the housing market.
Flexible credit requirements: Even borrowers with low credit scores can still get approved for an FHA loan since the credit score requirement is usually lower than the one for conventional loans.
Low interest rates: FHA loans are known for their lower interest rates, which may help the borrowers save money over the lifetime of these loans.
Cons:
Mortgage insurance: FHA loans request mortgage insurance premiums, both upfront and annually, which in some cases can increase the total cost of the loan.
Loan limits: FHA loans have a limit on the amount you can get loaned, which may not allow you to choose in expensive housing markets.
Property requirements: FHA loans have stringent property requirements, and the house must fulfill certain conditions in order to get financing.
FHA loans are best suited for:
- First-time homebuyers
- Those with lower credit scores
- People with little savings for a down payment.
The FICO score requirements for FHA loans differ and generally lie between 500 and 580. Better conditions are normally associated with a higher score.
Concerning APR (Annual Percentage Rate), it depends on factors such as a credit score, down payment amount, and current market conditions.
5. USDA Loan
USDA loans are guaranteed by the United States Department of Agriculture and are intended to afford low- to moderate-income borrowers in rural regions the opportunity for homeownership.
They offer interest rates that are as good or better than those of traditional lenders, and they don’t require a down payment, making them very appealing to those who qualify for one.
USDA loans are perfect for families or individuals with moderate incomes who wish to purchase residential property in rural locations.
In addition, they can be convenient for mortgage loan applicants with insufficient funds for a big down payment and individuals who do not want to pay a PMI.
Pros and cons of USDA loans
Pros:
There is no down payment, low interest rates, flexible credit requirements, and closing costs can be rolled into the loan.
Cons:
Rural areas only, income limits included, and probably property eligibility requirements will apply.
6. Jumbo Loan
This is among the different types of mortgage loans homebuyers can choose from. Jumbo loans are mortgages that go beyond the loan limits set by government-sponsored institutions (GSEs) such as Fannie Mae and Freddie Mac.
This type of loan is often a necessity if a property exceeds these limits, such as high-value luxury homes or locations in expensive property markets.
Because of their size, jumbo loans usually have stiffer lending conditions and higher interest rates than conventional mortgage loans.
Pros and Cons
Pros:
Jumbo loans make it possible for buyers to purchase premium properties whose purchase price would otherwise be too high for a standard loan. They give the borrower the opportunity to afford housing at a high price with low risk.
The interest rate as well as a loan term are usually adjusted to the borrower’s financial situation.
Cons:
In most cases, a deposit of 10% to 20% of the property purchase value is expected. Moreover, jumbo loans usually have stricter credit scores and income guidelines, which may be less favorable to some borrowers.
Interest rates can also be variable, which can result in an increase in monthly payments.
Jumbo loans are exclusive to the wealthy who seek to buy exceptional properties in cities with high real estate prices.
Tips to consider when choosing different types of mortgage loans
1. Know Your Financial Situation
Consider your financial position in terms of your income potential, how much you have already saved, and the ability to pay it back.
2. Research Loan Options
Compare the types of mortgage loans, for instance, fixed-rate, adjustable-rate, FHA, USDA, and jumbo loans. Check the loan interest rates, terms, and conditions to know the best for you.
3. Calculate affordability
Use mortgage calculators to calculate the monthly payment, comprising principal, interest, taxes, and insurance (PITI). Decide what you are able to fit into the monthly budget without having to deviate from normal expenditures other than the agreed-upon repayment.
4. Shop Around for Lenders
Be picky and choose wisely among lending providers. Don’t rush into the first one. Conduct your research by browsing the offers of several banks, credit unions, and online lenders.
Conclusion
Being aware of the multiple types of mortgage loans available is necessary when searching for a mortgage loan to buy a home or refinance existing loans.
Each type has a variety of pros and cons that can suit different economic circumstances and individuals’ budget needs. So, you should consider factors such as interest rates, loan length, payback terms, and eligibility standards.
