When shopping for a home, finding the house of your dreams is only half the battle. Unless you’re paying cash, the second half of the homeownership challenge is finding a mortgage to finance that dream. How do you know which type of mortgage is best for you?
It’s not as simple as choosing between a 15-year and a 30-year term—or whether you prefer to pay a fixed interest rate for the life of the mortgage or to have an adjustable interest rate, or ARM. You’ll need to take into account how much money you need to borrow, which is affected by the size of the down payment you’ll make, as well as the state of your credit.
The best mortgage will always be the one that’s a match for your financial goals. With so many options, however, finding that ideal fit could feel daunting.
To help you choose a mortgage with greater confidence, let’s examine the six most common types of mortgages: conventional, jumbo, FHA, USDA, VA and 203(k). This information will help equip you to make decisions about the best mortgage to meet your needs.
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When you get a mortgage that’s not backed by a government agency, you’re likely getting a conventional mortgage.
Private lenders, such as banks and credit unions, fund conventional mortgages. These loans are flexible in purpose, and you can use the proceeds to purchase either your primary or secondary residence. The amount you’re able to borrow follows income and down payment guidelines set by Fannie Mae and Freddie Mac and loan limits set by the Federal Housing Finance Administration (FHFA).
Qualification guidelines for conventional mortgages often require a higher credit score than government-backed loans. According to Experian, it’s possible to qualify for a conventional mortgage with a score as low as 620. Many lenders prefer borrowers with credit scores 660 or higher. If you have a higher credit score, especially one that’s 740 or higher, you’ll be rewarded with a lower interest rate when you choose a conventional mortgage.
In addition to credit score guidelines, conventional mortgages typically require a 20% down payment for the best rates. If you’re putting down less, you’ll likely have to pay private mortgage insurance (PMI) until you have 20% equity in your home. PMI is an insurance policy that protects the lender if you default on your loan.
Lenders charge PMI to protect themselves because borrowers putting down less than 20% have less “skin in the game” and stand to lose less if they default. PMI adds extra to your monthly mortgage payment, usually between 0.3 to 1.5% of your loan amount.
Conventional mortgages can be conforming or nonconforming. A nonconforming loan is known as a jumbo loan. We’ll talk about that type of loan in the next section.
Conforming Conventional Loans
Conforming conventional loans do just that—they conform to high-end lending limits set forth by Fannie Mae. For 2020, the conforming loan limit for a single-family home is $510,400 for most U.S. states and Puerto Rico.
There are, however, exceptions to the high-end limits if you live in areas designated as “high cost” by the FHFA. There are 19 states and the District of Columbia with high-cost regions. If you live in one of these areas, the high-end loan limit for a single-family home goes up to $765,600.
Pros of Conforming Conventional Mortgages
- Available from a wide variety of lenders, both local and online
- Can be used for primary or secondary residences
- Low down payment options (often from 0% to 3%)
Cons of Conforming Conventional Mortgages
- Stricter qualifications than government-backed loans
- Potential PMI requirements if you put down less than 20%
When a Conforming Conventional Mortgage Might be Best
- You’re putting 10% to 20% down
- You have a higher credit score (over 740)
A “jumbo” mortgage is a loan that falls outside the lending limits set by the FHFA. Because of this, jumbo mortgages are nonconforming conventional loans. If you’re buying a luxury home, you’ll likely be looking at a jumbo mortgage to accommodate the price.
Lenders see these larger mortgages as riskier than conforming loans since they’re not guaranteed by any of the government-sponsored entities (GSEs). Thus, the qualification guidelines are often more stringent.
Borrowers should have credit scores in the 700 range when applying for a jumbo loan. Experian notes that many lenders want scores 720 or higher and won’t consider borrowers with scores lower than 600.
Jumbo loans have higher down payment requirements than conventional mortgages, usually in the 20% to 30% range. Lenders also like to see higher cash reserves for jumbo loan borrowers and debt-to-income ratios at a maximum of 36%.
It’s not uncommon for buyers to encounter higher but competitive interest rates and closing costs compared to conforming conventional mortgages and loans backed by GSEs.
Pros of Jumbo Mortgages
- Higher lending limits to broaden your purchase options
- Interest rates that are competitive with conforming conventional loans
- Can help buy more expensive homes in areas not designated as high-cost areas by the FHFA
Cons of Jumbo Mortgages
- Higher asset requirements than conventional conforming mortgages
- Stricter qualifications than conforming conventional mortgages and government-backed loans
When a Jumbo Mortgage Might be Best
- You have substantial funds for a down payment and a high credit score
- Your home purchase price is higher than $510,400 in most areas, or $765,600 in some high-cost regions
Government-insured mortgages are plentiful in the marketplace. A different government-sponsored entity guarantees each type of loan and has unique qualification procedures.
These loans make homeownership accessible to a wide range of low- to mid-income buyers, including first-time buyers, because of their flexible qualification and down payment criteria. We highlight four different kinds of government-insured mortgages below.
Federal Housing Administration (FHA) Loans
FHA loans are guaranteed by the Federal Housing Administration and have qualification criteria that open the door for a variety of borrowers. With an FHA loan, your credit score and down payment are linked.
Borrowers with a minimum 580 credit score qualify for the lowest down payment: 3.5% of the purchase price. If your credit score is a bit lower (in 500-579 range), you’ll need to bump your down payment up to 10%. There’s a maximum debt-to-income ratio of 43% for all borrowers, and these mortgages must fund a borrower’s primary residence. For all borrowers, PMI is required for down payments less than 20%.
Pros of FHA Mortgages
- Flexibility on credit score and down payment
- Down payments as low as 3.5%
Cons of FHA Mortgages
- Can only be used for primary residences
- Low down payments require PMI
When an FHA Mortgage Might be Best
- You can only afford a small down payment
- You have credit bumps in your past but a current good pay history
United States Department of Agriculture (USDA) Loans
Backed by the U.S. Department of Agriculture, USDA loans help low- to moderate-income buyers in designated rural and suburban areas. While it might seem to be only for farmland on the surface, USDA loans can buy primary residences for qualified applicants.
Borrowers looking to buy a home in areas designated as eligible by the USDA need to meet strict income limits. These limits are specific to the locality where you’re buying a home. Buyers under the USDA program typically don’t qualify for mortgages from other sources. USDA loans are available from a wide variety of local and online lenders and, in some cases, directly from the USDA itself for some low-income applicants.
The USDA doesn’t set minimum credit score guidelines. Borrowers with a score of 640 or higher are said to experience a more streamlined loan process. Down payments can be as low as 0%, but, as with an FHA or conventional mortgage, buyers will have to pay PMI if they put down less than 20%.
Pros of USDA Mortgages
- No minimum credit score to qualify
- Targeted for low- to mid-income households in rural areas
Cons of USDA Mortgages
- Income and geographical restrictions
- Will usually come with PMI, which adds to the monthly mortgage payment
When a USDA Mortgage Might be Best
- You’re a lower-income buyer interested in buying a home in a qualified area.
- You have a credit history that makes qualifying for other mortgages difficult.
Department of Veterans Affairs (VA) Loans
If you’re active duty or a veteran of the U.S. Armed Forces, or a family member of one, you might qualify for a mortgage backed by the Department of Veterans Affairs. There’s no limit on how much you can borrow, but there are limits to how much of the loan the VA will guarantee—and that determines whether you’ll have to make a down payment.
VA loans have no down payment requirement as long as you don’t buy a home more expensive than the VA home loan limit and aren’t subject to PMI, which is unlike other mortgage types. Homes purchased using VA loans must be a primary residence for the service member or spouse. Active-duty personnel can use a VA loan to buy a home for a dependent.
To get a VA loan, qualified applicants can visit a wide variety of local or online lenders. Anyone applying for a VA loan will have to present a Certificate of Eligibility, or COE. Buyers who qualify should sit down with a mortgage officer at an institution that offers VA-backed loans.
There, you can explore the procedures, how much you can borrow and a unique detail called “entitlements”—how much of the loan the Department of Veterans Affairs will guarantee.
Pros of VA Mortgages
- Flexible credit qualification
- No down payment in most cases and no PMI requirements
Cons of VA Mortgages
- Limited to active duty, veterans and qualifying family members of the U.S. Armed Forces
- Must present a COE to prove eligibility
When a VA Mortgage Might be Best
- You’re active duty, a veteran or a qualifying family member of the U.S. military
- You’re looking for a low down payment without having to pay PMI
For Fixer-Uppers: 203(k) Loans
If you’ve got your eye on a fixer-upper home, it’s worth taking a look at a 203(k) loan, guaranteed by the FHA.
A 203(k) loan lets you take out one loan to cover the purchase of the home and the improvements you need to make. Unlike other types of mortgages, however, 203(k) loans have some specific nuances.
First, any repairs funded by the loan must be completed within six months. Next, you can use the additional proceeds above the purchase price to pay for temporary housing while you or your contractor makes renovations. Finally, 203(k) loans can only be used by individual owners/occupants and qualified nonprofit organizations. You can’t buy a second or investment property with this type of loan.
With 203(k)s, funds above the purchase price go into an escrow account. Contractors performing the repairs get paid out of the escrow account. It’s also wise for borrowers to work with contractors who are familiar with the 203(k) process, so there aren’t miscommunications on how to get paid.
With 203(k) loans, down payments are as low as 3.5%, yet interest rates trend higher than regular FHA loans. Credit scores are flexible, and buyers must have a minimum score of 500 to qualify. Borrowers also can expect to pay a loan program fee each month with their mortgage.
There is also an upfront mortgage insurance premium (MIP) payment required at closing. Your lender can help walk you through closing costs and program fees. The 203(k) loans are available from a variety of local and online lenders.
Pros of 203(k) Loans
- A single loan to pay for your home and renovations
- Can help buyers enter a more expensive housing market by renovating a home
Cons of 203(k) Loans
- The lengthy approval process, which might not work for all housing markets
- Investment properties don’t qualify
When a 203(k) Mortgage Might be Best
- You’re interested in buying a fixer-upper
- You want a lower interest rate than credit cards to pay for home improvements
Which Type of Mortgage Is Best for You?
Now that you have the basics about the different types of mortgages, you can start matching them with your dream home. A savvy next step is to sit down with a mortgage professional and discuss your finances and homeownership goals. Together, you’ll find the best loan—for your needs, your dream home and your specific real estate market.
Source: forbes.com ~ By: E. Napoletano ~ Image: Canva Pro