Types of Mortgage Loans

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You may have thought that getting a mortgage was all about crunching numbers, but then you found out you must also decipher an alphabet soup of acronyms — FRM, ARM, FHA, USDA, VA. And just who are Fannie and Freddie, and what do they have to do with your loan, anyway?

Don’t let the terminology scare you. There are different types of mortgages for different situations, and this article will look at various types in terms of three key distinguishing characteristics:

  • Loan insurer
  • Loan-interest structure
  • Loan size

Once you understand the different options as they relate to these characteristics, you’ll be in a better position to decide which mortgage is right for you.

Insurer: conventional and government-backed home loans

Lending money is a risk, and lenders help manage that risk by obtaining insurance for their mortgages. Different insurers have their own rules about what types of loans they will back, so loans’ insurers significantly influence the nature and purpose of different types of mortgages.

Some mortgages are insured by government agencies such as the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA) and even the U.S. Department of Agriculture (USDA). Loans that are not government-backed are often referred to as conventional home loans, and these are insured by private finance companies, most notably Fannie Mae and Freddie Mac.

These days, nearly two-thirds of mortgage originations are for conventional loans, though that percentage can change drastically over time, depending on economic conditions and policy changes.

Read on for descriptions of the government-backed and privately insured mortgage options, so you can start to see which may be best for you.

FHA Home Loans

The FHA works with private lenders to insure mortgages that meet certain conditions. FHA mortgages were created to support the housing industry during the Great Depression, and from those beginnings in 1934, the FHA has grown to be the world’s largest insurer of mortgages.

FHA mortgages require a fairly low down payment and less strict credit standards than privately insured conventional loans. For these reasons, they are often seen as ideal for first-time home buyers, but they are not strictly limited to first-timers.

FHA loans are intended for residential properties of one to four units, where the property will be the borrower’s primary residence. As of 2017, FHA loans were generally available up to $275,665 for a single unit property, though they can go up to as much as $636,150 in designated high-cost areas or even $954,225 in Alaska, Guam, Hawaii and the Virgin Islands.

The willingness of the FHA to insure these loans means lenders may take risks on borrowers they might otherwise not approve for a mortgage. While that helps make mortgages available to more would-be homebuyers, there’s a catch: The FHA funds its insurance by charging a mortgage insurance premium (MIP) both upfront and annually for most or all of the length of the loan, depending on your down payment.

This MIP requirement is heavier for FHA loans than for other types of insurers, so while FHA loans may be the most easily obtainable loan type if you have a weaker credit history, they also tend to be the most expensive option.

VA Home Loans

VA loans are available to active-duty service members in the U.S. military, honorably discharged vets and some surviving spouses of deceased veterans or service members.

Like FHA loans, VA mortgages are insured by the federal government and are subject to the same loan limit guidelines, which vary from county to county depending on local housing costs. Despite sharing the same loan limits, VA loans have a couple of important advantages over FHA loans.

VA loans are available with little or no down payment. Also, VA loans do not require the borrower to pay mortgage insurance. This means that VA loans have a distinct cost advantage for those who qualify. There is, however, a funding fee for VA loans, which ranges from 1.25 to 3.3 percent of the loan. The fee you pay depends on your type of military service, your down payment amount and whether you’re using a VA loan for the first time.

USDA Home Loans

If you’re accustomed to seeing USDA ratings on food products like meat and eggs, you may be surprised to find out the department also has a hand in home loans.

Like the FHA and the VA, the USDA provides government-backed mortgage insurance to encourage private lenders to make home loans in certain circumstances. In the case of the Department of Agriculture, its interest is in making sure rural areas remain populated enough to support the farming industry that is essential to the nation’s food supply. So, USDA loans mean insurance is provided for mortgages in designated rural areas.

You can find out if a given address qualifies as a rural area on the USDA website. Besides being limited to these designated rural areas, USDA mortgages are subject to income limits. Benefits vary according to your income level and are not available for borrowers with high incomes. The definitions of these income levels vary according to county, and again, can be found on the USDA website.

In short, USDA loans can help you qualify for a mortgage without having to pay mortgage insurance, but are only available in a limited set of circumstances. If you are a would-be homebuyer with a low to moderate income and are interested in residing in a rural area, USDA loans are worth a look.

Conventional Home Loans

Mortgages insured by private companies rather than the government are referred to as conventional mortgages. The most prominent private insurers are Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corp.), so they effectively set the standards for conventional loan eligibility. (While the government chartered Fannie Mae and Freddie Mac, they are owned and operated by private shareholders, making them government-sponsored entities rather than wholly owned by the government.)

Because they are not backed by the government, conventional mortgages generally apply stricter underwriting standards. This means you should expect to need a stronger credit rating and lower debt-to-income ratio to qualify for a conventional loan, or else you should be ready to make a larger down payment.

If conventional loans are harder to get than government-backed loans, why bother? Well, first of all, not everybody meets the requirements for VA or USDA loans, which, as mentioned above, come with some restrictions and limitations.

As for FHA loans, remember that these require both upfront and ongoing MIP payments. Conventional loans also require mortgage insurance, but without an upfront payment, and you can get rid of these premium payments when the remaining loan-to-value ratio drops below 80 percent. Put simply: With a conventional mortgage, you can avoid paying for mortgage insurance altogether if you put down at least 20 percent on the purchase.

If your credit is pretty good (including a credit rating at least in the 620 range, though the vast majority of conventional mortgages are approved for borrowers with credit ratings of at least 700) and you don’t meet the requirements of a VA or USDA loan, a conventional loan may be your best option. The milder mortgage insurance requirement can make it less expensive than an FHA loan.

Interest structure: fixed and adjustable-rate mortgages

A mortgage’s insurance source can impact your ability to get a home loan, but how a loan’s interest is charged will affect how much you pay both on a monthly basis and over the course of the loan.

There are two major methods of charging interest on mortgages: fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs). With FRMs, the interest rate is set in advance for the entire term of the loan. In comparison, with an ARM the rate will change over time according to changes in market interest rates.

Fixed-rate mortgages

As the name suggests, FRMs have an interest rate which stays the same throughout the life of the loan. This also means that your monthly payment will be the same throughout the loan term.

Fixed-rate mortgages are available in a variety of lengths ranging from 10 to 40 years, with 15- and 30-year loans being the most common. In general, interest rates will be higher for longer mortgages, though by stretching principal repayment over a longer time you can lower your monthly payment. Thus, with a longer-term mortgage, you trade paying less from month to month for paying more in total over the life of the loan.

This is all pretty straightforward, except for the fact that some FRMs charge upfront points. Points are a percentage of the principal charged at the start of the loan, in exchange for a lower ongoing interest rate. Some loan calculators can help you figure out whether paying points upfront will be worth it in exchange for the interest you will save over the life of the loan.

Fixed-rate mortgages are ideal for people who plan to be in their homes for a long period of time and want a predictable monthly payment.

Adjustable-rate mortgages

ARMs have interest rates that may change according to market conditions at scheduled periods of time. This can allow you to lower your monthly payments without the expense of refinancing if interest rates fall, but it can also mean higher monthly payments — and possibly unaffordable ones — if interest rates rise.

ARMs are listed showing a combination of two numbers — 5/1, for instance, or 7/1. The first number shows the number of years for which the initial loan rate is fixed before it is subject to potential fluctuation. The second number shows how frequently (also in years) the rate is subject to change after the initial period. So a 5/1 ARM will have a five-year fixed-rate period, while after that, the rate will adjust annually for the remainder of the loan term.

In addition to knowing when an ARM is subject to change, there are two other important elements in determining how much your interest rate may fluctuate: The market index on which future rates will be based, and the maximum amount (if any) the rate may change in any one adjustment period.

ARMs make sense if you think current interest rates are unusually high and are likely to fall. On the other hand, an ARM might be risky if current rates are unusually low and seem likely to rise.

Another characteristic of ARMs is that the initial rate is often (though not always) lower than the rate for FRMs. This means that if you only expect to be in the house for a few years (or otherwise expect to be able to pay off the mortgage before long), you could be in a position to benefit from an ARM’s lower initial rate.

Head-to-head: FRMs and ARMs

To show an example of how FRM and ARM costs may differ, we’ll use the assumption of a $200,000 loan at recent mortgage rates for each type of loan. While the lower initial interest rates give the ARM a cost advantage over the first five years, whether proves to be more or less expensive in the long run depends entirely on whether interest rates rise, fall or stay as they are.

30-year fixed
5/1 ARM
Monthly payment
$862.75 first five years, variable after
Interest paid in first five years
Total interest paid over life of mortgage
Unknown, because APR is variable after first 5 years
Total amount paid over life of mortgage
Unknown, because APR is variable after first 5 years

Loan size: conforming and jumbo loans

In addition to type of insurer and method of charging interest, another key characteristic of mortgages is based on the size of the loan. This determines if the mortgage is considered a conforming or a jumbo loan.

Conforming mortgage loan

There are legal limits on how large a loan Fannie Mae and Freddie Mac can insure. These limits change over time and for 2017 the limit in most of the country is $424,100, though it is higher in certain high-cost areas (i.e., Hawaii and Alaska and a few federally designated high-cost markets, where the limit is $636,150). Loans within these limits are considered conforming loans.

The ability to have Fannie Mae or Freddie Mac insure your mortgage can have a big effect on your ability to get a loan and on the amount of interest you pay. So, it is a good idea to be aware of the conforming loan limits in your target buying area, because it may be to your advantage to stay within those limits.

Jumbo mortgage loan

Suppose you have your sights set on a particularly lavish property, or live in a part of the country where home prices generally have soared through the conventional loan limits. If you plan to borrow above those limits, you need to find a jumbo loan.

Without mortgage insurance available from Fannie Mae, Freddie Mac or the government, jumbo loans represent a bigger risk to lenders. Many will still make those loans, but it is likely to cost you in the form of a higher interest rates. Also, expect lenders to mitigate their risks by requiring a larger down payment and demanding tougher qualifying standards for credit and debt-to-income ratios (DTIs).

All of this may be for the best. It is perfectly fine to want a more expensive house, but these higher hurdles will help make sure you can really afford it in terms of credit history and resources.

What’s the best type of mortgage for you?

Sifting through all the different types of mortgages can be challenging, but to help you figure out which to focus on, here are a few questions to ask yourself:

  • Would you qualify for a VA loan? If you or a spouse has qualifying military experience, you may find this to be both the most easily available, least costly option. See the VA website for more details on eligibility. You can compare VA mortgage offers here.
  • Are you looking for a home in a rural area? If that is the case and you have a low to moderate income, you may qualify for a USDA mortgage. This may be easier to get than a conventional loan, and cheaper than one through the FHA program. See the USDA site for more details — you might be surprised what qualifies as a rural area. You can compare USDA loan offers here.
  • Do you have a credit rating of at least 700? If you do, and you don’t qualify for a VA or a USDA loan, then a conventional loan could easily be your most cost-effective option. With a credit score below 700, take another look at FHA; an FHA loan might be your best shot.
  • Are interest rates unusually low or unusually high? When rates are low, your best move might be to lock those rates in with a fixed-rate mortgage. If rates are unusually high, you may want to consider an adjustable-rate mortgage so you benefit if they fall. Pay close attention to the market if you get an ARM, and have a plan for what to do if interest rates rise.
  • Do you plan to be in your home for a long time? If you plan to be in the home for many years, a fixed-rate mortgage can protect you against changes in your monthly payments. If you expect to be moving on after a few years, you may be able to benefit from a lower initial rate on an ARM.
  • Are you interested in a house that is much more expensive than the norm for the area? The applicable dollar figures vary from area to area, but generally speaking, if you are looking at a property that’s low- to moderately priced, everything is on the table. If you are looking at a moderately priced to fairly expensive property, a conventional loan might be the best fit, and if you are interested in a very expensive property, your only option may be a jumbo loan.

Just remember that once you have decided which type of loan to pursue, different lenders are apt to charge different interest rates and closings costs for the same types of mortgages. So shop around.