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Types of home loans: How do I choose the right home loan?

Dahna Chandler
The Mortgage Reports contributor

In this article:

When shopping for a mortgage, you’ll be able to choose among several types of home loans:

  • Home loans can have fixed or adjustable interest rates
  • Terms range from 5 to over 30 years
  • Loans can be conventional or government-backed

Each loan offers advantages and drawbacks, and is good for some borrowers and a bad fit for others. This article helps you decide among products and choose the right loan for your circumstances.

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Fixed vs variable

One of the first choices you’ll make is whether you want a fixed-rate mortgage (FRM) or adjustable rate mortgage (ARM). The main difference between them is that fixed mortgages have interest rates and payments that do not change over the life of the loan, while ARM interest rates and payments can change, depending on the terms of the product.

FRMs most commonly come in 15-year and 30-year terms. The 15-year loans generally have rates about .5 percent lower than the 30-year loans, but the payments are higher. You can save a lot of interest expense if you choose the shorter term, but only if you are comfortable paying the higher amount.

ARM loans come with introductory periods in which the rate may be fixed for one, three, five, seven or ten years. If you can get a lower interest rate with one of these products, and expect to sell your home or refinance within that introductory period, the ARM can be a smart choice.

Your decision depends on how okay you are with the risk of your payment increasing, and how long you expect to keep your loan.

FRM pros:

  • Fixed interest rate and payment make budgeting easier
  • You are protected from rate increases regardless of what happens to the economy

FRM cons:

  • The fixed rate is usually higher than the introductory rate of the ARM, so your payments will probably be higher, at least in those first few years
  • If interest rates fall, those with FRMs can’t take advantage of this without refinancing

Related: Guide to fixed-rate mortgages in 2018

Choose the FRM if you are uncomfortable with the possibility of an interest rate increase. This is especially true if you plan to keep your home for many years.

ARM pros:

  • The introductory interest rate of most ARMs is typically lower than that of FRMs, so your payment is lower (at least during the introductory period)
  • After the introductory period, if rates fall, your interest rate and payment will drop as well

ARM cons:

  • Your interest rate and payment can increase after the introductory period ends. This can make your loan unaffordable if you are unprepared
  • Qualifying can be more difficult because lenders know this loan is riskier

Related: 3 questions to ask yourself if considering an ARM

Choose an ARM if you want the lowest rate and payment right now, and are either sure that you will not keep the home much longer than the introductory period, or that your income will grow significantly in the future.

Conventional vs government-backed loans

You may be able to choose between government-backed loans like FHA, VA and USDA, and conventional mortgages, which the government does not insure. Conventional loans may require private mortgage insurance (MI) if your mortgage amount exceeds 80 percent of the property value.

Conventional loan pros:

  • If you have a substantial down payment, conventional loans are usually less expensive
  • Processing for conventional loans can be faster than government-backed loans
  • Conventional loans can finance second homes and rental properties

Conventional loan cons:

  • These loans typically carry stricter underwriting requirements
  • They can be more costly than government-backed loans if your down payment is low

Conventional loans: conforming or non-conforming

Conventional mortgages come in two forms:

  • Conforming (backed by Fannie Mae or Freddie Mac)
  • Non-conforming (all other non-government mortgages)

The terms “conforming” and “conventional” are often used interchangeably by writers and even some lending professionals, but that is technically incorrect. All conforming loans are conventional. But not all conventional loans are conforming.

Conforming mortgages comply (or conform) to guidelines issued by Freddie Mac and Fannie Mae so that one loan is pretty much like another regarding risk. The corporations pool the loans they buy, break them into shares like stock, and sell them to investors.

Conforming mortgage pros

Conforming mortgages are the most common and popular loans, and are widely available.

  • They are easy to shop for because there are many lenders and competition is fierce
  • Guidelines are standard, although individual lenders can add stricter requirements
  • Conforming loans are usually underwritten using automated underwriting software (AUS), which gives you a decision in minutes
  • Conforming loans, if you meet income eligibility limits, are available at up to 97 percent of the purchase price or property value
  • You can use conforming loans to purchase fixer-uppers and include construction costs
  • Conforming mortgages allow you to finance primary, vacation and investment homes
  • You can refinance and cash out home equity with a conforming mortgage

However, conforming home loans are not for everyone.

Conforming mortgage cons

Conforming mortgages have their limits. Literally.

  • Conforming mortgages are available only up to specific loan amounts. More expensive homes won’t be eligible
  • The loans have a strict set of guidelines that not everyone can meet
  • Conforming loans are considered very safe, plain vanilla loans. Which is great unless you don’t fit into that particular box — being self-employed, buying unusual properties or having credit issues, for instance

For most repeat buyers and many first-timers, conforming home loans are still the easiest and cheapest option.

Jumbo non-conforming

Non-conforming loans are conventional mortgages underwritten with different guidelines. In many cases, a loan is non-conforming simply because its amount is higher than allowed by Fannie or Freddie. For this reason, non-conforming loans in higher amounts are often called “jumbo” loans.

Related: How to use jumbo mortgages to buy high-priced homes

Rates for non-conforming mortgages tend to vary more because guidelines are set by the lenders themselves or a group of investors. Loans that require excellent credit, cash reserves, and higher down payments will usually carry lower rates than riskier products.

Jumbo loans can be less expensive than conforming loans if you choose an ARM product, beating fixed-rate mortgages by 2.5 percent or more. Because of the wider range of rates, it can really pay to shop more aggressively and contact more lenders.

Other non-conforming: portfolio and non-prime

Other programs that don’t conform to Fannie Mae or Freddie Mac guidelines include portfolio loans. Portfolio simply means that the lender keeps the loan in-house and does not sell it or offload the risk onto investors.

Because the lender is risking its own money, it can create almost any guidelines it wants — for example, allowing self-employed applicants to prove their income with bank statements instead of tax returns.

One type of portfolio lender specializes in “non-prime” lending. This is not the sub-prime lending that started the last housing crisis. If you have bad credit, you’ll need a significant down payment and proof of income.

Others who choose non-prime financing may have good credit, but they don’t have time to waste. They plan to fix and flip the house quickly, so they just want fast money and don’t care what the interest rate is.

Related: Crazy mortgage programs that really exist

Federal laws require all lenders to determine your ability to repay. This is called the ATR rule. However, you may be able to prove your income with bank statements rather than tax returns.

Portfolio lenders examine income, employment, assets, cash reserves, credit score, and DTI. There are other ability-to-repay qualifiers depending on your situation. Which qualifications count most depends on the type of home loan you’re getting.

Types of portfolio home loans

Portfolio home loans are designed to solve a variety of problems, so their costs and guidelines vary widely. For instance, the needs of a property flipper (fast cash) differ from a self-employed applicant who wants a forever home, or someone with credit problems but plenty of income.

Portfolio mortgages do require documentation, and it can be extensive. For instance, if you apply for a bank statement program, you may have to prove that you are self-employed, with a business license and perhaps financial statements, a physical address, and a business phone number.

Doctor and professional home loans

You’ve just left medical school in a whole lot of debt. Student loans and little savings can be a qualifying mortgage killer for new physicians. But, lenders may consider you a low-risk borrower since you’ll likely have years of steadily rising income. That can qualify you for specialized portfolio loans just for doctors. If you can show a future work contract, find a lender that provides these loans.

Other professionals like teachers also may have special mortgages offered to them. Compare these products to standard loans to see if they are really anything special.

Bank statement mortgages

These home loans are exactly what they sound like. You prove your income with bank statements instead of tax returns. You must usually be self-employed to be eligible for them. They’re best for those who have plenty of cash flow, but their tax returns show lower income due to high deductions.

Those in the gig economy who’ve got multiple income streams also can qualify, some with less than two years in business.

Related: Your profession could give you access to special mortgage programs

Lenders will expect at least 12 months of solid revenue inflows on your bank statements, and many require 24 months. They must show you can cover these loans and all other debts and expenses, including those for your business. What type of home loan you can get still depends on your credit score and down payment.

Investor residential loans

These mortgages are for experienced real estate investors who hold their properties for business purposes. Because lenders secure these mortgages with rental real estate, your personal income is not an issue as long as the property income is enough to pay the mortgage.

However, lenders will review the property’s cash flow and require sufficient debt coverage ratio. Expect that to be 1.0 (100 percent) for purchases, meaning that the property’s net operating income must be at least as much as the loan payments, and 1.25 (125 percent) for refinance loans.

SIVA stated income verified assets loans

Similar to bank statement loans, you won’t need income tax statements to qualify for a SIVA. Even though it’s called a s”stated income” loan, it’s not really. The lender uses your assets to estimate your income.

You’ll need a substantial amount of  highly liquid assets, like bank deposits or stocks, bonds, mutual funds, and similar investments that can be easily converted to cash. “Substantial” typically means at least five years of cash reserves to cover the mortgage and every other obligation, including child support, alimony, taxes, revolving, and installment debt plus monthly housing costs.

Bring at least 12 consecutive months of statements from your bank accounts, investment portfolios, IRAs or other retirement accounts and mutual funds to apply.

Portfolio loans for oddball properties

If you’re buying a property with quirks that won’t qualify for conforming mortgages like a condotel or non-warrantable condo. Properties not allowed by Fannie Mae or Freddie Mac might get financed with a non-qualified home loan. Expect to meet other criteria related to income, assets, and credit, though.

Costs and terms vary widely by the lender for portfolio loans. Shop around for these mortgages because two lenders on the same block might have entirely different offers for the same types of home loans. You don’t want to overpay

Portfolio loan pros

  • Portfolio loans offer alternative documentation flexibility. If you don’t have all the documents you’d have to proffer for standard, prime mortgages, you may still get a portfolio loan. That makes these loans more widely available for unconventional borrowers
  • Traditional employment isn’t always required for portfolio loans. Self-employed people who have variable but high revenue or multiple income streams with sufficient income can get these loans
  • Foreign nationals can qualify for some portfolio loans
  • Borrowers with higher debt may get portfolio loans. Depending on your income or asset situation, higher debt won’t disqualify you from these mortgages as long as you can prove you can repay them
  • Stellar credit isn’t necessary for many portfolio loans. Even if you’ve had a significant credit setback in the past like a bankruptcy or foreclosure, you may qualify for a non-qualified mortgage. It will depend on the reasons for the event and your current credit, asset, and income profile

Portfolio loan cons

  • Portfolio loans come with higher costs and interest rates. If you qualify for a “regular” prime loan, there is no reason to get a portfolio mortgage
  • Documentation isn’t optional with portfolio loans. True no-doc and stated income and asset loans no longer exist, and lenders want to protect themselves from legal liability. You’ll have to provide several verifiable documents specific to the type of home loan you’re applying to get. The more unusual your financial picture, the more records you’ll produce
  • Legal protections aren’t the same for portfolio loan borrowers. Qualifying mortgages have strict requirements for borrowers to meet because they provide legal protections if the buyer gets into trouble repaying. Don’t expect those protections with portfolio loans because they’re riskier by nature. You’re putting real skin in the game with these

Government-backed mortgages

For some borrowers, government-backed loans are the best fit (or sometimes the only option). The most commonly-used programs are FHA, VA and USDA home loans.

FHA loans

The FHA mortgage was created to expand homeownership in the US with low down payments and flexible underwriting. But FHA should not be considered the first choice just because you are a first-timer or have a small down payment.

Related: FHA home loans (the program first-time buyers love)

FHA loan pros

The FHA mortgage offers some unique advantages.

  • FHA home loans allow credit scores as low as 580 for a 96.5 percent mortgage and 500 for a 90 percent mortgage. However, few applicants with very low scores get loan approval. It depends on the cause of the scores
  • The FHA mortgage program allows down payments to be gifted by approved persons or borrowed under an approved program
  • FHA 203(k) home loans can finance fixer-uppers, with the loan amount being based on the improved value of the property
  • You can use an FHA loan to buy a home for a family member, such as a child in college, with minimal down payment

If you have a low down payment and less-than-perfect credit, the FHA may be your only option. But try less expensive programs first.

FHA loan cons

The FHA program may not be the best choice for those who have a larger down payment or applicants who qualify for Fannie Mae or Freddie Mac loan down payment products, which allow financing up to 97 percent of the home purchase price.

  • FHA mortgages require you to pay a 1.75 percent upfront insurance premium, which most borrowers add to their mortgage so it doesn’t have to come out-of-pocket
  • FHA also imposes monthly mortgage insurance premiums, and the only way to stop paying them is to sell or refinance your home. It doesn’t matter what your loan-to-value (LTV) ratio is.

FHA mortgage drawbacks mostly come down to costs. So compare with other programs first, then choose FHA if it does a better or less expensive job for you.

VA loans

Administered by the U.S. Veterans Administration, these home mortgages were created solely for U.S. military members and their families who meet specific criteria. They allow more military borrowers to overcome the challenges of high down payments and demanding credit requirements. There are numerous financial benefits to getting these loans, but there are some drawbacks, too.

Related: Everything you need to know about VA home loans

VA loan pros

  • VA loans are true “no money down,” 100% financing, lower interest rate no down payment mortgages. Expect lower closing costs, no PMI required, and no prepayment penalties
  • VA loans don’t have limits on the amount you can borrow. But the VA only guarantees up to the maximum established by Federal Housing Finance Agency guidelines conforming loan limits
  • VA loans are easier to get after bankruptcy and foreclosure. If you qualify, you could get a VA home loan two years after either event
  • VA lenders offer loans to those with lower credit scores and qualified borrowers with a DTI above 41 percent
  • Refinance your VA loans in two ways. Use the Interest Rate Reduction Refinance Loan (IRRRL) for existing VA loans, or you can refinance a other types of loans into a VA mortgage if you are eligible.
  • VA refinances allow 100 percent cash-out refinancing

VA loan cons

  • These loans are for primary residences only. You can’t use them for a second home or investment properties
  • They can take longer and be more complicated to close. Also, more stringent appraisal requirements may eliminate some homes from consideration for military buyers
  • VA loans require lenders to charge a mandatory funding fee to pay for the loan’s guarantee and operational cost. However, some VA borrowers can get it waived or refunded
  • Some VA lenders apply overlays, which are requirements that exceed the VA’s official minimum standards. For example, lenders may establish a minimum credit score, higher maximum debt-to-income, minimum loan amounts or restrictions on what you can buy

USDA loans

If you have a moderate -to low-income and live in rural America — which comprises the majority of the US land mass and includes about half the population — this home loan program may be your best mortgage.

Related: What is a USDA home loan (guidelines and rates for 2018)

There are two types: USDA Guaranteed 30-year from private lenders, and USDA Direct 33-38 year loan from the USDA directly. The Guaranteed program allows higher maximum incomes than the Direct program. The Direct program is only for those with very low income and offers subsidized interest rates as low as 1 percent.

USDA loan pros

  • Lower credit scores and bruised credit aren’t deal breakers for USDA loans. However, in most cases, you need a credit score of at least 640 to be eligible
  • Get a USDA home loan with zero down payment
  • Streamlined refinancing with USDA loans means faster closing, in an average of three weeks. The USDA does not require credit qualifying or an appraisal for most streamlined refinances

USDA loan cons

  • Household income limits apply, and there are maximum loan amounts. These loans are not meant to finance estates, just modest homes for people with income challenges
  • Not all home qualify for financing under the USDA loan program. You’ll only get financing on certain types of primary residences located in areas the government designates as “rural”
  • USDA loans only finances primary residences. You can’t get the mortgages for vacation properties or those with commercial concerns on the property, including farms.
  • USDA mortgages can be harder to find, depending on your location
  • USDA mortgages come with both a guarantee fee, which can be rolled into the loan, and monthly mortgage insurance premiums

Know your home loans

The mortgage lending environment is changing rapidly, so it’s more important than ever for you to do your due diligence before getting a mortgage. This guide provides a great starting point. But, be confident you understand how any loan you’re considering fits your financial picture.

Verify your new rate (Nov 20th, 2018)