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Buying a home is perhaps the most exciting phase of life. But, figuring out the financing part of the deal may seem a tad overwhelming. Well, you needn’t worry. Choosing from the various types of home loans out there isn’t all that painful, if you know how to. 

All it takes is some research to get a better idea of which loan works best for your needs. Keep in mind that your loan choices depend on where you live, how long you plan to live in your house, or if you’re looking to buy a real estate merely as a financial asset for a good return on investment (ROI). 

The answer to these will make certain types of home loans better suited for you over others. Choose wisely and you could save a bundle on your down payment, fees, and interest. This guide will help you know about the types of loans available and the advantages and disadvantages for each of them. FYI, These types of mortgage loans are well-suited for first time home buyers too. 

1. Conventional loans 

Conventional mortgage is a type of home loan that’s not insured by the federal government. It’s a deal between you and your money lender, but has to meet certain guidelines by agencies such as Fannie Mae. 

There are two types of conventional loans: conforming loans and non-conforming loans, depending on your loan amount. 

  • Conforming loans

Here, the loan amount falls within maximum limits set by Fannie Mae or Freddie Mac. You’ll pay a lower interest rate than non-conforming loans. For instance, the average 15-year rates are under 4% while they’re over 4% on jumbo loans, one of the most popular non-conforming loans.

  • Non-conforming loans

As the name suggests, you can exceed the loan amount limits of conforming loans — making it easy for you to buy a higher priced home. But, keep in mind that these loans require excellent credit scores and larger down payments. Moreover, they have higher interest rates.

Conventional loan

Pros Cons Ideal for
  • The loan can be used to buy a primary home, second home, or investment property
  • You require a minimum FICO score of 620 or higher
  • Borrowers with a strong credit score, a good and stable income as well as employment history
  • Lower borrowing costs than other types of loans 
  • Your debt-to-income ratio should be 45 to 50 percent
  • You can cancel PMI once you’ve gained 20 percent equity
  • A PMI must be paid if your down payment is less than 20 percent of the sales price
  • You can pay only 3 percent down payment (for Fannie Mae or Freddie Mac loans)
  • You require documentation to verify your income, assets, down payment, and employment history
 

2. Government-insured loans

Getting a loan

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Although the U.S. government is not a lender, it does help Americans in achieving their dream of becoming homeowners. There are three types of home loans that are government-backed. These include the Federal Housing Administration (FHA loans), the U.S. Department of Agriculture (USDA loans), and the U.S. Department of Veterans Affairs (VA loans). Let’s explore each of them for better understanding.

  • FHA loans

These loans are ideal for borrowers who cannot afford a large down payment and don’t have an excellent credit score. A minimum FICO score of 580 is enough to get FHA’s maximum 3.5 percent financing. In some cases, a credit score of 500 is accepted too, but with at least 10 percent down payment. 

Keep in mind that FHA loans require two mortgage insurance premiums. You can pay private mortgage insurance for one upfront and the other annually for the entire loan term if you put less than 10 percent down. On the downside, this requirement can increase the overall cost of your loan.

  • VA loans

VA loans are especially designed to provide flexible, low-interest home loans to active as well as veteran members of the U.S. military and their families. 

To make VA loans more affable, there’s no requirement for a down payment or PMI. Moreover, the closing costs are generally capped and paid by the home seller. 

However, there’s a funding fee on VA loans (a percentage of the loan amount) to help offset the program’s cost to taxpayers. 

  • USDA loans

These loans are great in helping moderate- to low-income borrowers who want to buy a home in a rural area or a USDA-eligible area. Most USDA loans do not require a downpayment for eligible borrowers with low incomes.

Government-insured loans

Pros Cons Ideal for
  • You can finance a home if you fail to qualify for a conventional loan
  • Mandatory mortgage insurance premiums
  • For borrowers who have low cash savings, less-than-perfect credit score, and don’t qualify for a conventional loan
  • VA loans are for military borrowers
  • Relaxed credit requirements 
  • Higher borrowing costs (overall)
  • No requirement for a large down payment
  • Requires detailed documentation to prove eligibility
  • Open to repeat as well as first-time buyers
 


3. Fixed-rate loans

In the case of fixed-rate mortgages, you pay the same interest rate over the entire life of your loan, typically 15 years, 20 years, or 30 years. The rise and fall of market interest rates won’t affect your monthly mortgage payment in this predictable loan type. But, you will have to give a down payment. 

Such a home loan is best for people who plan to stay in their home for the major part of their loan term. It’s not a good option for those who might move in the near future. 

Read more: What Home Lenders Should Tell You

Fixed-rate loans

Pros Cons Ideal for
  • Monthly principal and interest payments remain same throughout the loan term
  • Higher interest rates
  • Homebuyers who prefer predictability and stability with monthly payments
  • Those who are planning to stay in their home for at least seven to 10 years
  • Helps you better budget other month-to-month expenses 
  • It takes longer for you to build equity in your home


4. Adjustable-rate loans

Adjustable-rate mortgages (ARMs) come with fluctuating interest rates — rising and falling according to market conditions. Sometimes, ARM products begin with a fixed interest rate for the initial years before resetting to a variable interest rate for the rest of the term. 

It’s best to find an ARM loan that offers a maximum cap on the interest rate or monthly mortgage rate so you don’t wind up in financial trouble when the rates shoot up.

Adjustable-rate loan

Pros Cons Ideal for
  • Offers a lower fixed rate in the first few years of homeownership
  • Your monthly mortgage payments may become too high due to the fluctuations
  • Those who plan to move and sell their home before their fixed-rate period is up
  • Borrowers with lower credit scores who anyway can’t get good rates on fixed-rate loans
  • Homebuyers who’re comfortable with a certain level of risk
  • It’s easier to find competitive mortgage rates 
  • If home values fall, it might be difficult to refinance or sell your home before the loan resets
  • Comes with a pre-approval option
 


5. Equity loans

loan application

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Home equity loans give you access to large amounts of money as you’re putting up your home as collateral. Here, you borrow money against your home’s value minus the amount of any outstanding mortgages on the property. Of course, using your home to guarantee a loan comes with some risks. Home Equity and Home Equity Line of Credit are popular types of equity loans. 

Check these First Time Home Buyer Loans

Here, you get lump sum cash upfront when you take out a loan. Your interest rate is set at the time of the borrowing and remains the same for the loan term. Therefore, you have fixed monthly payments, with each payment reducing your loan balance and covering some of your interest costs. 

This loan gives you access to a line of credit from which you can borrow multiple times whenever you require the money. In a way, a HELOC is like a credit card. You don’t receive a lump sum but rather a maximum borrowing amount available for you. A HELOC has varying interest rates. But the good thing is that you only pay interest on the amount you actually use from the available money.

Equity loans

Pros Cons Ideal for
  • Good loan option if you use it to buy, build, or improve your home
  • In case of any failure to make the loan payments, you risk losing your home to foreclosure
Those with good home equity
  • You can claim a tax deduction on the interest
  • If you plan to sell your home, you’ll have to pay off this debt immediately
  • Using your home as collateral ensures lesser interest rates
  • You will have to pay closing costs


Read more:
Home Equity Loans vs Home Equity Lines of Credit 

Last thoughts

Out of the different types of home loans available, you must select the right one for buying your dream house. Trust us, it pays to familiarize yourself with all the available choices. We hope this guide helps you get a good idea of which loan might provide the best value for you. Happy home buying!

You can take a look at our guide on HELOC on rental property here.

Types of Home Loans: Which One Is Right for You? was last modified: December 1st, 2020 by Ramona Sinha
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