What are the Different Types of Mortgage Loans?

You have probably encountered the often-complicated world of mortgage rates, types and terms if you are interested in buying a home.

Although discussions about mortgages can be confusing, they do not have to be.

What types of mortgages and loan terms you have access to depend largely upon your credit rating. Whether or not you can make a down payment on a home and, if so, how much you can put down also strongly influences the terms of your home loan options. Understanding the primary types of home loans available to you and the key differences between them can help you make smart financial decisions when buying your home. It can also prevent significant stress and risk down the line.

What is a mortgage?

A mortgage is simply a loan that you take out for the express purpose of buying a home. Mortgages are like all loans in that you borrow money from a lender with an agreement to pay it back over a set period of time with interest. Unlike most other loans, mortgages typically span very long periods of time. Many are for 15, 20 or even 30 years.

Which type of home loan is the best?

While mortgage terms can vary widely, the most important difference to consider when selecting a loan is how interest rates are calculated and managed. Most mortgages fall in one of the three following categories:

  1. Fixed Interest Rate Mortgage
    In a fixed rate mortgage, you and your lender agree upon an interest rate at the time of signing. That rate continues to apply for the duration of the loan, regardless of fluctuations in the larger market. For instance, if you agree to an eight percent interest rate, then you will pay eight percent for the lifetime of the loan even if the market rate drops to four percent or raises to 10 percent over that time.
    Fixed rate mortgages are beneficial in that you always know exactly how much you will be charged and you are protected against costly interest rate The downside of such terms is that if rates drop and remain low, then you will not benefit from the change but continue to pay the higher agreed upon amount.
  2. Adjustable Rate Mortgage
    In an adjustable rate mortgage, or ARM, you pay a fixed interest during the initial period of your loan. After that period, your mortgage is subject to whatever the market rate is when each payment is due. For example, you might pay eight percent interest for the first year and then switch to owing-market rates. On some payments, you might be charged a lower rate, such as six percent, when the market drops. On others, when the market rate increases, you would be charged more interest, raising your monthly payments and the overall cost of repaying your loan.
    ARMS benefit you in that if prices drop after you buy your home, then you are able to take advantage of the best mortgage rates, as you are not locked into higher interest costs. However, they can also be risky because if interest rates continue to go up after you buy your home, then you can end up owning significantly more money than you anticipated or were prepared for over the lifetime of your loan.
  3. Interest-Only Mortgage
    In an interest-only mortgage, for the first five to 10 years of your repayment period, you pay only the interest on your loan. Principle payments are deferred. This allows you to pay much lower amounts initially. After the initial interest-only term ends, your mortgage lenders will charge your both interest and principle, leading to larger monthly payments.
    The benefit of these loans is that initial payments are typically very low, which can help people who want to purchase a house but who do not have much more to put toward a mortgage at the moment. The risk associated with these loans is that payments will increase by a generous amount at the end of the initial term. If you have not increased or adjusted your income or cash flow to meet those higher payments, then you risk defaulting on your loan and losing your house.

What other types of mortgages exist?

Besides traditional loans through private lenders, there are also government loans for veterans, low-income families and farmers. Government organizations that provide these loans include Veterans Affairs (VA), the Federal Housing Administration (FHA) and the United States Department of Agriculture (USDA).

FHA loans are provided to home buyers who are otherwise unable to obtain a loan. These loans are provided by approved third-party lenders and insured by the FHA, which means the FHA will repossess and re-sell a home if the homeowner defaults on his or her loan. Homebuyers may qualify for a down payment as low as 3.5 percent of the total cost and with credit scores as low as 580 because of this added protection. However, they must also purchase mortgage insurance, which will increase their monthly payments.

VA home loans are similar to FHA loans because they are insured by the VA. As a result, lenders are willing to take a chance on these applicants, even if they do not have the best credit scores. Service members, veterans and their immediate families may qualify for these loans. Once an applicant receives approval for VA insurance on a home loan, he or she is responsible for researching different homes and lenders available.

Government loans for houses also exist through the Rural Housing Service (RHS), which is run by the USDA. To qualify, applicants must be rural residents on a low income who have yet to receive approval for a conventional home loan. In addition, the incomes of applicants must not exceed 115 percent of the adjusted area median income (AMI).

How much mortgage can I get approved for?

“How much mortgage can I get approved for?” is a common question. This is understandable considering the critical role it plays in your ability to obtain the kind of housing you want and what areas you will be able to afford to buy in. Lenders calculate the total amount of money for which you qualify primarily using your:

  • Current debt load.
  • Credit rating.
  • Anticipated down payment.
  • Desired mortgage duration (e.g. 15 years, 30 years)

You can use a free online mortgage qualification calculator to explore your mortgage options. Experimenting these calculators can be extremely informative. For instance, you may find that increasing your hypothetical down payment by a few thousand dollars noticeably improves the interest rates available to you or reduces your monthly payments by a larger than expected amount.

Loan calculators are not guaranteed. Each lender will apply its own specific calculations, and individual lenders may weight various factors differently. For instance, some lenders will emphasize the importance of a good credit rating, while others might give preference to those with large down payments. Still, mortgage calculators can give a strong idea of the general funding range for which lenders might qualify and what their monthly payments will look like.

After you have received your mortgage and purchased your house, you will enter the loan repayment period. Each month, your mortgage company will issue you a bill. Depending on the type of mortgage you have, the bill may include both interest and principle or just interest. It may be the same every time or it may change based on fluctuations in current mortgage rates if you have an ARM.

If you continue to make payments on time, then you will steadily reduce the amount of money you owe in both interest and principle. At the end of the loan term, when you make your final payments, your mortgage will be closed out and you will be the full legal owner of your home. In most cases, if you sell your home before your mortgage term ends, then you can use the money you receive from the sale to pay off the remainder of your loan.