Anyone interested in applying for home loans, or just in learning more about them, may find themselves inundated with information, with endless details and distinctions, before they’ve even clicked on their first search result.
But you’ll find that as distinctive as they can be, most home loans fall into a few broad categories – and once you have a basic understanding of those, you can start to see which mortgage might be best for you, whether you’re an existing homeowner or a first-time buyer.
Requirements to Get a Mortgage
Before we get going, let’s run through basic requirements to get a mortgage. You should expect to have a few key things when you apply: Proof of income, proof of assets or funds (see our recent blog post on proof of funds for more), your credit score, proof of employment, and other documentation like your ID or Social Security card.
You might be wondering what kind of credit score is “good enough” for a mortgage, but the simple and complicated answer is that it just depends. The lowest mortgage interest rates generally go to customers with credit of 760 or above, but anyone with a credit score of at least 500 will find some options for them among the loans we cover here.
Conventional Home Loans
Conventional loans are the most popular type of mortgage in the US, funding an estimated 76% of new home sales in the second quarter of 2021. These loans are offered and secured by private lenders like banks and mortgage companies, as opposed to government agencies (we’ll get into government-insured loans later).
One of the best things about conventional loans is that there’s a large pool of plans to choose from. They offer a variety of options on loan terms, time frames, interest rates, and more; fixed-rate loans in particular are generally considered a steady, reliable choice.
On the other hand, conventional loans require a homeowner to pay private mortgage insurance (PMI), if they put down less than 20% as a down payment. PMI typically ranges 0.3% and 1.5% of the loan value, and is wrapped into your monthly payments – but once you’ve paid off 20% of your home’s value, you’ll no longer have to pay PMI for the remainder of the loan.
The toughest thing about conventional loans may be just that they’re harder to get. Most conventional loans require a down payment of at least 3 percent, a credit score of at least 620, and a debt-to-income ratio below 44%. Those who’ve suffered bankruptcy or foreclosure in the last seven years will also find it difficult to qualify.
There are two main loan types underneath the broader conventional loan umbrella: fixed-rate and adjustable-rate. Fixed-rate loans offer a 15 or 30-year term (the 30-year option is the most popular type of mortgage in the US) with an interest locked in from the start, so that payment amounts will always stay the same regardless of interest rate fluctuations.
This makes the loan a great choice for borrowers who have a strong financial profile, don’t plan to move in the near future, and would rather not have any surprises in store where monthly payments are concerned (though if interest rates go down, they could be missing a chance to save, unless they refinance). Lower payments can also give a borrower greater buying power over time, enabling them to afford a broader range of homes.
Unlike fixed-rate mortgages, adjustable-rate mortgages (ARMs) do fluctuate as interest rates change. After an initial fixed interest period – which typically ranges from 5-10 years, though it could be as short as a few months – when borrowers pay a fixed-rate, monthly payments will adjust with interest rates, usually once a year.
ARMs are generally easier to qualify for than fixed-rate loans, and the initial fixed-rate period also offers lower interest and payments than a loan that’s fixed-rate from the start — so they can be a good choice for first-time buyers. For those who anticipate moving and selling their home – or paying off the loan with a financial windfall – before the adjustable-rate payments kick in, an ARM can also be a smart way to arrange lower monthly payments.
Of course, there’s always the risk that things don’t go as planned and these buyers will still find themselves in their home when higher payments kick in. Fluctuating mortgage payments can also be stressful at the best of times (though some lenders will cap how much your monthly payment can change), and some ARMs also have prepayment penalties.
Jumbo home loans are conventional loans that are considered too high to be guaranteed by Fannie Mae or Freddie Mac. (Loans below that threshold are known as conforming loans.) These limits can change depending on where you live, and are updated periodically; in 2022, the average cap for a single-family home in most areas of the country is $647,200, though in higher-cost areas, that ceiling could rise to nearly $1 million.
These loans can open the possibility of a larger or more luxurious home, a property with more land, or a residence in a high-price area like New York City. They’re also an option to consider for someone wanting to consolidate several smaller loans into one.
That said, as jumbo loans are considered high-risk to lenders, they also come with more paperwork, higher credit requirements (typically 700 or above), and higher down payments (usually 10% or more).
Borrowers with good credit and substantial cash reserves may find jumbo loans a good choice, to close the gap to a higher-priced home. But for those who could never afford such a home otherwise, they’re not the most realistic – or prudent – choice.
Government-Insured Home Loans
These loans are backed by the US federal government, and come with more relaxed borrowing standards than most conventional loans. This makes them an excellent option for borrowers whose finances don’t clear that standard, and for first-time buyers, who may not have the savings and demonstrated ability to pay what private lenders like to see.
The trade-off can be that these loans can come with more strings attached on certain issues: For example, government-insured loans are only meant for single-family homes that constitute someone’s primary residence, and don’t apply to secondary residents like vacation homes, or real estate investments.
There are three kinds of government-insured home loans, which we’ll cover next.
FHA Home Loans
The most popular government-insured mortgage is the FHA loan, backed by the Federal Housing Administration. Designed to put home ownership in reach of low- and middle-income buyers, FHA loans have relatively forgiving requirements: applicants with credit scores of 580 or higher can qualify for a mortgage with a 3.5% down payment, and those with credit of 500-579 can still qualify, if they put down a 10% down payment. These loans also tend to have lower closing costs than conventional mortgages. However, just like conventional loans, primary mortgage insurance is required for FHA loans — and unlike conventional loans (which drop PMI payments after the borrower has paid off 20% of the home), FHA loans require PMI for the lifetime of the loan. They also charge an upfront mortgage insurance premium of 2.25% of the loan’s value, either paid in cash when you get the loan or rolled into the loan.
USDA Home Loans
USDA loans are backed by the U.S. Department of Agriculture, and are designed for would-be homeowners in rural areas who might not qualify for a conventional loan. (Keep in mind that here the word “rural” doesn’t necessarily mean that you’ll be living in a farm – just that you live in a neighborhood with a population below certain limits, which can include plenty of suburbs and towns.)
Because the government finances 100% of the home price, no down payment is necessary for USDA loans. They also offer discounted mortgage interest rates, and the seller of the home may pay the closing costs. There’s no pre-payment penalty, and the loan can be used to purchase land, fund renovations or repairs, or build a new home, in addition to a mortgage (see more on construction loans below).
A major potential downside, of course, is that USDA loans restrict where you can live. There are also income limits on who qualifies, USDA loans require mortgage insurance, and adjustable loans are not available; all USDA loans are a 30-year, fixed-rate mortgage.
But for those who are building their credit or struggling financially, and don’t mind ruling out major metropolitan areas, a USDA loan could be a great way to make home ownership more affordable.
VA Home Loans
Backed by the U.S. Department of Veterans Affairs, the VA loan is available to those on active military duty, veterans who have served for a certain amount of time, and surviving spouses of veterans. And for those who qualify, the VA loan is in many ways the best option out there.
The VA loan requires no down payment, no PMI, low closing costs, and no prepayment penalties. They can be fixed-rate or adjustable, and offer flexible refinancing. They also generally have a lower credit score threshold than many other loans. It’s worth noting that while borrowers don’t have to pay closing costs, they do have to pay a funding fee, which comes to 2.3% of the loan principal – either paid at closing, or rolled into the rest of the loan. And like USDA and FHA loans, VA loans can’t be used for secondary residences or investments.
A construction loan is any loan– either conventional or government-backed — that covers the construction or renovation of a home. They generally fall into three broad categories:
Construction-Only Loans are short-term (typically one year) and are considered specialty financing, with higher interest rates than a typical home loan. This loan does not include a mortgage, which the homeowner must acquire separately for the completed home.
Construction-to-Permanent Loans fund both the construction and subsequent mortgage, rolled into one loan. During the construction phase, borrowers only make payments on the interest, and principal payments start when the home is completed. All the government loans we’ve discussed also offer the option of construction-to-permanent.
Renovation Loans, also known as 203(k) loans, can be used for home renovation and are insured by the Federal Housing Administration (FHA). 203(k) home loans can be used either for renovation of your existing home, or to renovate one you’re purchasing, and can be either construction or construction-to-permanent.
Interest-only mortgages require payments only on the interest charge of the home loan, and not on the loan principal itself, for an initial period (typically no more than 5 years, although some lenders will allow up to 15). After that, payments go up substantially, as payments on the principal kick in.
This kind of loan can be a good option for homebuyers who don’t expect to stay in their home for the long term, and can sell again before the higher payments begin. It can also work for homeowners who plan to stick around, if they have the discipline and cash flow to make periodic principal payments during the interest-only period.
An obvious drawback to this approach is that for that period of time, you’re not building equity into your home, unless you make voluntary principal payments. There’s a risk of payment shock when payments suddenly increase, especially if you’d planned to be out of the home (or to have paid it off) by then.
For these reasons, interest-only mortgages are more often used by investors as a way to manage their cash flow than by people financing their own home.
Piggyback loans are a second mortgage that a homebuyer takes out at the same time as their first mortgage, secured with the same collateral (most often the home itself). Typically the first mortgage is fixed-rate, and the second piggy-back mortgage is adjustable-rate.
These kinds of loans are most commonly used to avoid the PMI requirements that come from putting down less than 20% as a down payment. The most common approach is known as 80/10/10: The first loan is 80% of the home’s value, the second is 10%, and the remaining 10% is paid by the homeowner as the down payment.
They can also be useful to buyers who find their dream home earlier than expected (say, before they sell their current home), and need funds to purchase their new home while they await proceeds from the sale of their old one.
Piggyback loans can be hard to get, typically requiring credit scores of at least 700. They can also end up being more expensive than you’d think, as you’re paying closing costs, origination fees, and administrative fees on two loans. The second mortgage will also likely carry a higher interest rate, and can make it harder to refinance down the road.
When all is said and done, perhaps the most important thing to remember about home loans is that there is no one-size-fits-all. What’s perfect for one homeowner might be a bad choice for another, and one of the best ways to cut down on unnecessary stress in home financing is to make sure you’ve picked the right mortgage for you.