Homeownership is one of the highly coveted life goals and a pinnacle of the American dream. Decades ago, buying a home was a hassle since banks and lending institutions were very specific about who could qualify for a loan. That meant most wannabe homeowners who didn’t meet the high-income limits or raise the required down payment didn’t have a chance.
Nowadays, owning a home is a lot easier, thanks to the many mortgage programs offered by different lenders and even government institutions. Before we explore the common types of mortgages, let’s first understand how these loans work and how to apply for one.
Getting a Mortgage
A mortgage loan is a financing option where a lender pays for your home with the agreement that you’ll pay back the principal plus interest over a set period. Like any other loan, a mortgage has terms and conditions that dictate how much the borrower will pay per month, the interest rates, and what happens in case of default. The typical mortgage repayment period ranges between 10 and 30 years.
Before qualifying for any mortgage product, the lender will evaluate your application to check if you meet the eligibility requirements. The latter often varies among lenders and is based on the mortgage product you want. For instance, the loan requirements for USDA loans vary from that of conventional loans. Some of the basic mortgage loan requirements include:
- Credit Score. This measures your creditworthiness or how likely you are to repay a loan. Most lenders expect borrowers to have a credit score of 680 and above. A score of 740 to 799 is considered ‘very good’ while a score of 800 and above is considered ‘excellent,’ and most lenders will be comfortable approving a higher loan amount. Lenders look for certain factors when determining your credit score. These include your recent loan amount, repayment schedule, and how often you missed a payment.
- Proof of income. Proof of income assures the lender that you have an income source and can meet the monthly payments. Some lenders will pay attention to proof of income and assets to minimize the risk of default.
- Debt-to-income ratio. The debt-to-income (DTI) ratio measures your monthly expenses or debt to your income. The standard DTI for most lenders is 36%, meaning you should make and keep more money than you spend. A higher DTI, often above 50%, shows that you spend more than you earn, which is usually a sign of accrued debts or poor financial management.
- Property Requirements. Before a lender finances your home, the property will undergo a home inspection and appraisal to ensure it meets some quality standards. The appraisal process varies from one loan and lender to another.
If you are looking forward to taking out a mortgage in the near future, below are the four main types you’ll choose from.
Four Types of Mortgages
Mortgage loans can be classified in one or more categories depending on factors such as the maximum loan amount and whether it’s guaranteed/insured or not. There are four main types of mortgages under which you can classify different loan products in the market. These are:
1. Conventional Mortgages
Conventional mortgages are offered by private lenders. These housing loans come with stricter requirements, such as credit score and debt-to-income ratio. The minimum down payment for this loan is 3% and attracts a slightly higher private mortgage insurance (PMI). The latter is an insurance cover that protects the lender in case the borrower defaults, dies, or cannot meet contractual obligations.
Any mortgage product whose down payment is less than 20% of the loan amount attracts a PMI. You will pay this premium with conventional mortgages until you’ve built a 20% equity in your home. The benefit of conventional mortgages is that a larger down payment affords you a lower interest rate. You can buy virtually any property, provided it passes the inspection and appraisal process.
Some cons of conventional mortgages include a costly PMI and higher rates if you don’t make a sizable down payment. This loan product is ideal for borrowers with stable incomes and excellent credit scores.
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2. Fixed-Rate Mortgage
As the name suggests, a fixed-rate mortgage features a fixed interest rate throughout the loan duration. The nature of the loan makes the monthly payments quite predictable, hence easier to plan for. Still, it’s worth noting that property taxes and insurance may fluctuate during the loan duration.
Most lenders offer fixed-rate mortgages to attract borrowers who value predictability in their mortgage repayment. Unlike adjustable-rate mortgages, this loan product is ideal for someone who’s buying a ‘forever home.’ The latter could be expensive but has everything that you desire in a home; hence you have no plans of moving out soon.
The risk of a fixed-rate mortgage is that once the rates have been locked, you won’t change them unless you refinance. If the market rates drop, you could end up overpaying thousands of dollars.
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3. Adjustable-Rate Mortgage
With adjustable-rate mortgages, the interest rates change depending on the market conditions. Typically, the rates are fixed for a given period, say 5, 7, or 10 years, called an introductory period; then, it becomes adjustable for the remaining period. The fixed interest rates during the introductory period are often less than that of the 30-year fixed mortgage.
This loan product also comes with rate caps to protect borrowers and lenders from sudden fluctuations. In other words, there’s a limit on how low or high the interest rates can go. Adjustable-rate mortgages are ideal for borrowers who want to pay more towards the loan early on, i.e., during the fixed-rate introductory period.
The benefits of adjustable-rate mortgages are lower introductory rates, while the drawback is that high-interest rates mean you are paying more for the remaining loan duration. This mortgage is ideal for borrowers buying a starter home, meaning they don’t necessarily have to live in that home for the entire loan term.
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4. Government-Backed Loans
Last but not least are the government-backed loans, which consist of loan products such as FHA, VA, and USDA loans. All these loans are guaranteed by the government, meaning they are less risky for lenders. In case of a default, the government will pay a portion of the loan amount. Below is a quick overview of the popular government-backed loans:
- FHA loans – These loans are insured by the Federal Housing Administration and issued by a bank or approved private lender. The loan is available for borrowers with a lower credit score, e.g., in the higher 500s and low 600s. It features a minimum down payment of 3.5% and mortgage insurance paid upfront and in monthly installments.
- VA loans – these loans are designed for qualifying veterans and their spouses. It’s a zero-down payment, low-interest rates offered by approved lenders, and backed by the Department of Veteran Affairs.
- USDA loans – These are zero-down, low-interest loans issued by approved lenders and guaranteed by the U.S. Department of Agriculture. It targets borrowers with low to medium income below 115% of the area median income.
All government-backed loans are non-conforming since they do not adhere to the requirements of Freddie Mac and Fannie Mae. Another example of a non-conforming loan is a Jumbo loan, ideal for high-net-worth individuals looking to buy high-value property. A jumbo loan is a product above a conforming loan limit of $647,200.
Loan Closing and Moving to Your New Home
You can apply for any of the loan products listed above based on your needs and qualifications. If your application goes through to final approval, you’ll proceed to close and be ready to take ownership of your new home.
After signing the closing documents, you’ll have 60 days to move in. This applies to all owner-occupied properties, so you want to find reliable movers who can beat the deadline, i.e., whether you are relocating from another town, city, state, or even country.