Unless you’re lucky enough to be able to pay for a home entirely in cash, you’ll need a mortgage to buy one. Just as important as finding a home that fits your needs and budget, so is finding a mortgage.
With so many complicated requirements, understanding which mortgage is right for you can be hard. Here are some basics to get you started.
Fixed-Rate vs. Adjustable-rate Mortgages
Mortgage terms, including the length of repayment, are key factors in how a lender prices a loan and interest rate.
Fixed-rate loans are just what they sound like – a set interest rate for the life of the loan. The longer the term of the loan, the lower the payment. Thus, a 30-year fixed loan is a safe bet for those who plan to stay in their home long term. If a borrower has the resources to pay the mortgage off faster, a 15-year fixed loan can save a lot of interest.
Adjustable-rate mortgages (ARMs) have a fixed rate for an initial period of up to 10 years. Initial rates for ARMs tend to be lower than fixed-rate loans. Following the initial period, the rate begins to fluctuate with market conditions. Some ARM products have a rate cap so that the monthly mortgage payment can’t exceed a certain amount. If a borrower is willing to risk changing market conditions and changes in personal finance, ARMs have the potential to save thousands of dollars in interest in the initial years of homeownership.
Types of Mortgages
When considering types of mortgages, it’s important to clarify that the U.S. government is not a lender, but it does guarantee certain types of loans which meet rigid income, loan limit, and geographic area eligibility requirements.
Fannie Mae and Freddie Mac are two government-sponsored enterprises (GSEs) that are part of the private sector. Fannie and Freddie buy and sell most of the conventional mortgages in the U.S.
There are six types of mortgages:
#1 Conventional Loans
Conventional loans are some of the most common loans in California. If a borrower has good credit, a history of stable employment and income, and the ability to make a 3% down payment, they can usually qualify for a conventional loan backed by Fannie Mae or Freddie Mac. These borrowers will usually be required to pay private mortgage insurance (PMI) on top of their monthly mortgage payment. To avoid paying PMI, borrowers generally need to make at least a 20% down payment. Fixed or adjustable rates, as well as short or long terms, are all available with conventional loans.
#2 Conforming Loans
A conforming loan may not exceed maximum loan limits set by the Federal Housing Finance Agency (FHFA), which oversees Fannie Mae and Freddie Mac. These limits vary by geographic area and are higher in certain regions. Regions with higher limits are considered high-cost areas because home prices exceed the baseline loan limit by at least 115%. The FHFA set the baseline loan limit at $510,400 for a one-unit property in 2020. In Contra Costa County, the limit is currently $765,600 for a one-unit property.
To qualify for a conforming loan, borrowers generally need a credit score of at least 620, a debt to income ratio (DTI) below 50%, and a maximum loan to value ratio (LTV) of 97% – meaning they’ll need to put at least 3% down.
These factors are interdependent, so the exact requirements for a loan will depend on each individual’s application. For example, if a borrower’s credit score is on the lower end of the range of what qualifies, they might have to make a larger down payment or have a low DTI. Additionally, depending on their financial profile, they may need to have a few months’ worths of reserves. Reserves are cash savings that could be used to cover mortgage payments if a borrower were to unexpectedly experience financial hardship.
#3 Non-Conforming Loans
Jumbo loans are the most common type of non-conforming loan. They’re called “jumbo” because the loan amount typically exceeds conforming loan limits. In some instances, jumbo mortgages can exceed $1 million. Thus, this type of loan cannot be sold to GSEs. These loans are also riskier to lenders, so borrowers typically must show larger cash reserves, make a down payment of 10%-20% (or more), and have strong credit.
#4 Government-Insured Federal Housing Administration (FHA) Loans
FHA is one of the most popular government-insured home loan types. The money still comes from a bank or mortgage lender in the private sector, like a conventional home loan; however, FHA insures the loan. This type of loan has flexible qualification requirements, so is best for borrowers with low to middle-income or for those who can’t afford a significant down payment. FHA loans allow a credit score as low as 500 to qualify for a 10% down payment, and as low as 580 to qualify for a 3.5% down payment. One drawback is that all borrowers pay both an upfront and an annual mortgage insurance premium (MIP) for the life of the loan. MIP is a type of mortgage insurance that protects the lender from borrower default—for the loan’s lifetime.
#5 Government-Insured Veterans Affairs (VA) Loans
VA home loans are a type of loan that is similar to FHA loans in that the government backs it; however, the U.S. Department of Veterans Affairs guarantees this loan. This program is available to military service members and veterans, as well as their spouses in some instances. With a VA loan, eligible borrowers can purchase a home with no down payment. Other benefits include a cap on closing costs (which may be paid by the seller) and no MIP.
VA loans do require a “funding fee,” a percentage of the loan amount that helps offset the cost to taxpayers. The funding fee varies depending on the borrower’s military service category and the loan amount.
#6 Government-Insured U.S. Department of Agriculture (USDA) Loans
The U.S. Department of Agriculture guarantees loans to help make homeownership possible for low-income buyers in rural areas nationwide. These loans require little to no money down for qualified borrowers—as long as properties meet the USDA’s eligibility rules.
The Bottom Line
Every mortgage product is different and there are various programs available. Yet, the best option for you will depend upon your financial situation and the property being purchased. Mortgage lenders can help you analyze your finances and, if necessary, identify areas to improve so that you are in the strongest position possible to get a mortgage and buy a home. Let’s talk if you or someone you know could use recommendations to trustworthy local lenders.
