Mortgage Loan Programs 101: What are the most common loan types?
When buying a home, finding the right type of mortgage is critical. With so many options available, from 30-year fixed-rate loans to adjustable-rate mortgages (ARMs), Government loans, and other loans for non-traditional borrowers, it’s easy to feel overwhelmed. However, understanding the basics of the most common loan programs can help you prepare to take this big step forward. In this blog post, we’ll explore the details of each loan type, so you can decide which mortgage loan program is right for you.
A 30-year fixed-rate mortgage loan is one of the most popular loan options for homebuyers. As the name implies, this mortgage loan program comes with a fixed interest rate for the entire 30-year term. The monthly payment is predictable and remains the same throughout the loan’s term. This loan is an excellent option for homebuyers who want a consistent monthly payment and plan to stay in their home for a long time.
30 year fixed-rate
Pros:
Stable monthly payments: With a 30-year fixed-rate mortgage, you will have a consistent monthly payment for the entire loan term, making it easier to budget for other expenses. The payments remain the same, even if interest rates rise, adding a layer of financial security that many homebuyers appreciate.
Lower monthly payments: Compared to shorter-term loans, such as 15-year loans, a 30-year fixed-rate mortgage will have lower monthly payments due to a more extended repayment period. This lower monthly payment may make homeownership more affordable for buyers who need more financial flexibility.
Cons:
Higher interest rates: While 30-year fixed-rate mortgages offer stability, they come with higher interest rates than shorter loan terms. This means that you may end up paying more in interest over the life of the loan than you would with a shorter-term loan.
More interest paid over the loan term: As mentioned earlier, a 30-year fixed-rate mortgage accrues more interest over its life than shorter-term loans, making it a pricier option.
ARMs
An adjustable-rate mortgage, or ARM, is a mortgage loan with a low introductory interest rate that adjusts periodically over the life of the loan. An ARM is an excellent choice for buyers who plan on selling or refinancing their home within the first few years, as it offers a lower initial monthly payment. While they can be appealing due to their low initial interest rates, they aren’t without their drawbacks.
An adjustable-rate mortgage’s interest rate has two components: a base interest rate and a margin. The base interest rate, also known as the index, is a publicly available interest rate that fluctuates throughout the life of the loan. Commonly used index rates include the LIBOR (London Interbank Offer Rate) and the COFI (Cost of Funds Index). The margin is a fixed percentage added to the base interest rate to determine the overall interest rate.
It’s important to note that while the base interest rate can fluctuate, there is a cap on how much it can increase or decrease. This cap is typically around two percentage points per year and is known as the periodic cap. There is also a lifetime cap that limits how much the interest rate can increase over the life of the loan. Understanding these caps is essential because they can impact your monthly payments throughout the life of the loan. Before making this choice, you should speak with a licensed loan officer to learn all the details of an ARM.
Pros:
Lower monthly payments: Due to lower interest rates during the introductory period, ARMs provide a lower monthly mortgage payment for the initial term of the loan. Some common terms include:
3/1 ARM, 5/1 ARM, 7/1 ARM and 10/1 ARM. The first number refers to the length of the initial fixed rate, and the second number refers to how often the rate adjusts after the initial term. So, the 5/1 ARM’s introductory period ends after five years and adjusts once a year after that.
Flexibility: ARMs provide homeowners with financial flexibility for the initial term of the loan, allowing them to use the savings for other expenses.
Cons:
Difficult to Budget: Because the interest rates on your mortgage can change after the initial fixed-rate period, it can be challenging to budget your monthly expenses and manage your finances.
Prepayment Penalties: Some ARMs can have prepayment penalties. So, if you plan on paying off your mortgage or refinancing in the future, you should check into this before getting an ARM.
FHA
An FHA loan is a government-backed loan that is more relaxed regarding underwriting standards and down payment requirements than conventional loans. It’s an attractive option for first-time homebuyers with a modest income or low credit score. With an FHA loan, the buyer must have a credit score of at least 500 and pay a minimum down payment of 3.5%. The government backs this loan, which allows lenders to offer competitive interest rates.
Pros:
Low Down Payment: One of the most significant advantages of an FHA loan is its “low down” payment requirement. Borrowers can qualify with a 3.5% down payment, making it an attractive option for first-time homebuyers who typically have limited funds for a down payment.
Lenient Credit Requirements: FHA loans are more forgiving regarding credit scores. While borrowers need a credit score of 700 or above to qualify for a conventional loan, FHA borrowers may qualify with a 580 or above. This aspect of FHA loan eligibility can be a significant advantage for those with lower credit scores.
Fixed-rate Loans: FHA loans allow higher debt-to-income (DTI) ratios than conventional loans. To calculate DTI, take all monthly debt payments and divide them by gross monthly income.
Cons:
Mortgage Insurance Premium: All FHA loans require the payment of an upfront mortgage insurance premium (MIP), which can be a significant expense. The MIP must be paid in cash when you close on the loan or rolled in the loan amount.
Lower Loan Limits: FHA loans have lower loan limits than conventional loans, which means that borrowers may be unable to purchase a more expensive home. The loan limits vary by county but are generally lower than conventional loans.
Higher Interest Rates: FHA loans may have higher interest rates than conventional loans due to the relaxed borrower eligibility requirements.
VA
The VA loan program is designed for veterans and active military personnel. VA loans do not require a down payment, which makes them very attractive for those who qualify. The interest rates on VA loans are very competitive, and there is no mortgage insurance requirement, resulting in lower monthly payments.
Pros:
No Down Payment: This is one of the most significant advantages of a VA loan. Traditional mortgages usually require a down payment of about 20 percent.
Competitive Interest Rates: Typically, VA loans come with low-interest rates when compared to the rates of traditional mortgages. Lower interest rates could mean substantial savings over the life of the loan.
Easy Qualification: VA loans usually have less stringent credit score and income requirements when compared to traditional mortgages.
Cons:
Funding Fee: VA loans come with a funding fee, contributing to the program’s cost. There are some exceptions, primarily if the borrower receives disability compensation.
Property Limitations: VA loans can only be used for primary residences but not for investment properties. If you intend to use a VA loan for your primary residence, it should meet the VA’s minimum property requirements.
Limited Property Types: It is essential to note that VA loans may not be available for all property types. Borrowers can use a VA loan to purchase a single-family home, VA-approved Townhome or Condo, and some modular homes. Check with your loan officer for additional clarification on property types.
VA Appraisal Process: Before your VA loan application can be approved, the property must undergo an appraisal process, and the VA sets strict guidelines for appraisal and inspection. If the appraisal comes back low, it could impact the loan processing time or even application approval.
USDA
A USDA loan is a mortgage loan backed by the United States Department of Agriculture designed for rural and some suburban homebuyers. The property must be located in a USDA-eligible area to be eligible for a USDA loan. The USDA loan has lenient underwriting standards and requires no down payment. It offers fixed interest rates and affordable monthly payments.
Pros:
No down payment required: The most significant advantage of a USDA loan is that it requires no down payment. This feature can be particularly beneficial for first-time homebuyers who may struggle to save enough money for a down payment. It also allows borrowers to keep their savings for unforeseen expenses.
Lower interest rates: USDA loans offer lower interest rates than conventional mortgages. This is due to the government backing and the fact that they are meant for low- to moderate-income families.
Flexible credit requirements: While USDA loans have credit score requirements, they are often more relaxed. Borrowers with a lower credit score may still be able to qualify for a USDA loan.
Cons:
Property location restrictions: The biggest drawback of a USDA loan is strict property location requirements. To be eligible, the home must be located in a rural area or approved suburban area, which can limit the options for some borrowers.
Income limitations: While USDA loans are designed for low- to moderate-income families, there are still income limitations. Borrowers must meet specific income requirements to qualify for a USDA loan.
Upfront fees: USDA loans require an upfront fee at closing.
Lengthy processing time: USDA loans can take longer to process and close than other mortgage products. Since the government backs the loans, they must go through multiple levels of approval, which can result in delays.
In summary, many mortgage loan programs are available, and it’s essential to understand the options to make an informed mortgage decision. Knowing which mortgage loan program is right for you is crucial whether you are a first-time homebuyer or a seasoned homeowner. At MEP, our team will work with you to determine which loan program is right for you, and each has its requirements and advantages. Contact a mortgage consultant today and get started on your homeowner journey.
