Whether you’re looking to buy a new home or remodel an existing one, chances are you’ll need a loan. In earlier times home buyers had only three mortgage loan types to choose from. The fixed-rate conventional mortgage, an FHA loan or a VA loan. Nowadays there’s far more to choose from and if you don’t understand the subtle differences between them it can be hard knowing which one to pick. Fact is, there is no one size fits all loan types. Your financial situation and home-ownership needs will help point you in the right direction. To make things easier, here are the most common loan types and what they cover.
Fixed vs. Adjustable Rate
When deciding on a loan one of the first choices you’ll have to make is whether you want a fixed-rate or adjustable-rate mortgage loan. Every loan fits into one of these two categories, or sometimes a “hybrid” combination of the two. These are the main differences between them and as you’ll see both choices have pros and cons that have to be weighed carefully.
- Fixed Rate – The interest rate is set for the entire duration of the repayment term. Month after month, year after year, your monthly payment will stay the same. However, for this stability, you will pay a higher interest rate than the initial ARM rate.
- Adjustable Rate – An adjustable rate mortgage loan (ARM) has an interest rate which will change over time. In most cases, the change will come once every year after an initial period of remaining fixed. For example, the 5/1 ARM loan starts with a fixed rate of interest for the first five years. After that, it will adjust each year. The main benefit of an ARM loan is that the initial rate and monthly payments are lower than a fixed rate loan. But it comes with the uncertainty of changing rates in the future.
Government Issued vs. Conventional Loans
So, once you know whether you want a fixed or adjustable rate loan, next you’ll want to consider whether you want a government-backed loan or a conventional one.
- Conventional Loans – These are loans from mortgage lending institutions that are not backed by an agency of the government. This sets it apart from FHA and VA loans
- FHA Loans – This is the most common loan choice for first-time buyers but it’s available to all other buyers as well. The Federal Housing Commission (FHA) is an offshoot of the Department of Housing and Urban Development (HUD), a part of the federal government. Through this, the government insures the lender against any losses that may result from a default. What’s great about this loan is that your down payment can be as low as 3.5% of the purchase price. The downside is that you’ll have to take out mortgage insurance which will increase the size of your monthly payments.
- VA Loans – Military veterans and their families may qualify for this program through the U.S. Department of Veteran Affairs. As with the FHA loan, the government will reimburse the lender for any damages resulting from a default. The difference with the FHA is that the down payment is 0%. That’s right, the borrower receives 100% financing.
Secured vs. Unsecured Loans
Another distinction between loans is that they can be secured or unsecured.
- Secured Loans – Most loans are of this type and designate a loan that is covered by collateral such as your house or car. In the event of a default, your property will be transferred to the lender. How much you qualify for and the interest rate will be determined by the value of the property but also your credit history.
- Unsecured Loans – As the name suggested, an unsecured loan is not backed by any collateral. Instead, the interest rate and loan amount are determined by your credit history and loan amount. For those with a good income, superb credit history, and solid paycheck plan, this can be a good option.
Jumbo vs. Conforming Loans
How much you wish to borrow puts your loan in one of two categories.
- Conforming Loans – To meet the criteria for a conforming loan it must meet the underwriting guidelines of Fannie Mae or Freddy Mac. These are two government-controlled corporations that buy and sell mortgage-backed securities (MBS). The main guideline is the maximum loan amount.
- Jumbo Loans – Any loan that doesn’t meet the guidelines of Fanny Mae or Freddy Mac is a non-conforming or jumbo loan. Because of its size it presents a much bigger risk for a lender. Usually, to secure one you’ll need excellent credit and have to make a large down payment.
Open-ended vs. Close-ended Loans
Depending on whether you’re borrowing to finance a home purchase or a renovation, one final distinction remains between loans.
- Open-ended Loans – This is a loan with a fixed-limit line of credit that you can borrow from again and again. A credit card is one example of an open-ended loan. Another example is a home equity line of credit (HELOC). Based on a percentage of your homes appraised value, the lender approves you a certain set amount. This allows you to easily borrow and pay back over time. Homeowners going through a renovation project find this very useful.
- Close-ended Loans – Mortgages, car loans and student loans all fall into this category. You are approved for a set amount and can now borrow from again. If you need more credit, then you will need to take out a new loan.