When you apply for a mortgage, you have three big decisions to make: loan type, rate type, and repayment term. In this guide, we break down what all these things mean and compare the advantages and disadvantages. We also show how Covid-19 and record low-interest rates are changing old assumptions.
Loan Types: Conventional vs. Government-Backed
Broadly speaking, mortgage products can be divided into two categories: conventional loans and government-backed loans. Although both types of loans are issued by private lenders, government-backed loans are partially guaranteed by the government. In this section, we’ll explore what these differences mean for borrowers.
- Lowest rates
- Less paperwork
- Shorter closing times
- Not suitable to anyone with poor credit
- Usually requires 20% down payment
Conventional loans are the most common type of home loan, accounting for 76% all mortgage originations, according to mortgage industry software provider Ellie Mae’s Origination Insight Report for March 2020.
Because conventional loans have no government backing, the onus is on the borrowers to prove themselves. Most lenders will tell you the minimum credit score requirement for a conventional loan is 620. However, Ellie Mae statistics reveal that 92% of people approved for conventional loans have credit of 700+. Traditionally conventional loans have required 20% down payment, although these days many lenders offer low (3-10%) down payment options.
Conventional loans have the best rates and quickest closing times for those in a position to qualify. If you have strong credit, then a conventional mortgage is a no-brainer. You can easily compare conventional loans with LendingTree.
- Low (or sometimes no) down payments
- Good solution for bad credit
- Low closing costs (VA loans only)
- Compulsory private mortgage insurance
- Stacks of paperwork
- Not everyone qualifies
The most common types of government-backed loan are FHA loans and VA loans, while there are also a few lesser-known types like USDA loans.
FHA loans give borrowers with bad credit the chance to break into the housing market with a small down payment. To qualify for a 3.5% down payment, you must have at least 580 credit. If you have 500-579 credit, you can still qualify but with a 10% down payment.
VA loans are for service members, veterans, and surviving spouses who meet the VA’s strict qualifying requirements. VA loans don’t require any down payment and the closing costs are lower than for FHA loans.
Government-backed loans have given tens of millions of American homeowners a way into the housing market. However, they can potentially cost you a lot more money over the duration of the loan. For starters, the interest rates on FHA and VA loans are generally slightly higher than for conventional loans. Then there’s the compulsory private mortgage insurance (PMI) you have to pay for having a low down payment – which usually costs 0.5-1% of the loan amount each year. And there are additional fees worth up to 1.75% per year on top of all that.
Many top lenders specialize in FHA and VA loans, including nbkc Bank.
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Rate Types: Fixed Rate vs Adjustable Rate
Whatever your loan type, most lenders will give you a choice of fixed rate mortgage (FRM) or adjustable rate mortgage (also known as ARM). Your best choice depends on your appetite for risks and rewards.
Fixed Rates (FRMs)
- Predictable monthly payments
- Good for locking in low Covid-19 rates
- Protects you from economic upheaval
- Risk of paying too much over time
- No backing out unless you refinance
Fixed rates are the simplest concept in mortgage borrowing. When you take an FRM, you lock in the same rate for the entire duration of the loan. For example, if you take a fixed 3% interest rate, it stays at 3% until you pay off the mortgage.
Most borrowers are conservative by nature, meaning we prefer to avoid losses than acquire equivalent gains. This is what makes the fixed-rate mortgage so attractive to most people. With a fixed rate, you never have to lose sleep at night worrying that your rate might go up.
Fixed rates are proving especially attractive in 2020, thanks to the economic conditions caused by Covid-19. According to Freddie Mac’s weekly data for May 14, the average 30-year FRM hit an all-time low of 3.28% and the gap between FRMs and ARMs is narrower than ever.
Basically, the only reason not to choose a fixed-rate mortgage right now is if you believe average rates will keep falling. An easy way to quickly scan the best FRMs is with a search tool such as MortgageOnline.com.
- Lower introductory interest rates
- Potential to pay less over duration of loan
- Risk of rate increasing over time
- Covid-19 has stripped ARMs of their advantage
If fixed rates are for the conservative borrower, adjustable rates are for the borrower who likes a bit of risk. ARMs come in four types: 3/1, 5/1, 7/1, and 10/1. The first number refers to the number of years where you get a low introductory rate. The second number refers to the fact that your rate changes every year following the introductory period.
What does this mean in practice? For the first few years, an ARM will cost you less than a fixed-rate loan. However, you run the risk of interest rates being much higher once your introductory period ends – and paying more in the long run.
As mentioned above, ARMs have become less attractive due to Covid-19. Due to record-low interest rates, FRMs are now only slightly more expensive than ARMs in year one, making it almost not worth the risk of taking the cheaper ARM. What’s more, with interest rates so low right now, in all likelihood they will be higher in 5-7 years and an ARM will end up costing you more.
Finally, we come to our last parameter: repayment terms. Most lenders offer a choice of a 15-year term or 30-year term, although some also offer 10-year and 20-year options. Your choice depends on your ability to pay in the given period of time, and on whether you prefer to pay less each month or less overall.
A 30-year fixed-rate mortgage is ideal for homeowners who are looking to settle down in a forever home. Families with children often choose this type of loan term for its smaller monthly payments. However, because you are dragging out the interest payment over many years, you will end up paying more to your lender over the life of the loan.
If you've recently acquired a high-paying job or are looking to pay off your home as quickly as possible, you may want to consider a 15-year mortgage. Because of the larger monthly payments and quicker payoff, a 15-year mortgage also comes with a lower interest rate than a 30-year mortgage. This type of mortgage payment is ideal for people who come into large sums of money through settlements, winnings, or family inheritance.
Whatever your repayment term, here’s an easy hack that will save you tons of money: bi-weekly payments. Click here to read more about getting your lender to agree to bi-weekly payments.
Going over your loan term options will help you make an informed decision that you won’t regret down the road. Choose a loan product, term, and rate type that makes the most sense with your budget and long-term goals. Next, be sure to browse reviews and explore the different rates and options provided by top lenders. You can then ask yourself, “Which mortgage is right for me?”