The “Big 3” Different Types of Mortgages
*SPOILER ALERT* There are WAY more types of Mortgage loans than just three. You have 30 year and 15 year, Fixed and Variable Rate, Conforming and Non-Conforming loans, Jumbo loans, and many more in between. If I broke them all down in this post, it wouldn’t be a post but a whole book on mortgages (a.k.a. too much info) so we’re going to focus on 3 main types. Now all the variations we talked about above can fall under the three types we’ll talk about today. These “Big 3” are just the starting blocks; Conventional Loans, FHA Loans, and VA Loans.
Conventional Loans
Conventional loans are loans that aren’t backed by the Federal Government. These are the most common type of mortgage loans and most anyone can apply. They come in two types; Conforming and Non-Conforming.
Conforming Loans are bound by maximum Federal Limits based off the region the home will be purchased in, set by the Federal Housing Finance Agency (FHFA). In 2022, the baseline limit for single units are $647,200 although it can go as high as $970,800 in more expensive regions. Non-Conforming Loans are the exact opposite. The Don’t follow Federal Limits to allow homeowners to purchase more expensive properties
Requirements
To qualify for this loan, you’ll generally need to meet these requirements;
Minimum Credit Score of 620 (learn how to Improve your Credit Score here)
Debt-to-Income Ratio of Less than 45%
Minimum 3% Down Payment with Property Mortgage Insurance (PMI)
PMI is NOT required for a Down Payment of 20% or more
Property Appraisal Verifying Home Value (can sometimes be waived)
The Pros and Cons
Starting off with the Pros, this can be used for any type of property such as a first or second home or even an investment property, so it doesn’t have to be your permanent residency. Also, you generally only need 3% down. This would require PMI, but you can cancel PMI after 20% Principal Paydown. If you’re able to avoid PMI or paying points, Conventional sometimes have cheaper overall borrowing costs than some government insured loans.
The Cons for a conventional start with the higher credit score to qualify than Government Insured Loans. These loans generally have a Higher Minimum Down Payment and a Maximum Debt-to-Income of 45% or lower as well. Not to forget, you will also likely have to pay PMI with a less than 20% Down Payment. Meeting that down payment can be very difficult. For example, if you bought a $300,000 home, you would have to pay $60,000 as a down payment to avoid PMI. That’s BEFORE including closing costs. So lets look side by side;
PROS
Can be Used for Residence, Second Home, or Investment
Minimum Down Payment of 3% (with PMI)
Cancel PMI after 20% Equity Paydown
May have Cheaper Overall Borrowing Costs
CONS
Higher Credit Score to Qualify
Higher Minimum Down Payment
45% Maximum Debt-to-Income Ratio
Pay PMI with less than 20% Down Payment
Should you consider a Conventional Loan?
A Conventional Loan may be ideal for you if you at least meet or exceed the minimum requirements. Having a high credit score, substantial Capital for Down Payment, and safe and consistent income relative to your intended purchase may make a conventional loan ideal for you. Also, if you don’t qualify for Government Insured Loans or you are purchasing an investment property you may have to utilize a conventional loan. The 30-year fixed rate conventional loan is commonly the most popular loan choice.
FHA Loans
An Federal Housing Administration (FHA) Loan is a Government Insured Loan specifically designed to help those with lower credit scores and down payments. The way an FHA Loan works is that when you qualify for the loan and pay less than a 20% down payment, you will have to pay FHA Mortgage Insurance in two premiums; Upfront Premium and Annual Premium.
The Upfront Premium will cost roughly 1.75% of Loan Amount paid when you get the loan. It can be added into the financing of the loan as well. Annual Premium costs around 0.45% to 1.05% of the loan amount annually, paid monthly. So for a $300,000 loan, Upfront Premium would equal $5,250. Let’s say the Annual Premium is 1.05%, so you would pay $3,150 per year, which becomes $262.50 a month.
Requirements
To qualify for this loan, you’ll generally need to meet these requirements;
Minimum Credit Score of 580 for 3.5% Down (learn how to Improve your Credit Score here)
Credit Sore of 500 to 579 also qualifies with 10% Down Payment
Debt-to-Income Ratio of Less than 43%
Minimum 3.5% Down Payment
Minimum 10% Down Payment for credit score less than 580
Must be Home Buyer’s Primary Residence
Property Appraisal Verifying Home’s Value
The Pros and Cons
Beginning with the Pros again, FHA Loans allow those with lower credit score and lower down payments to qualify for a loan. That really translates into getting into a home faster. Often, you may also see a lower interest rate than conventional loans, but that doesn’t mean lower cost of the loan overall. Closing Costs limited at 3% to 5% of loan amount which can be very beneficial.
Now for the Cons, you will have to pay FHA Insurance. The other issue with FHA Insurance, it doesn’t cancel after 20% like with PMI. You will have to pay FHA Insurance for at least 11 years generally and if you put down less than 10%, you end up paying insurance until you pay off your entire mortgage. With all that, it is likely you will pay More Overall in Borrowing Costs. After that, you’re home also has to meet certain requirements. Like with a Conforming Conventional loan, an FHA Loan has price limits but they are significantly lower. FHA Loan limit is $420,680 in low income areas. This home also has to be your primary residence. Another unintentionally downfall is some Sellers look poorly on FHA Loans. So, when you’re in a Seller’s Market, it may be even harder to have an offer accepted.
PROS
Lower Credit Score Required
Lower Minimum Down Payment
Get into a Home Faster
May have Lower Interest Rate (not always)
Limited Closing Costs of 3% to 5%
CONS
Have to Pay FHA Insurance
FHA Insurance DOESN’T Cancel
More Overall Borrowing Cost
Lower FHA Loan Limits
Must be Primary Residence
Seller’s may have Negative Opinion about FHA Loans
Should you consider an FHA Loan?
An FHA Loan may be right for you if you have less than ideal credit or little capital for a down payment but want or need to get into a house right away. However, if you have the credit, capital, or time to work on improving both, you may want to wait until you can qualify for a conventional loan. If you need tips to Improve your Credit Score, you can click the link. If you happen to be in the Military, a Veteran, or a Family Member, than stayed tuned for the next loan.
VA Loan
This one goes out to all my Military brothers and sister. A Veterans Affairs (VA) Loan is another government insured loan designed to help Active Duty, Veterans, and surviving family members purchase homes. These loans have substantial benefits and may be the best option for those that apply. If you’re in the National Guard or a Reservist and not sure you are eligible, you can click this VA Eligibility link to find out. VA loans work without Mortgage Insurance but instead, you will pay a one-time, upfront Funding Fee based on your down payment amount. If it’s you’re first VA Loan, your Funding Fee will be 2.3% with 0 down. That drops to 1.65% for 5% down or more, and even lower to 1.4% with 10% down or more. If this is your second or later VA Loan, your Funding fee will be 3.6% with 0 down. The Funding Fees will be the same if you pay 5% or more in down payment as listed above. You may also be eligible to waive the funding fee in certain cases.
Requirements
To qualify for this loan, you’ll need to meet these requirements;
Must have Active Service in the Military (The requirements can be found here: VA Eligibility)
Minimum Credit Score is Lender Dependent (620 is recommended so learn how to Improve your Credit Score here)
Debt-to-Income Ratio is also Lender Dependent (generally offers higher DTI than other loans)
NO Minimum Down Payment
A 5% Down Payment can reduce your Funding Fee
Must be Home Buyer’s Primary Residence
Property Appraisal Verifying Home’s Value
Wood Destroying Organism (WDO) Inspection Required
The Pros and Cons
For the Pros, there is NO Down Payment Required! That’s right! NO Down Payment at ALL!! You also have NO Mortgage Insurance! You will generally have to pay an upfront Funding Fee, but you can reduce your Funding Fee with a higher Down Payment as described above. There is also NO Minimum Credit Score, although your score will effect your interest rate. That being said, VA Loans typically have lower Interest Rates than other loans. The lower interest along with only a one time Funding Fee means you may have lower Overall Borrowing Costs with low down payment. All that makes it easier to qualify than other loans. There is also NO loan limit and multiple, available convenient ways to refinance.
The Cons start with you must have Active Military Service. You can review the VA Eligibility requirements here. After that, since you typically can’t waive the Funding Fee without having a qualifying service related disability, that can be a bit frustrating. These loans are also Less Flexible than other loans. For example, you can’t waive the Appraisal, Home Inspection, or WDO Inspection. VA Loans also require that the loan be for your Primary Residence like FHA Loans. Also like FHA loans, since some Real Estate Agents aren’t well educated on VA Loans, they may advise Seller’s not to consider these loans. This can make an offer being accepted harder.
PROS
NO Minimum Credit Score
NO Down Payment Required
NO Mortgage Insurance
Can Reduce Funding Fee with larger Down Payment
May have Lower Interest Rate (not always)
May have Lower Overall Borrowing Costs
Easier to Qualify
NO Loan Limit
Convenient Refinance Options
CONS
MUST have Active Military Service
Funding Fee typically can NOT be Waived
Less Flexible Loan
Can’t Waive Appraisal, Home Inspection, or WDO Inspection
Must be Primary Residence
Seller’s may have Negative Opinion about VA Loans
Should you consider a VA Loan?
A VA Loan can be an exceptional option if you have qualifying Military Service. Of course, you should always compare all your options. It is possible a conventional loan may be better if you have 20% for a down payment, great credit, and possibly lower conventional interest rates. Also, if you’re purchasing an investment property or already have a VA Loan, a VA Loan may not apply to your second purchase.
The Wrap-Up
As a reminder, there are way more different types of loans than these “Big 3” we’ve discussed here. Also, each of these loan types have plenty of possible terms such as rate type, loan length, discount points, and so on. However, understanding these three give you a good place to start. Remember;
Conventional Loans are the most common loan type, with 30-year fixed rate being the most popular
FHA Loans exist for those who may not have the credit or capital to qualify for Conventional Loans. This may cost you more overall
VA Loans are Incredible loans for Service Members and Veterans
With all this, Experts recommend you consider a home purchase if it meets a 30% Debt-to-Income Ratio or Less
All and all, everyone’s financial situation is different so there is a lot more to consider than just what was reviewed here. You should always speak with a mortgage broker and/or a local real estate agent before making decisions on how to pursue a home purchase. Also, discussing the plan with a certified Financial Advisor is always beneficial. And remember, Financial Literacy is the Number 1 Key to Financial Success! Keep learning!
*Disclosure* This is NOT financial advice and I am NOT a Certified Financial Planner. All information is provided for educational purposes only and is not to be construed as advice. Everyone’s financial situation is different and requires individualized planning. Seek out a Certified Financial Planner for assistance with your own financial situation.