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Choosing the Type of Mortgage Loan that Fits Your Needs

Buying a house usually means taking out a mortgage. Understanding different types of mortgage loans can ease the process of buying a house and potentially save you money, too.

By Karen Lynch | American Express Credit Intel Freelance Contributor

7 Min Read | November 30, 2020 in Money

 

At-A-Glance

There’s an array of mortgage types to choose from, with different down payment requirements, interest rates, and monthly payments.

Choosing the right type of mortgage loan for you can make a difference in whether you qualify for the mortgage or get the lowest financing costs.

Mortgages come in more shapes and sizes than you might imagine. Knowing the types of mortgage loans available can aid you in making choices that can help you be approved by a lender to buy the house you want – and potentially save money in the process.

 

The Two Main Types of Mortgage Loans Have Many Variations

While there are only two main mortgage types, each has numerous variations. The two overarching types are:

  • Fixed: Most homebuyers take out fixed-rate mortgages for 30- or 15-year terms. Often called “conventional,” these mortgages have fixed interest rates and regular monthly principal-and-interest payments that don’t vary over the life of the loan.
  • Adjustable: There are several kinds of adjustable-rate mortgages (ARMs), too, where your interest rate and monthly payments usually change over time. 

 

Each of these two main mortgage categories has many variations depending on who’s backing the loan – bank or government agency – how big it is, whether it’s for a first-time homebuyer, whether it’s in an urban or rural area, and other factors. The variety of interest and down payment options adds up to a wide array of mortgage types with sometimes hard-to-understand terms and acronyms. For example, there are:

  • Jumbo loans.
  • Two-step mortgages.
  • Balloon mortgages.
  • Bridge loans.
  • Piggyback loans.

And in addition to loans backed by private banks and quasi-governmental organizations like Fannie Mae and Freddie Mac, depending on your circumstances you may qualify for mortgages backed by the:

  • Federal Housing Administration (FHA).
  • Veterans Administration (VA).
  • U.S. Department of Agriculture (USDA).

But wait – there’s more: Another whole category of mortgages is for generating cash instead of buying a house, including refinancings, second mortgages, and reverse mortgages

 

Below is a deeper dive into these various types of mortgages.

 

Fixed Mortgages: 30-Year Versus 15-Year

Historically, 70–75% of homebuyers choose fixed-rate mortgages because of their predictability, according to the Consumer Financial Protection Bureau (CFPB).1 Fixed-rate mortgages are available at many institutions and at different interest rates, but they all have this in common: The shorter the term of your mortgage, in years, the higher your monthly payment – and the lower your total cost over the life of the loan. 

 

So, it’s not surprising that the two main fixed-rate mortgage options differ by term. The interest on a 15-year mortgage is usually a bit lower than a 30-year mortgage, by an average of 0.5% at this writing.2 The advantage of the 15-year is that you’re paying the principal amount that you owe on the house faster. This time difference also is why the amount you pay over the life of the mortgage is lower. Other fixed-rate mortgage terms include 20-year and 10-year loans, though they are not as common as 30- and 15-year mortgages.

 

Shorter term Longer term
Higher monthly payments Lower monthly payments
Typically lower interest rates Typically higher interest rates
Lower total cost Higher total cost

Source: Consumer Financial Protection Bureau

 

Homebuyers choose one or the other fixed-rate mortgage term for specific reasons. A 30-year loan may help them afford a larger home than a 15-year loan, for example, by spreading the cost out more. Or, the lower monthly payments on a 30-year loan might fit their budget better. Borrowers have some flexibility, even within a 30-year mortgage. You can always choose to accelerate your payments on your own. And, in the end, you may not even remain in the home you’ve bought for 30 years, so that the total cost of the loan becomes less of a concern. 

 

On the other hand, a 15-year mortgage’s lower interest rate can save you thousands of dollars over time. And, by helping you to pay off your house in half the time, it wipes what is usually one of the biggest recurring bills off your household budget much sooner. Mortgage calculators are available online to help you compare loan terms and their monthly payments, total costs, and more. 

 

Keep in mind that these loans technically require a 20% down payment. Otherwise, you’ll likely have to take out private mortgage insurance (PMI), driving up your financing costs. In practice, however, most buyers put down less: The median down payment in 2019 was just 6% for first-time homebuyers and 16% for repeat buyers, according to the National Association of Realtors.3 For more, read “How Much of a Down Payment Do You Need to Buy a House?

 

 

Adjustable-Rate Mortgages Explained

Although many borrowers prefer the predictability of fixed-rate mortgages, some 25% to 30% choose ARMs.4 ARMs usually carry a fixed interest rate for a specified number of years after which your rate can go up or down depending on economic conditions – and your monthly payment with it. For example:

  • A 5/1 ARM: Your rate is fixed for the first five years, after which it resets every year.
  • A 10/5 ARM: Your rate is fixed for the first 10 years, after which it resets every five years.

Other common ARM options include 3/1, 7/1, and 10/1. The full term of an ARM is typically 30 years, although shorter terms are available. 

 

With fixed-rate mortgages at historically low interest rates, ARMs’ introductory interest rates are not always lower than fixed-rate loans, as they tended to be in the past. ARMs may cost less than 30-year rates, in the introductory period, though not necessarily less than today’s 15-year fixed rates.5 Still, they often have less stringent requirements to qualify, such as lower credit scores. Many who take out ARMs intend to resell their homes before their loan resets. 

 

Loans similar to ARMs include two-step loans, which reset only one time, and balloon loans, which have relatively low monthly payments leading up to a large lump-sum payment at the end of the loan.

 

Other Types of Mortgages to Match Different Needs

Beyond the basic fixed-rate or ARMs, you can find a host of other mortgage types in the market. These include: 

 

FHA, VA, and USDA loans: FHA loans are targeted at first-time homebuyers. They require lower credit scores than other types of mortgages and down payments as low as 3.5%.6 But at this writing, their interest rates were slightly higher than a 30-year mortgage rate.7 Mortgage insurance is an added cost because of the low down payment, though with FHA loans it’s less expensive than standard PMI. Certain FHA loans offer first-time homebuyers graduated monthly payment options that start small and grow as their income grows.8 VA loans provide similarly favorable terms to veterans and USDA loans do so for rural homebuyers. 

 

Jumbo loans: These are loans of about $500,000 or higher. Because of the large amount, they are subject to stricter requirements and reviews. 

 

Piggyback loans: A piggyback loan is taken out at the same time as your main mortgage to make a down payment and qualify without paying PMI. 

 

Bridge loans: A bridge loan might help you purchase a new home while you’re still waiting to sell the one you’re in. 

 

Refinancing, Second Mortgages, and Reverse Mortgages

These loans are not for purchasing a home, but for getting cash based on your home’s equity. 

 

Refinancing: Some people refinance to get a better loan term and interest rate. Many do “cash-out refinancing,” which replaces your current mortgage with a loan for a larger amount than you actually owe on your house; you receive the difference in cash. For more, read “Guidelines for When and How to Refinance a Home Loan.” 

 

Second mortgage: A second mortgage doesn’t replace your mortgage, but adds a new mortgage based on the equity you have built up in your home since you bought it. They’re also sometimes called home equity loans.  

 

Reverse mortgage: This lets you borrow against the equity in your home, as a kind of advance on the day that you die or sell your home – at which time repayment is due.

 

The Takeaway

Buying a house usually means taking out a mortgage. To make this complex transaction as smooth and successful as possible, it’s a good idea to brush up on the many types of mortgages available today. A little knowledge could help you get the house you want while paying the lowest possible financing costs.

Karen Lynch

Karen Lynch is a journalist who has covered global business, technology, finance, and related public policy issues for more than 30 years.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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