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Writer's pictureDenise Johnson- MBA, REALTORĀ®

What are the Different Loan Types and Terms

A previous employer of mine mandated that employees get at least 3 quotes before hiring a vendor for high-dollar purchases. I still use this approach today, even for personal acquisitions, because it allows me to compare pricing and gain insight into the vendorā€™s services and ability to perform. Even though it felt like a time-consuming process, I do believe that it saved the company time and money in the long run. The three-bid process always gave me and the company the confidence that we were getting the best deal available.


Since purchasing a home will be one of the most expensive purchases you will make, shopping around before selecting a loan will serve you well. Choosing the wrong product can result in thousands of dollars in interest and fees over the life of the loan, so getting at least 3 quotes is highly recommended. Letā€™s take some time to understand the different mortgage options and terms that are available.

According to the 2019 Home Mortgage Disclosure Act (HMDA) report, four types of mortgages make up the majority of the loans originated in the U.S. These mortgages are Conventional, Federal Housing Administration (FHA), Veterans Affairs (VA) and U.S. Department of Agriculture (USDA) loans. Conventional loans account for most of the reported mortgages, with 72% market share (See Chart 1). These loans have less restrictions on what property you buy and how you buy it, but they do have stricter financial requirements. The remainder of the financing is covered by the unconventional products such as FHA (17%), VA (9%) and USDA (2%) loans, which are mostly geared to buyers that may need more help financially.

Chart 1

Source: The Federal Financial Institutions Examination Council (FFIEC) Snapshot National Loan Level Dataset- HDMA Report 2019 Link to dataset

Letā€™s take a more detailed look into each type of loan.

CONVENTIONAL LOANS

What is it?

Conventional loans are mortgages issued by a bank or lending organization but are structured according the guidelines set by the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae). These guidelines are very detailed but some of the basics include meeting the required credit score, debt to income (DTI) ratio and down payment. These mortgages are not backed or insured by the Federal government so if a borrower defaults on the loan, the lender has to cover the loss. As a result, lenders have the ability to adjust the guidelines as necessary to reduce their risk

Who is it for?

Typically for those who have a credit score of 620 or higher and a large down payment, ideally 20% or more. They will accept lower down payments but it will cost the buyer more. The max debt to income (DTI) ratio is typically 43%

Pros

  • Financial Standing: High credit scores and good income rewarded

  • Total Costs: Total interest and fees will typically be less than unconventional loans (FHA, USDA)

  • Availability and Options: More options available because it is preferred by lenders

  • Primary Residence: Purchased home doesnā€™t have to be your primary residence. Can include investment properties, secondary homes and fixer uppers

  • Mortgage Insurance Elimination: The Private Mortgage Insurance (PMI) monthly fee will automatically drop off your loan once the principal is paid down to 78% of the property value. For example, on a $200,000 home, if the original loan was $190,000, once the loan balance reaches $156,000 ($200,000x.78), then your monthly payment will be reduced by the PMI amount

  • Attractiveness to Sellers: Sellers may have the perception that a buyer with a conventional loan may have a greater chance of purchasing at their desired price vs someone with an unconventional loan.

  • Loan Limits: Do apply, but are higher than FHA loans. In 2020 the limit is typically $510,400. Check the Federal Housing Financing Agency for limits in specific areas. Link to Website

  • Co-Signers: They do not have to be an occupant of the property

Cons

  • Mortgage Insurance (PMI): If a buyerā€™s down payment is less than 20%, the lender will charge a PMI fee in order to protect themselves in case of default

  • 100% Financing: Not available. However, you can try to qualify for a second mortgage to cover a portion of the home price

o Having the second mortgage equal to 20% of the home value allows you to avoid PMI payments. Requires a high credit score and a solid income

  • Interest Rates: Lenders can charge higher interest rates and require higher down payments (typically 5% but can go as low as 3% with income limits) since they are not backed by the government

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Confident Home Buyer Tool Kit Tips:

  • Conventional loans are mortgages issued by a bank or lending organization but are structured according the guidelines set by the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae).

o Typically for those who have a credit score of 620 or higher and a large down payment, ideally 20% or more. They will accept lower down payments but it will cost the buyer more. The max debt to income (DTI) ratio is typically 43%

  • Unconventional loans are mortgages that do not follow the guidelines of Fannie Mae or Freddie Mac. These loans include FHA, VA and USDA Loans.

  • FHA loans are issued by a bank or lending organization but are insured by the Federal Housing Administration (FHA).

o Typically for those who have a credit score of 580 or higher but a score as low as 500 may be accepted. Scores greater than 580 only require a down payment of 3.5% but scores that are lower will require a 10% down payment. The Debt to Income (DTI) ratio needed is typically less than 43%. Lenders also have the ability to add their own guidelines as necessary.

  • VA loans are issued by a bank or lending organization but are backed by the Department of Veteran Affairs and they only guarantee a portion of the loan if it goes into default.

o Created for U.S. Veterans, active duty service members and widowed military spouses. The VA does not have a credit score requirement but lenders typically require a 620 or higher. Lenders also have the ability to add their own guidelines as necessary. The max Debt to Income (DTI) ratio is 41%. Lenders also have the ability to add their own guidelines as necessary.

  • USDA loans can either be issued by a bank or lending organization or by the USDA directly. The loans are insured or guaranteed by the Department of Agriculture for up to 90% of the loan.

o Typically for those with a credit score of 640 or higher who live or want to live in rural areas (population of less than 35,000) and have low or modest income. There are some exceptions for lower credit scores such as temporary hardships. Lenders also have the ability to add their own guidelines as necessary.

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UNCONVENTIONAL LOANS

What is it?

These are mortgages that do not follow the guidelines of Fannie Mae or Freddie Mac. These loans include FHA, VA and USDA Loans.

FHA Loan

What is it?

o These loans are issued by a bank or lending organization but are insured by the Federal Housing Administration (FHA); an agency of the Department of Housing and Urban Development (HUD). Like Freddie Mac and Fannie Mae, FHA also has guidelines that lenders follow in order to issue a loan to a borrower. Unlike conventional loans, if a borrower defaults, FHA has to pay the lender the remaining amount owed

Who is it for?

Typically for those who have a credit score of 580 or higher but a score as low as 500 may be accepted. Scores greater than 580 only require a down payment of 3.5% but scores that are lower will require a 10% down payment. Lenders also have the ability to add their own guidelines as necessary. The Debt to Income (DTI) ratio needed is typically less than 43%


Pros

  • Financial Standing: They accept lower credit scores and down payments

  • Co-Signers: They do not have to be an occupant of the property

Cons

  • Mortgage Insurance (MIP): A Mortgage Insurance Premium (MIP) is required for the life of the loan if the down payment is less than 10%. If the down payment is greater than 10%, then it is only required for 11 years

o The only way to stop paying the MIP is if the loan is in good standing, then the borrower can refinance to a conventional loan after 6 months to stop paying the MIP fees

  • 100% Financing: Not available. You cannot roll any fees into the mortgage

  • Total Costs: Overall costs, interest, and fees, are typically higher than conventional loans

  • Primary Residence: Must be your primary residence for at least for 1 year

o If a home needs significant repairs, the FHA 203b loan may not be approved due to strict guidelines. You may have to look into an FHA 203K loan for fixer uppers

  • Attractiveness to Sellers: A seller may prefer a buyer with a conventional vs a FHA loan, especially in a multi-offer situation. Sellers may have the perception that a conventional buyer will be stronger financially, which increases their chances of selling. Sellers may also be concerned that the final amount they will receive will be lower since the guidelines for appraisals are stricter for FHA loans

  • Loan Limits: Yes, they do apply and will vary by locations. As of 2020, the limit for most areas is $331,760 for single family homes. Check FHA for limits in specific locations. Link to website

VA Loan

What is it?

These loans are issued by a bank or lending organization but are backed by the Department of Veteran Affairs and they only guarantee a portion of the loan if it goes into default. They set the guidelines that lenders must follow in order to qualify a buyer. The lender can also add their own requirements to reduce risk

Who is it for?

U.S. Veterans, active duty service members and widowed military spouses. The VA does not have a credit score requirement but lenders typically require a 620 or higher. Lenders also have the ability to add their own guidelines as necessary. The max Debt to Income (DTI) ratio is 41%

Pros

  • 100% Financing: Yes, you can buy a home without a down payment. You can also roll the funding fees into the mortgage

  • Loan Limits: No limit but the amount is based on the borrowerā€™s qualifications

  • Mortgage Insurance: There is no Mortgage Insurance (MIP or PMI)

Cons

  • Mortgage Insurance: Although it is not called mortgage insurance, there is a funding fee, of 1.25%ā€’3.3% of the loan amount, which gets built into the mortgage, increasing your monthly payment and interest payments

  • Primary Residence: Must be your primary residence until you sell. There are also limitations on the types of properties that qualify. Vacant land and co-ops will not qualify

  • Attractiveness to Sellers: Like the FHA Loan, sellers may be more favorable to buyers with conventional loans for similar reasons. VA appraisers are found to be even stricter than FHA appraisers

  • Co-Signers: They must be an occupant of the property

USDA Loan

What is it?

These loans can either be issued by a bank or lending organization or by the USDA directly. The loans are insured or guaranteed by the Department of Agriculture for up to 90% of the loan. The USDA sets the guidelines but lenders can also add their own guidelines as necessary

Who is it for?

Typically for those with a credit score of 640 or higher who live or want to live in rural areas (population of less than 35,000) and have low or modest income. There are some exceptions for lower credit scores such as temporary hardships


Pros

  • 100% Financing: Yes, you can buy a home without a down payment. You can also roll the funding fees into the mortgage if the home appraises higher than purchase price

o Renovation and repair costs can be rolled into the loan

  • Loan Limits: No limits but will be based on the buyerā€™s qualification

Cons

  • Primary Residence: Must be your primary residence until you sell

  • Income Limits: There are income limits. The income of everyone who will be living in the home will be taken into consideration, even if they are not listed on the loan

  • Location Limitations: Yes. Link to eligible rural areas

  • Mortgage Insurance (MIP): Yes. It is required for the life of the loan

o You can refinance to get rid of the MIP, but only after 12 months of on-time payments. Your new payment also has to be $50 cheaper than the current payment

  • Attractiveness to Sellers: Like the FHA Loan, sellers may be more favorable to buyers with conventional loans for similar reasons

  • Co-Signers: They must be an occupant of the property

LOAN TERMS


In addition to the loan types, a borrower should consider the different loan terms. These terms will include how long you will pay on the mortgage along with the interest rates. The typical mortgage loan periods are 15 and 30 years. There are some lenders that will offer different term periods if needed. The interest rates will vary based on the loan type and the borrowerā€™s credentials. There are also Adjustable Rate Mortgages (ARM) that have fixed interest rates for a period of time, but once that period is complete, the rates will adjust for the remainder of the term. For example, if a borrower signs up for a 5/1 30-Year ARM, the buyer will make the same monthly payment for the first 5 years of the mortgage. After 5 years, the interest rate will adjust, based on the market rate, and their monthly payment will change. These changes typically occur annually. The other common ARMS are for 3-, 7- and 10-year fixed periods. ARMs are not recommended if you plan on staying in the home longer than the fixed period, as the changing interest rates can become costly. (See Charts 2 and 3 to compare estimated overall cost and monthly payments by the most common loan types and terms.)

Chart 2: Loan Comparison Ranked in Order of Lowest to Highest Overall Costs

Note: The Conventional 15-Year Loan will have the least overall cost at $241,828 on a $200,000 home. The 5/1 ARM will be most expensive overall at $375,827 on a $200,000 home. Take note that there was no down payment required for the VA or USDA Loans for 100% financing, and the additional fees were built into the loan. Interest rates gathered on October 8, 2020. Interest rates will vary based on your credit score.

Chart 3: Loan Comparison Ranked in Order of Lowest to Highest Monthly Payment

Note: The VA Loan will have the lowest month payment of $838 throughout the life of the loan for a $200,000 home, followed by the Conventional 30-year Loan at $885 per month. Take note that the monthly payment changes for the Conventional 30-Year Loan after the PMI expires. The 5/1 ARM increases by more than $300 per month ($838 vs $1,155) by the end of the 30-Year Loan Term. The 15-year mortgage will have the highest monthly payment. Interest rates gathered on October 8, 2020. Interest rates will vary based on your credit score.

As you can see, there are several loan types that have been structured to meet the needs of many types of buyers. Conventional loans will have fewer overall restrictions, but it may be harder to qualify for these loans without the right credit score and financial readiness. The Unconventional loans (FHA, VA and USDA) are customized for those that need more help financially but these loans, with the exception of the VA loan, can have a higher cost for the buyer in the long run. It will be important that you understand the different options that are available once you begin the process of getting at least 3 quotes from different lenders. Be sure to ask the lenders to compare the cost of the different loan types or terms if you are considering both conventional and unconventional loans, or different loan periods.

If you havenā€™t done so already, take advantage of the Confident Home Buyer Toolkit to help you get in the best financial position and more readily qualify for the loan that best fits your needs.


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Denise Johnson, MBA, REALTORĀ®, is often referred to as a "Data Nerd" by family and friends and has a gift for seeing the important facts of a situation. She aims to fit all the pieces of the jigsaw puzzle together into a complete picture, making it easier for herself or anyone she counsels to make sound and rapid decisions.


After 10+ years of working for multiple Fortune 500 and 1000 companies across Logistics, Finance and Marketing, Denise made the leap into the Real Estate Industry hoping to help others achieve their homeownership desires. She can remember purchasing her first home at the age of 23, and it being both a time of joy and stress because she didn't fully understand the process and the implications of owning a home. Since then, she has owned and sold multiple personal properties, including selling an investment home that turned from a Rehab to a New Construction project in 2020. She has a desire to share all that she has learned and continues to learn with future customers to tip the scales towards a joyous homeownership and home-selling experience.

When she is not busy finding solutions in business, she loves large get-togethers with friends and family, international travel adventures with her hubby, and growing her passion for gardening and cooking healthy recipes.

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