Understanding different types of mortgage loans

When you're getting ready to finance a home purchase, all the mortgage choices and terms can be a little confusing. Fortunately, it gets much simpler when you understand the basic ways of categorizing mortgages.

Fixed or adjustable rate mortgage

A fixed-rate mortgage has an interest rate that's locked in for the full term of the mortgage. That means your principal and interest payment remains the same for the length of the loan.

With an adjustable-rate mortgage, or ARM, the interest rate and payment stay the same for an initial period of years. Then, they adjust, often yearly, based on changes in the market. ARMs usually have caps that limit their increases. A periodic rate cap limits how much the rate can change in a year, while a lifetime cap limits the total increase over the life of your mortgage.

Lenders give ARMs labels indicating how long the initial rate is guaranteed and how often the rate is adjusted after that.

ARMs usually have lower initial interest rates and payments than fixed-rate mortgages. The trade-off is that you don't know how much you'll pay after the adjustments start. Your monthly payment could be significantly higher than if you'd chosen a fixed-rate mortgage. However, if you don't plan on keeping the home longer than the fixed period, you might see significant savings with an ARM product.

Conventional or government-backed loans

In addition to being categorized as fixed or adjustable, mortgages can be classified as either conventional or government-backed. Since the government isn't involved in backing conventional loans, lenders may have more flexibility in setting the terms.

A conventional loan requires you to pay for private mortgage insurance, or PMI, if your down payment is less than 20% of the home's appraised value. This insurance protects the lender if a borrower defaults on their payments.

You can request to remove the PMI when your loan balance drops to 80% of the home's original appraised value. Contact your mortgage servicer for more information.

Government-backed loans give some assurance to the lender that they'll be repaid even if you default on the loan. Because of that, these mortgages usually require lower down payments.

Two of the most common government-backed mortgages are:

• Veterans Administration, or VA: Available to military service members and veterans, VA loans require no down payment in most cases. While there's no requirement for mortgage insurance, you may have to pay a VA funding fee.^{See note1} The fee varies depending on whether you put money down and whether it's your first VA loan. You may be exempt from paying the funding fee if you receive service-related disability payments or are the surviving spouse of someone who died while serving or from service-related disabilities.
• Federal Housing Administration, or FHA: These loans can be helpful for borrowers who have a lower credit score or less money for a down payment. Because FHA loans require an initial mortgage insurance premium, or MIP, and monthly MIP payments after that, the cost for these loans can be greater over time. Because of these costs, it may make sense to see if you qualify for a VA or conventional mortgage first.

Conforming or nonconforming mortgages

A conforming mortgage fits the guidelines established by government-sponsored mortgage entities, such as Fannie Mae and Freddie Mac. These entities buy mortgages from lenders and then sell them to investors.

For nonconforming loans there may be options where the buyer may not need to have a 20% down payment, but there may be other requirements, and you should speak with your loan officer for more details. One type of nonconforming loan is commonly referred to as a "jumbo" mortgage. It's one with larger loan limits than those set by Fannie Mae and Freddie Mac. The larger loan amount means more risk for the lender, which may translate into a higher interest rate and more strict qualifying criteria for the loan.

These loan types suit borrowers purchasing beyond the county loan limit established by the Federal Housing Finance Agency, or FHFA. These loan limits are subject to change annually. If you have questions about whether a jumbo loan is best for you speak with your loan officer.

Some uncommon mortgages

In addition to the types of mortgages already covered, there are a few others you may come across.

• Balloon: A balloon mortgage generally offers lower monthly payments at the start of the loan, and carries a large principal balance to payoff at a later date. If the borrower is unable to pay off the large principal balance all at once, they could sell the home, or take out a new loan to cover the payment - effectively refinancing the mortgage.
• Interest-only: As the name implies, with an interest-only mortgage, you only pay interest to the lender for a period of years. After that period, rates typically adjust and you start paying both principal and interest. This may cause a significant increase to your monthly payments.
• Construction-to-permanent: If you're building a home, this two-step mortgage first provides money to pay for the lot and construction. When you're ready to move in, that balance is rolled into a permanent mortgage.