Loan Types Explained

Posted by Elle Seybold on Monday, February 15th, 2021 at 4:05pm.

 

This week I’d like to share information regarding loans.  Many of my clients choose to use financing to purchase property.  This article will review several of the more common loan and lender types.  I hope this is helpful for everyone!

 

MORTGAGE TYPES

Conventional

These loans can be fixed rate, adjustable or balloon loans.  They can be conforming or non-conforming.  A conforming loan falls within the rules set by Freddie Mac and Fannie Mae. 

 

Conforming loans are mortgages that conform to financing limits set by the Federal Housing Finance Agency (FHFA) and meet underwriting guidelines set by Fannie Mae and Freddie Mac, whereas nonconforming loans do not.  Conforming and nonconforming loans are both types of conventional loans.

 

The maximum value of a conforming loan in 2021 is $548,250.  Loans above this amount are considered jumbo loans.

 

Fannie Mae and Freddie Mac are the government-sponsored entities that buy conforming loans. These behind-the-scenes companies provide a secondary market for mortgages, more on them later.

 

Jumbo

Jumbo home loans are mortgages above a certain dollar amount.  Jumbo loan limits vary by county and are adjusted periodically.  For 2021, the thresholds for jumbo loans are above: $548,250 for a single-family home in most areas of the country, including New Mexico.  Or $822,375 for high-cost areas, like Washington, D.C., or California.  Because jumbo loan values exceed these limits, they are nonconforming loans.  Lenders view nonconforming loans as riskier because Fannie and Freddie won’t guarantee them.  

 

Jumbo’s can have fixed or adjustable rates and often require a credit score of 700 or higher.  Usually they require: a down payment of 10% or more, cash in the bank, and higher fees.   Historically, interest rates on conforming loans have been lower than jumbos, but in recent years, the rate spread between the two has narrowed significantly.  I have seen jumbo loans offer lower rates than conforming loans.

 

Fixed Rate Mortgages

Guaranteed “fixed” interest rate over a set period of time.  This is a good choice if you want to set a budget.  Payments only change if your property tax or homeowners insurance changes.

 

These loans are generally available at 15, 20, or 30-year lengths.  The longer the term, the lower the monthly payment.  However, the longer the term, the greater you pay in interest costs.

 

Adjustable Rate Mortgages (ARMs)

An adjustable-rate mortgage is a home loan with an initial rate that is fixed for a specified period, then adjusts periodically.  For example, a 5/1 ARM has an interest rate that is set for the first five years and then adjusts annually.  Typically, the initial rate is lower than on most other loans, giving comparatively lower monthly payments at first.  Initial rates are often locked for one, five, seven or 10 years.  If you don’t plan on having the mortgage for a long time, or you believe interest rates will be lower in the future – this is a good option.

 

Interest-Only Mortgage

An interest-only mortgage requires payments only on the lender’s interest charge.  The loan balance, or principal, is not reduced during the interest-only payment period.  These can be appropriate for borrowers who are disciplined enough to make periodic principal payments.  They are useful to home buyers who don’t expect to remain in a house for the long term.  Borrowers will have to show lenders substantial assets or a proven ability to pay.  This works best for borrowers with high monthly cash flow, a rising income, large cash savings or an income that varies from month to month.  Also for those who receive large annual bonuses they can use to pay down the principal balance.

 

Balloon Mortgages

A balloon loan is any financing that includes a lump sum payment schedule at any point in the term. It’s usually at the end of the loan.

 

Balloon loans come in a few different types: there are interest-only mortgages where you just make the interest payments and the entire balance is due at the end of the loan.  Then there are loans where there are balance and interest payments that lead to a smaller lump-sum payment at the end.  

 

Reverse mortgages

A reverse mortgage is the opposite of a traditional home loan; instead of paying a lender a monthly payment each month, the lender pays you.  

 

The sum you receive in a reverse mortgage is based on a sliding scale of life expectancy.  The older you are, the more home equity you can pull out.  To apply for a reverse mortgage, you must meet the following FHA requirements:

 

  •         You’re 62 or older
  •         It is your primary residence
  •         You have no delinquent federal debts
  •         You own your home outright or have a considerable amount of equity in it
  •         You attend the mandatory counseling session with a home equity conversion mortgages (HECM) counselor approved by the Department of Housing and Urban Development
  •         Your home meets all FHA property standards and flood requirements
  •         You continue paying all property taxes, homeowners insurance and other household maintenance fees as long as you live in the home

 

Before issuing a reverse mortgage, a lender will check your credit history, verify your monthly income versus your monthly financial obligations and order an appraisal on your home.

 

Nearly all reverse mortgages are issued as home equity conversion mortgages (HECMs), which are insured by the Federal Housing Administration.

 

MORTGAGE PLAYERS & LENDERS

Fannie Mae [Federal National Mortgage Association], Freddie Mac [Federal Home Loan Mortgage Association] & Ginnie Mae [Government National Mortgage Association]

Fannie Mae, Freddie Mac, and Ginnie Mae are all government-sponsored mortgage companies.  These organizations are actually shareholder-owned, for-profit companies.  Or, at least, they were shareholder-controlled companies — until the government took over operation of the firms following the mortgage crisis in 2008.

 

Ginnie, Fannie and Freddie are considered government-sponsored enterprises, or GSEs.  They were created by Congress: to provide "liquidity, stability and affordability to the mortgage market," the Federal Housing Finance Agency says. The FHFA oversees Fannie and Freddie.

  

Ginnie Mae was established in 1968.  Ginnie Mae is an extension of the Department of Housing and Urban Development (HUD) and specifically deals with non-conventional loans such as FHA loans, VA Loan, and USDA loans, also known as government-insured loans.  

 

Fannie Mae was created in 1938 as part of FDR’s New Deal, in an effort to secure mortgages via what are called mortgage-backed securities (MBS). Mortgage-backed securities are packaged mortgage loans that are then sold to investors.  Typically, Fannie Mae purchases home mortgage loans from commercial banks, or big banks.  Fannie Mae loans are typically conventional loans, which are not insured by the government.

 

Freddie Mac was created in 1970.  Typically, Freddie Mac purchases home mortgage loans from smaller banks and lenders.  Freddie Mac loans are typically conventional loans, which are not insured by the government.

 

Fannie and Freddie buy about half of all the mortgage loans lenders make providing lenders with capital to make more loans.  Because lenders want to sell their loans to the GSEs, they structure mortgages to Fannie and Freddie standards.

 

While separate companies, Fannie and Freddie's home loan guidelines are nearly identical and establish some of the basic terms of home loans, including the debt-to-income ratio and the required down payment.  Generally, conventional mortgages that meet Fannie or Freddie standards require a minimum 620 credit score.  To avoid mortgage insurance, they want at least 20% down.

 

Mortgages also must be conforming, as discussed above.

 

GOVERNMENT BACKED MORTGAGES

Loans guaranteed by the Department of Veterans Affairs (VA loans), FHA-insured loans and loans backed or issued by the Department of Agriculture (USDA loans).

 

VA

A VA loan is issued by a private lender, such as a bank, credit union or mortgage company.  Only qualified U.S. veterans, active-duty military personnel and some surviving spouses are eligible for VA loans.  No down payment or mortgage insurance is required but there is an upfront funding fee.

 

FHA

An FHA mortgage is a home loan insured by the Federal Housing Administration.  FHA loans are backed by the government and designed to help borrowers of more modest means buy a home.  Allows down payments as low as 3.5%.  Credit scores as low as 500 can qualify.  Mortgage insurance premium payments are required.  Borrowers with lower credit scores and down payments less than 20% should investigate this option.

 

FHA v Conventional

FHA loans have a minimum down payment of 3.5% for borrowers with credit scores of 580 or higher. Some conventional mortgages allow a 3% minimum down payment, but it’s reserved for borrowers with credit scores in the high 600s and ample savings.

 

Debt-to-income ratios

Your debt-to-income ratio, or DTI, is the percentage of your monthly pretax income that you spend to pay your debts, including your mortgage, student loans, auto loans, child support and minimum credit card payments.  Your debt-to-income ratio must be 50% or less to qualify for an FHA loan. Conventional loans can debt-to-income ratios up to 50% though lenders approval is more likely for mortgage borrowers with DTIs of 43% or less.

 

Mortgage insurance

Mortgage insurance protects the lender in case of default. Conventional loans require borrowers to pay for mortgage insurance if their down payment is less than 20%.  FHA loans require mortgage insurance regardless of down payment amount.  

 

FHA mortgage insurance premiums cost the same no matter your credit score.  Private mortgage insurance on conventional loans costs more if you have a low credit score, but it may cost less than FHA mortgage insurance if your credit score is above 720.

 

FHA mortgage insurance premiums last for the life of the loan if you make a down payment of less than 10%.  You can get rid of FHA mortgage insurance by refinancing to a conventional loan.  By contrast, private mortgage insurance is automatically cancelled on conventional loans after your equity reaches 78% of the purchase price.

 

Both FHA and private mortgage insurance costs vary according to the size of the down payment.

 

Loan limits

Both conventional and FHA loans limit the amount you can borrow, and the maximum loan sizes vary by county.  The 2021 FHA loan limit is $356,362 in low-cost areas and $822,375 in expensive markets.

 

Property standards

The property’s condition and intended use are important factors when comparing FHA vs. conventional loans.

 

FHA appraisals are more stringent than conventional appraisals.  Not only is the property's value assessed, but it is also thoroughly vetted for safety, soundness of construction and adherence to local code restrictions.

 

Summary

To get an FHA loan, it must be your primary residence.  Investment properties and homes that are being flipped (sold within 90 days of a prior sale) are not eligible for FHA.  Conventional loans can be used to buy a vacation home or an investment property, as well as a primary residence.

 

Conventional

FHA

Require higher credit scores.

 

Allow slightly smaller down payments.

 

Have more liberal property standards.

 

Require private mortgage insurance when the down payment is less than 20%, and it may be cancelled.

Allow lower credit scores.

 

Require slightly higher down payments.

 

Have stricter property standards.

 

Make FHA mortgage insurance mandatory regardless of the down payment amount, and it can’t be cancelled unless refinanced into a conventional loan.

 

Borrowers with credit scores below 620 don't qualify for conventional mortgages, so FHA is the most likely option for them. Borrowers with credit scores lower than 720 will usually find that FHA loans cost less per month than conventional loans.

 

USDA

These loans are for those who live in a suburban or rural area.  USDA loans do not require down payment on most properties.

 

There are three USDA home loan programs:

  1.        Loan guarantees: The USDA guarantees a mortgage issued by a participating local lender - similar to an FHA loan and VA-backed loans - allowing you to get low mortgage interest rates, even without a down payment.  If you put little or no money down, you will have to pay a mortgage insurance premium.
  2.        Direct loans: Issued by the USDA, these mortgages are for low and very low-income applicants.  Income thresholds vary by region. With subsidies, interest rates can be as low as 1%.
  3.        Home improvement loans and grants: These loans or outright financial awards permit homeowners to repair or upgrade their homes.  Packages can also combine a loan and a grant, providing up to $27,500 in assistance.

 

Income limits to qualify vary by location and depend on household size.  To find the loan guarantee income limit for the county where you live, consult this USDA map and table: https://www.rd.usda.gov/files/RD-GRHLimitMap.pdf.

 

To qualify the home must be your primary residence, you must be a U.S. citizen.  The monthly payment –  including principal, interest, insurance and taxes – must be 29% or less of your monthly income.  DTI cap at 41%, though the USDA will consider higher debt ratios if you have a credit score above 680.  You must have dependable income, typically for a minimum of 24 months, an acceptable credit history, with no accounts converted to collections within the last 12 months.

 

The USDA issues mortgages to applicants deemed to have the greatest need. That means an individual or family that:

  •         Is without “decent, safe and sanitary housing”
  •         Is unable to secure a home loan from traditional sources
  •         Has an adjusted income at or below the low-income limit for the area where they live

 

The USDA usually issues direct loans for homes of 2,000 square feet or less, with a market value below the area loan limit.  Again, that’s a moving target depending on where you live.  Home loans can be as high as $500,000 or more in pricey real estate markets like California and Hawaii, and as low as just over $100,000 in parts of rural America.

 

 

 

Definitely meet with a mortgage loan officer who can help you compare loans and answer questions about their differences. 

Happy hunting!

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