If you’re considering buying a home, having a knowledge of basic mortgage and loan terminology can help prepare you for a meeting with a lender. Here are insights you can use to understand basic loan types and how they affect borrowers.
Loan types: Government-backed vs. conventional
The two different types of loans are conventional loans and government-backed loans. The main difference is who insures these loans:
- Are, unsurprisingly, backed by the government.
- Include FHA loans, VA loans and USDA loans.
- Make up less than 40 percent of the home loans generated in the U.S. each year.
- Are not backed by the government.
- Include conforming and non-conforming loans (such as jumbo loans).
- Make up more than 60 percent of the loans generated in the U.S. each year.
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Let’s dive a little deeper into what a government-backed loan is and why you may want to pursue that route for your home mortgage loan.
Government-backed loan types
There are three primary types of government-backed loans: FHA loans, VA loans and USDA loans.
FHA loans, which are insured by the Federal Housing Administration, are typically designed to meet the needs of first-time homebuyers with low or moderate incomes. For this reason, FHA loans are often called “helper loans,” because they give a leg up to potential borrowers who may not be able to secure one otherwise.
Those who take out an FHA loan must purchase a home within a certain budget. The maximum lending limit for FHA loans are redetermined annually, based on the housing values of the county where the for-sale home is located. See Minnesota FHA loan limits and Wisconsin FHA loan limits by county.
Because the agency is taking on more risk by insuring FHA loans, the borrower is expected to pay mortgage insurance both at the time of closing and on a monthly basis, and the property must be owner-occupied.
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VA loans are backed by the Department of Veterans Affairs and they are guaranteed to qualified veterans and active-duty personnel and their spouses. VA loans can be approved with 100 percent financing, meaning VA borrowers are not required to make a down payment.
You may also hear about USDA loans, which are backed by the United States Department of Agriculture mortgage program. USDA loans are intended to support homeowners who purchase homes in rural and some suburban areas. USDA loans do not require a down payment and may offer lower interest rates; borrowers may have to pay a small mortgage insurance premium in order to offset the lender’s risk.
What’s a conventional loan? Understanding what it means to be conforming and non-conforming
Buyers who have a more established credit history and a larger down payment may prefer to apply for a conventional loan. These loans may offer a lower interest rate and only require the home buyer to purchase monthly mortgage insurance while the loan-to-value ratio is above a certain percentage, so a conventional loan borrower can typically save money in the long run.
Conventional loans are divided into two types: Conforming loans and non-conforming loans.
Conforming loans are those that meet (or conform to) predetermined standards set by Fannie Mae and Freddie Mac – two government-sponsored institutions that buy and sell mortgages on the secondary market. By selling the loans to “Fannie and Freddie,” lenders can free up their capital and return to issue more mortgages than if they had to personally back every loan that they approve.
The main standard for conforming loans is that the amount borrowed must be under a certain amount; in Minnesota and Wisconsin, a single-family home loan must be under $726,200 in order to be considered conforming.
Non-conforming (jumbo) loans
But what happens if a borrower wants to borrow more than the Freddie- and Fannie-approved loan amount? In this case, they would have to apply for a “jumbo loan,” which is the most common type of non-conforming loan.
Because the lender cannot resell the jumbo loan (or any non-conforming loan) to Freddie Mac or Fannie Mae, jumbo loans are considered to be riskier than a conforming loan. To protect against this risk, the bank will typically require a higher down payment; the interest rate on a jumbo loan may also be higher than if the same borrower applied for a conforming loan.
Rate types: Fixed-rate vs. adjustable-rate mortgages
In addition to the loan type you choose, you’ll also have to determine if you want a fixed-rate mortgage or an adjustable-rate mortgage (ARM). A fixed-rate mortgage has an interest rate that does not change for the life of the loan, so it provides predictable monthly payments of principal and interest.
An adjustable-rate mortgage typically offers an initial introductory period with a low-interest rate. Once this period is over, the interest rate adjusts periodically, based on the market index. The initial interest rate on an ARM can sometimes be locked in for different periods, such as one, three, five, seven, or 10 years. Once the introductory period is over, the interest rate typically readjusts annually.