You may have already had a student loan or taken out a personal loan in the past. If you’re thinking about buying a home, you’ve probably had a car loan and maintained a credit card. But a mortgage loan is far more complicated — and determining the right type of loan can feel overwhelming. Here’s what you need to know before you start shopping.
The Basics of a Conventional, Fixed-Rate 30 Year Mortgage
First, let’s take a look at the most basic type of mortgage. This is the mortgage that most people talk about when they talk about getting a loan.
The basic mortgage is a 30-year loan: the payments are made for 30 years, after which you own your property outright. Conventional mortgages require 20 percent down, so you need to provide 20% of the home’s purchase price yourself. Apart from this, the most important number is the APY: the percentage of interest that you pay.
Mortgage loans in America are “front-loaded,” which means you pay more interest at the beginning of the loan. Towards the end, you will mostly be paying the principle. This means that you won’t be building a lot of “equity” in the first years, but you will get a tax deduction for your mortgage interest paid.
But most people don’t get a conventional 30-year mortgage, because there are also types of mortgage:
- FHA loans. FHA loans are federally backed loans for first-time homebuyers. These loans only require 3.5% down rather than 20% down, and borrowers can qualify with credit scores that are as low as 500.
- VA loans. VA loans are Veteran’s loans, available for active and former duty veterans. These loans only require 0% down, and there are no strict credit score or income requirements; the borrower’s entire financial situation is considered.
- USDA loans. USDA loans are rural loans that are meant to build out more rural locations. For those looking outside of the city, USDA loans may be best, but they have some income limitations: You can’t earn over a certain amount.
These programs are government-backed, which is what makes them easier to acquire. But they are also meant for specific situations.
Interest Rates, Terms, and More
Apart from the types of loan, the terms of the loans can be customized. First, there are both fixed-rate loans and adjustable-rate mortgages:
- Fixed-Rate. These loans will have the same APY the entire way through. If it is a 30-year mortgage loan, it will have the same APY each of those 30 years. A low rate fixed-rate mortgage is usually the best option, though there are some exceptions depending on the situation.
- Adjustable-Rate. These loans will have an adjustable rate, usually much lower at the beginning, but higher later on. Many borrowers choose an adjustable-rate mortgage (ARM) on the basis that they can refinance to a fixed-rate later, but this isn’t always a guarantee.
There are also different terms. While a 30-year loan is most popular, there are also 20-year loans and 15-year loans. The monthly payment increases, but the total amount of interest paid is drastically reduced, and the home is paid off much faster.
The Determining Factors for Getting a Loan
What determines which types of loan you can get? There are four things: prerequisites, credit, income, and debt.
Some programs do require that you meet some prerequisites. The USDA loan requires that your household income not be too far over the state’s median income, for example. These are important and will determine the type of loan you might look for.
After those prerequisites, credit controls what type of loan you’ll qualify for. If you have good credit, you are very likely to be able to get most types of loans, provided that you meet the prerequisites. It also isn’t solely the credit score: they will look to see if you have a bankruptcy or a foreclosure on file.
Credit controls the type of loan, but your income controls the size of the loan. Your income, along with your debts, is used to calculate how much house you can afford.
When home loans look at your debt, they want to know that your debt-to-income ratio meets certain standards. For some types of loan, your debt can’t exceed 42 percent of your income, regardless of whether you can afford the property. You also need to be able to reasonably afford the property.
If you don’t qualify for a loan, there are a few things that could be happening. It could be that you don’t have enough credit or enough income. Or it could be that there’s an error on your credit report. The best thing to do is to check your credit before you even apply.
Renovation and Recovery Loans
Most traditional mortgage loans require that a property be in relatively good condition and habitable. The bank doesn’t want to become responsible for a property that is in such poor condition that it cannot be sold, in the event of a foreclosure. But there is an exception.
There are renovation loans, which offer both the price of the property and a stipend for renovating it. For example, a renovation loan might give you $100,000 to buy the property and $20,000 to renovate it, for a total $120,000 loan on a $100,000 purchase price. Generally, the full amount cannot be more than a certain percentage of the purchase price.
ThesThese types of loans are very valuable for those who want to be able to remodel and renovate their own home. However, it’s not usually for DIYers: Most renovation loans require that the bulk of the work be done by professionals.
Some renovation loans can be tied to particular areas or houses. For instance, Fannie Mae renovation loans are only released to Fannie Mae foreclosures. Some cities offer renovation loans for historic areas or areas that have fallen into disrepair. These loans are used to rejuvenate an area that might not otherwise be desirable.
Unconventional Mortgage Loans
What if someone can’t get a conventional mortgage loan? In this situation, there are unconventional mortgage loans. These unconventional mortgage loans will almost universally cost much more, and they don’t have the legal protections that traditional loans do.
Nevertheless, some people do engage with them because they aren’t able to qualify for conventional loans.
- Hard money loans. These are loans provided by solo investors, backed by the equity in the property. This is usually for commercial properties rather than residential properties, and they can be much higher interest. Because they are backed with the equity of the house, foreclosure is likely if you fall behind on payments; this is the same with a typical mortgage, but with a typical mortgage the payments are also generally much lower.
- Rent-to-own. These are contract agreements under which a person will “purchase” a home through their rent payments. They make rent payments for a certain amount of time, after which they’re given the option to buy the house at a discounted price. Rent-to-own is usually more expensive, but it doesn’t have the credit requirements of buying through a mortgage. Borrowers have to be careful and skeptical when renting to own because this gives the landlord significant power. Renting to own usually means the monthly payments are higher, and an untrustworthy landlord can find a multitude of ways to avoid ultimately handing the property title over.
There are also special types of loans like a “bridge loan,” which are specifically created to bridge the gap when selling an old property and buying a new property. These loans are specialty loans that still rely on the individual’s credit and income, but may temporarily let them be making payments on multiple houses that they wouldn’t otherwise qualify for.
Usually, it’s better for someone to try to qualify for a more conventional mortgage loan—even if they need to wait a year or two to repair their credit or save up a larger down payment.
Residential vs. Commercial Loans
So far, we’ve talked primarily about residential loans. Commercial loans or investor loans are different.
When someone is buying a property to rent out rather than to live in, they usually need a larger down payment. The risk is greater with a commercial property. Most people are more careful about their residential properties because they don’t want to be evicted.
For investor loans, there’s will be higher standards for credit and income pictures. These loans also may not be as long. House flippers, as an example, frequently take out ten-year loans or shorter. They’re paying more in the interim but they know that they ideally aren’t going to pay the loan for very long.
Usually, the risk is distributed in commercial loans because investors will take out commercial loans with other investors. This is vastly different from residential loans which are only generally taken out by the homeowners themselves (though family arrangements are occasionally made).
Repairing Credit and Income Picture
It doesn’t always take a long time for an individual to repair their credit. First, they can pay down their debts and make sure they’re paying their bills on time. If they don’t have an established credit history, they should open an account. It may take a year or two for a new account to boost credit, but it’s worth it.
If someone can’t repair their credit in time, they can also consider a co-signed. A co-signer is usually a close family member. They become responsible for the loan if the primary borrower doesn’t pay. While the primary borrower can refinance in the future to get the co-signer off the loan, they will have to have improved their credit picture significantly. So, it’s not something someone should rely on.
Second is the income picture. Since income and debts are both calculated, paying down debts can help if your income is too low. Remember to log all your income, including bonuses, tips, and side jobs, because this will factor into the decision. The house payment includes the loan, insurance, and any HOA fees, so you may also be able to afford a home that is in a lower insurance area or doesn’t have an HOA.
The Bottom Line
As you can see, finding the right mortgage loan can be quite complex. But it’s such a large investment that it’s worth it to take the time and do the research. For most first-time home buyers, an FHA loan is going to be the right option: It’s a flexible loan package that requires only 3.5% down. For those that don’t qualify, a standard, fixed-rate, 30-year mortgage is the best choice. But for those who have credit or income challenges, or who want to purchase rural or damaged properties, loan choices may need to get a little more creative.