5 Types of Home Loans Explained

Mortgage rates have been at historic lows, but the Federal Reserve has indicated that rate hikes are coming. If you want to get in on lower rates, now's the time to figure out which of the five major types of loans is best for your homebuying needs.

Before we dive into the five types of mortgages, you should know that they all fall under one of two categories: conforming loans and nonconforming loans. The difference comes down to how much risk a lender is willing to take on with you as a borrower.

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Conforming loans conform to the criteria established by the government, particularly the Federal Housing Finance Agency, which oversees Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. In fact, Fannie or Freddie are likely to buy your loan, which means less risk for the original lender.

Your conforming loan will be bought from the original lender if it is below the max dollar limit, which is $647,200 for a single-family home, an increase from $548,250 in 2021. If you purchase a home in a high-cost area, the limit is $970,800, up from $822,375 in 2021.

Lower risk for the lenders means stricter criteria for borrowers. Conforming loan applicants need a credit score of at least 620, and there may be property and income restrictions.

ALSO READ: Conforming Loan Limits Will Rise for 2022: What Mortgage Borrowers Need to Know

Nonconforming loans do not have the strict borrower criteria that comes with conforming loans. However, they are also not bought by other agencies, which can be a bigger risk for lenders.

The two main types of nonconforming loans are jumbo loans and government-backed loans, like those insured by the Federal Housing Authority (FHA), Department of Veterans Affairs (VA), or US Department of Agriculture (USDA).

Now let's dive into the five major types of loans.

The most common mortgage is the conventional mortgage, a conforming loan not backed by a government agency. You can use this loan to finance any type of property, be it your primary home, a vacation home, or an investment property.

Strict criteria can make them harder for borrowers to qualify -- you'll need at least a 620 credit score and a low debt-to-income ratio.

You can put as little as 3% down for this mortgage, but you'll want to aim for that 20% down payment to avoid private mortgage insurance (PMI), which can add hundreds of dollars to your monthly payment. Lenders consider anything less than 20% ownership of the property as a risk, so you'll pay PMI until you get to that threshold.

Best for: Borrowers with a down payment and strong credit

ALSO READ: Mortgage Calculator: PMI, Interest, and Taxes

Higher property prices usually mean buyers need to borrow much more than conforming loans will allow, so jumbo loans are the way to go.

While the interest rates for jumbo loans are similar to their conforming loan counterparts, they are harder to qualify for because of their larger dollar amounts. You'll need a strong credit score (usually at least 700) and a lower debt-to-income ratio. You'll also need a down payment of 10 to 20%, which can be a hefty amount of cash if you're buying a million-dollar home.

However, now that the conforming loan limits have increased in 2022, some buyers might not need a jumbo loan and could instead qualify for a conventional mortgage.

Best for: Borrowers with strong credit and income who need larger loans to finance higher-priced properties

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An FHA loan is a government-backed loan that lends money to buyers with a minimum credit score of 580 and a down payment of 3.5%. If you have a 10% down payment, your score could be as low as 500 in some cases.

When the government insures a loan, it poses less of a risk for lenders in case of default. It's a good alternative for those who might not qualify for a conforming loan. You might qualify with a lower credit score and a much smaller down payment -- even no money down in some circumstances. If you have any negative items on your credit score, including a bankruptcy, you might still qualify for a government-backed loan like the FHA loan.

Best for: Buyers with lower credit scores and small down payments.

ALSO READ: FHA Loan Limits Are Rising in 2022

The U.S. Department of Veterans Affairs (VA) backs these mortgages. Borrowers must have served in the National Guard or the Armed Forces to qualify for this loan, which allows them to purchase a home with no money down. Even without a down payment, a VA loan carries lower interest rates than most other loans.

It's important to note that while there is ample opportunity to save money on interest and down payments with these government-backed loans, mandatory insurance premiums can drive up borrowing costs.

Best for: Service members who have little to no cash for a down payment and can't qualify for conventional loans

ALSO READ: Here's Why VA Loans Could Get More Expensive

The US Department of Agriculture backs these mortgages. As such, these loans are reserved for rural property purchases. You could qualify for a USDA loan with little to no money down if you meet income requirements—you must have a stable income that's no more than 115% of the median adjusted gross income in the area.

Best for: Rural residents who meet income requirements

ALSO READ: What Is a USDA Loan and How Can I Qualify?

Regardless of the type of mortgage you obtain for financing, you will pay it back at a fixed or an adjustable interest rate. The right choice for you as a homebuyer depends largely on your income and long-term plans as a homeowner.

As the name suggests, the interest rate and monthly payment won't change at any time during the length of the loan, aside from fluctuations in homeowner's insurance and property taxes. In general, a fixed-rate mortgage makes budgeting and planning easier.

Keep in mind, though, that you're locked into this rate until you decide to refinance. That means even if interest rates drop, you'll still be at the same rate as when you applied for the loan.

The 30-year fixed-rate conventional loan is the most common mortgage, though you can also secure them for 20-, 15-, and 10-year terms.

Best for: Buyers who have moved into their "forever home" or who have nabbed a low enough interest rate that they won't be in the market to refinance in the short term

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An adjustable-rate mortgage (ARM) is the opposite of a fixed-rate mortgage in that its interest rate will change as the market rates change.

However, you will have to agree first to a period of fixed interest -- anywhere from five to 10 years—when you choose an ARM. The rate for an ARM is typically lower than the current 30-year fixed rates, though.

Once the introductory period is over, your interest rate will change to reflect the current market rate. That means if the rates have gone up, yours will, too. Don’t worry: A rate cap will defend you from dealing with continually climbing interest rates. The cap also works in the opposite way, though, and will stop your rate from falling too far.

Best for: Borrowers who aim to pay off their home loan early or don’t plan to keep the property for the full term of the loan

ALSO READ: 3 Benefits of Fixed-Rate Loans Over Adjustable-Rate Mortgages

You'll likely have eliminated a number of these mortgages right away based on your qualification criteria, particularly your credit score, your income and current debt, and your property needs. Before you even begin your property search, you should get preapproved for a mortgage so that you know what type you are eligible for and, most importantly, how much home you can afford.

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