The Pros and Cons of Different Types of Mortgages

July 24, 2018

While it’s common to use the term “mortgage” as if it’s a single type of financial product, there are several different variations. Each provides basic home financing but with its features and nuances. You may find one loan type preferable to another, either based on personal circumstances or financial goals.

Let’s take a look at the different major types of mortgages, and the pros and cons of each.

Conventional Loans

These mortgages are called conventional to distinguish them from government loans, like FHA, the Federal Housing Administration, and VA, or Veterans Affairs, mortgages. The loans themselves are funded by the Federal National Mortgage Association (FNMA, or “Fannie Mae”) and the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”).

But perhaps what most differentiates conventional mortgages from government mortgages is the source of private mortgage insurance (PMI). While the PMI on FHA and VA loans is provided by government sources, it comes from private insurance companies on conventional mortgages.

PMI is required any time you either make a down payment of less than 20% of the purchase price on a home or have less than 20% equity in the case of a refinance.

Let’s look at the pros and cons of conventional mortgages:

Pros:

  • More lenders offer conventional mortgages; not all participate in FHA or VA loans.
  • Interest rates on conventional mortgages are often lower than they are under government loans.
  • Documentation requirements on conventional mortgages are generally lower than it is for government loans, especially if you have good credit and a large down payment.
  • If PMI is required, you generally don’t have to make an upfront payment; PMI is collected only on a monthly basis.
  • They can be used to purchase both second homes and investment properties; FHA and VA loans cannot.
  • There’s generally a wider variety of loan types, such as Adjustable-Rate or Fixed-rate, and terms available than with government loans.

Cons:

  • You generally have to have good credit to qualify.
  • In many cases, at least 5% of the purchase price must come from the borrower’s own funds.
  • Conventional mortgages are not assumable, meaning the outstanding loan and its terms cannot be transferred from the current owner to a buyer.

FHA Loans

These are mortgages that are insured by the Federal Housing Administration or FHA. The agency was created during the Great Depression to both standardize and liberalize mortgage financing. Over the years, FHA has made more generous loans to less qualified borrowers.

FHA mortgages are available in both fixed rate and adjustable. Terms can be from 15 years to 30 years.

Pros:

  • FHA loans tend to be more lenient when it comes to borrower credit.
  • Relatively low down payments on standard mortgages, of just 3.5% of the purchase price.
  • You can often get approved third-party financing or grants to cover the down payment.
  • Higher seller paid closing cost limits – 6% of the loan amount, compared to just 3% on low down payment conventional loans, and 4% on VA loans.
  • FHA mortgages are assumable.

Cons:

  • FHA loans charge borrowers mortgage insurance in two ways – upfront and monthly. The upfront charge is 1.75% of the loan amount, though it can be financed through the mortgage.
  • Sellers sometimes prefer to avoid buyers who need FHA loans, because of stricter property condition requirements.
  • FHA loans are not frequently available for condominiums.

Fixed Rate vs. Adjustable Rate Mortgage (ARM)

All three of the major mortgage types offer both fixed-rate loans and adjustable rate mortgages, called ARMs. Fixed rates range from as little as 10 years up to 30 years. And naturally, 30-year loans are the most popular.

ARMs are typically for 30 years. They offer a fixed term for a limited amount of time, then the rate will periodically adjust to a new rate based on the market rate index. On FHA and VA mortgages, an ARM has a fixed term of five years, then converts to a one-year adjustable over the balance of the loan.

Conventional mortgages offer initial fixed terms of three, five, seven and 10 years. After the initial term, they also become one-year adjustable-rate loans over the balance of the loan term.

For this reason, ARM loans are frequently referred to as 3/1, 5/1, 7/1 or 10/1 in the industry.

ARMs typically have what is known as “rate caps”. For example, the initial rate adjustment may be limited to 2%. That means an initial rate of 3.5% cannot exceed 5.5% on the first adjustment. A 2% cap on subsequent adjustments is also typical. There’s also a lifetime cap of 5%, which would limit an initial rate of 3.5% to no more than 8.5% over the life of the loan.

Since fixed-rate mortgages are self-explanatory, let’s focus on the pros and cons of the ARMs.

ARM Pros:

  • Lower initial rate than fixed-rate mortgages.
  • ARMs can be a real advantage if you plan to sell or refinance the home within the fixed rate term. For example, if you are frequently transferred for your job, and expect to be transferred within five years, a five-year ARM would make sense.
  • ARMs have a natural advantage if interest rates fall. After the initial fixed rate term, you’ll get the benefit of a lower interest rate without having to refinance.
  • Paying down your mortgage balance early will result in a lower monthly payment since each adjusted payment is calculated based on the remaining outstanding balance.

ARM Cons:

  • Since the rate on an ARM can change, your future house payment will be less certain.
  • If interest rates rise, your house payment can increase substantially.
  • Subsequent interest rate increases can more than double the initial rate on your loan.
  • It’s harder to pay off an ARM loan early since prepayments only reduce your monthly payment and not the term of the loan.

Final Thoughts on the Pros and Cons of Different Types of Mortgages

The mortgage industry has come a long way over the years. There are different mortgage types and specializations depending upon your particular circumstances and what it is you would like to do. For example, a VA loan provides many benefits for an owner-occupied property. But they don’t offer loans for vacation homes. That’s where a conventional mortgage becomes a better option.

If you have some credit issues, FHA mortgages tend to be the most accommodating. If you plan on staying in your home for life, you’ll favorite a fixed-rate 30-year mortgage, over a five-year ARM.

The good news is, wherever you are financially, and whatever your goals may be, the right loan exists. Choose the mortgage type that works best for you.

Send this to a friend