Popular Loan Programs For Home Buyers

When thinking about buying a home, many of us assume that one of the largest barriers to entry for us to be able to purchase a home is obtaining the financing to do so. After all, unless you’re buying a house in cash, you’ll need to obtain a loan to make the purchase. While there may be some truth to this, getting a pre-approval is often much less troublesome than you may think. In fact, it’s because of these doubts that I so often hear associated with getting a loan that provided me with the motivation to put together a blog discussing some of the most common loan programs, and some of the major facts, pros and cons associated with each one of them. By educating you on each type of loan, my goal in this is to show that regardless of your situation, there is often a loan that might suit you, and help you to finally buy the house you’ve been dreaming of buying. Without further ado, here are some of the most common loan programs you may be eligible for.

Fixed Rate Conventional Loans

Perhaps the most popular type of loan, this is precisely the loan that many of us believe we’ll need to be eligible for to qualify to purchase a home. So what exactly is a conventional loan? For starters, a conventional loan is any mortgage loan that is not insured/guaranteed by the government. Instead, these loans are provided by a private lender such as a bank or credit union. With a fixed rate conventional loan, you’ll receive the money for your house upfront, and slowly pay back the loan over a specific amount of time (typically 30 years), at a fixed (i.e. unchanging) rate.

These types of loans require a down payment and good finances (i.e. higher income and good credit) to secure better terms. Individuals looking to qualify for this type of loan will need a minimum credit score of 620, and debt to income (DTI) ratio at or below 50% after factoring in your mortgage payment. As a quick aside, for those wondering what your DTI ratio is, it is your monthly debt payments divided by your gross monthly income. Debt payments may include student loans, car payments, credit card payments, and of course, mortgages. Variable expenses such as food, cable bills, and your weekly bar tabs fortunately are not included in this calculation. To calculate DTI, let’s look at the following example: If you pay $2000 per month for your mortgage, $500 for student loans, $250 for a car, and $250 a month in credit card repayments, your monthly debt payments are $3000. If your gross monthly income is $6,000, your DTI ratio is 50%. If you were to make that much monthly, $2,000 would be the maximum amount you may pay toward your mortgage, taxes and insurance if using a conventional loan. 

Understanding some of the intricacies of this loan, it’s also important to consider how much you’ll have to put down on a house if you’d like to use a conventional loan. While many of us believe that we’ll need to put 20% down to buy a house, that couldn’t be further from the truth. For example, for first time home buyers, you can purchase a home with as little as 3% down, and for those of you that already own a home, as long as you are purchasing another with the intent for it to be your primary residence, you may be able to buy the home for only 5% down. Others may elect to put more down, and thus pay less toward their mortgage payments each month. For those that elect to go this route, you can select to put 10% down, 20% down, or even more than this if you’d like.

If you’d like to buy an investment property in addition to owning your primary residence, you may use a conventional loan to purchase the property; however, you must pay at least 20% down. Any conventional loan program in which you would be putting less than that 20% down is only possible when purchasing a primary residence.

Now, you might be asking yourself why you’d want to put more money down, especially 20% or more, if you can buy a house and only put 3-5% of the purchase price down? The answer lies in the monthly payment, and in having to pay something called private mortgage insurance (PMI).

First and foremost, when you put less money down, you’ll end up with a larger loan amount, which means you’ll be paying more each month to pay back this larger number. As a result, you’ll end up paying more in interest over time.

Second, you’ll owe something called private mortgage insurance (PMI) each month. PMI is a type of insurance that is made to protect your lender, not you, in the event that you default on the loan. Because loans in which you do not put down at least 20% are considered more risky to lenders (as they’re lending a greater amount of money), they charge this as a cost to you as protection.

The actual cost per month of PMI can vary, and operates differently depending on the loan. For conventional loans PMI typically depends on the amount of the loan, the amount you put down (the less you put down, the higher PMI payment/month), and your credit score. For those with average (700+) to above average credit scores who are planning to put 5% down on their loan, I often recommend factoring in a rate of about 0.5-0.75% toward the monthly payments.

Having a better understanding of the way conventional loans work, the next question you may ask yourself naturally is why should I go with this type of loan? To best answer this, lets explore some pros and cons to allow you to determine if it's a good option for you.

Starting with the pros, conventional loans typically offer more options (i.e. types of loans) for borrowers, provide flexibility in rates, have less strict standards on the type of home you can buy, and are viewed as more favorable by sellers, making your offer more likely to get accepted when using a conventional loan. I’ll go into more detail as to why that is the case when I discuss FHA loans below.

Conversely, there are some cons as well. The primary con is associated with the eligibility requirements for this type of loan. For example, for those with a credit score below 620, or with a high DTI, getting a conventional loan will be challenging, and may take longer for us to be eligible. The same can also be said to those with a history of declaring bankruptcy, or for those that have a history of foreclosure in the past. For these individuals, the time in which it may take for a lender to grant you a pre-approval (if they elect to grant one at all), is typically much longer for conventional loans than would be granted for government backed loans.

FHA Loans

FHA loans are government backed loans that typically provide looser financial requirements to allow you to buy a home. The Federal Housing Administration (FHA) is the institution insuring these loans, thus protecting the lender supplying the loan to you if you default on your loan. It is precisely for this reason why lenders will have more leniency to pre-qualify you for an FHA loan.

When using an FHA loan, individuals may borrow up to 96.5% of a home’s value, thus allowing you to put as low as 3.5% down. Those with a credit score > 580 will be eligible for this type of loan, as opposed to the 620 minimum seen with conventional loans. Your maximum DTI ratio % will vary based upon credit score. For example, those with a credit score closer to 580 will need to have a concurrently low DTI, typically falling somewhere around 40-45% after inclusion of your mortgage payment. For those with a credit score > 620, DTI may rise somewhere around 55% with inclusion of your mortgage payment.

When it comes to FHA loans, PMI is very important to consider as it relates to your monthly payments. Technically speaking, they don’t even call it PMI with FHA loans. Instead, they call it a mortgage insurance premium (MIP). MIP is charged at a flat 0.55% throughout the life of the loan. This is obviously different than PMI associated with conventional loans, as that fee is removed once you reach an equity of 20% or more. Fortunately for borrowers, this 0.55% is a relatively sizable decrease from previous years, in which the annual mortgage insurance premium was 0.85%. In order to rid yourself of this fee, it’s best to refinance into a conventional loan with no PMI once you’ve reached a point in which you have 20% equity in your home.

On the topic of mortgage insurance, there is also something else you’d want to consider when qualifying for an FHA loan. There is also an upfront insurance charge you will incur when you close on your home. The charge is typically 1.75% of the loan balance, which either can be paid at closing, or can be wrapped back into the loan and paid off over time. Either way, you’re still forced to pay that extra 1.75%.

Understanding the ins and outs of this type of loan, let’s dive into some of the pros and cons associated with it:

The pros for FHA loans essentially are the inverse of the cons for conventional loans. These types of loans are better for borrowers with credit issues, higher DTI ratios, and for borrowers who may not be able to put as much down. They also can be helpful for those with a recent history of bankruptcy or foreclosure, as the time requirements before regaining eligibility to qualify for a loan are much less than that of a conventional loan.

Regarding cons, perhaps the major drawback to using an FHA loan has to do exclusively with the likelihood of getting your offer accepted and finding a home that suits you. For starters, the property must meet basic health and safety requirements to get approved for the loan, so those of you looking for a fixer upper are likely going to struggle finding something suitable. Because FHA loans are held to these requirements I just mentioned, sellers are often more hesitant to select buyers who are offering to buy a home using FHA financing. These extra requirements may slow down or blow up a deal altogether, and thus incur a higher degree of skepticism from sellers, making it less likely that your offer will be accepted. 

With all that being said, FHA loans can offer a great way for buyers often stuck sitting on the sidelines to actually be eligible to purchase a home.

VA Loans

For those that are active-duty military members, veterans, or even surviving spouses, you may be eligible to purchase a home using a VA loan. These loans are also a type of government backed loan, this time being backed by the U.S. Department of Veterans Affairs.

To be eligible, it will depend on your status currently with the military. Generally, for ACTIVE DUTY service members, if you’ve served for at least 90 continuous days in war time (all at once, without a break in service) or 181 continuous days in peace time, you will be considered eligible. For veterans, to be eligible requires 2 years of regular service for members, and 6 years for reservists and national guard members.

For those eligible, VA loans offer a tremendous amount of benefits, including, but not limited to, no down payment, no mortgage insurance, lower interest rates, and lower closing costs. Remember, for conventional or FHA loans, each requires a down payment of at least 3-3.5%, with mortgage insurance required for each. With VA loans, you may purchase the house without putting a single dollar down, and refrain from paying any mortgage insurance, offering a huge advantage to any prospective borrower.

As is customary, there still are a few cons associated with this loan. The first involves a VA funding fee. If you are putting less than 5% down, you must pay a “funding fee” of 2.15% of the loan amount. This number does decrease as you put more down. For example, if you were to put more than 10% down, the fee can be somewhere around 1.25%. One important thing to note, however, is that not all borrowers are always required to pay this funding fee. For those receiving compensation for service-related disabilities, or are the surviving spouses of a veteran, you may be exempt from this fee.

Additionally, VA loans often limit the type of property you may buy. Just like with FHA loans, the eligibility guidelines for the home are stricter, and thus cause the same problems for borrowers. Again, it'll be more challenging to find a home, and for those sellers that are willing to accept an offer with a VA loan, they'll normally meet it with more skepticism. As a result, you may be stuck looking longer and may find yourself losing multiple bids in the process.

Still, for those that are eligible, because the loan offers the ability to purchase a home with little to no money down and with no mortgage insurance, I often recommend this great option.

Adjustable Rate Mortgages (ARMs)

A separate type of loan also provided by private lenders/banks, adjustable rate mortgages (ARMs) differ from your standard fixed rate mortgages in the way in which the interest rate changes over time. Similar to fixed rate conventional loans, an ARM is a 30 year adjustable rate type of loan that has an initial fixed rate period (typically less than 10 years), then, once that period ends, the interest rate on the loan adjusts each year. Each time the rate adjusts, so too does your monthly payment. For example, if the interest rate goes up, your payment will increase to cover the larger amount of accrued interest. The inverse is true if the rate drops. Most often, the way in which the rate adjusts after this initial fixed rate will be recalculated annually. This is why ARMs will earn the names of 3/1, 5/1, 7/1 or 10/1. After the initial fixed rate period of say 5 years, the rate will adjust annually (where the 1 comes from) for the remaining 25 years.

The start rate, or “intro rate,” is the ARM’s initial interest rate. This rate is typically lower than whatever the prevailing fixed rate loan interest rate is. This is precisely what makes this loan program attractive for borrowers. For an allotted period (i.e. 3, 5, 7 or 10 years), your interest rate will be a locked in rate that may be significantly lower than the going fixed rate. This is why ARMs can be a useful program to use in high interest rate environments (like what we find ourselves in in 2023). Another important thing to note is that the intro rate on a 3/1 will be lower than that of a 5/1 which is lower than a 7/1 and so on and so forth. The reason for this is that over a shorter time frame there is less likelihood of a fluctuation in either direction for the rate, lowering the risk for the lender in providing the loan.

As mentioned before, the reason why they’re termed “adjustable rate mortgages” is because the rate will change AFTER this initial rate period. The change in rate typically is tied to indexes such as the yield on one year treasury (T) bills, or the secured overnight financing rate (SOFR). With a change in rate, you also have a specific “margin” amount added back into the index rate to determine what your actual rate is. For example, if the SOFR rate is 3% and your margin is 2.5% on your loan, your ARM interest rate would be 5.5%. With each rate adjustment, the lender will add your margin rate to your index rate to get your new rate. Margin will be different from buyer to buyer. Things that may influence this include credit score and credit history, income and work history, and overall broader Real Estate market conditions.

In order to avoid a potential disaster in terms of how much your rate may go up above the initial rate amount, lenders set an ARM rate cap to determine how much your rate may go up if rates were to skyrocket over the life of your loan. This is precisely the value that a lender will also use to pre-qualify you for a loan. The reason is simple…prepare for the worst. Starting at a lower rate is great, but if the interest rate goes up over time and you’re unable to pay for this from the beginning, your risk of default is substantially greater.

The amount in which your interest rate can increase can vary. There are caps that apply only to the first interest rate adjustment, which limits the amount your rate can increase after the initial fixed rate expires. There is another cap that applies to each subsequent rate adjustment, limiting the amount by which your rate can rise each time it adjusts. One other type of cap (and potentially the most popular) is a lifetime interest rate cap. This determines how high your rate can go over the life of the loan, expressed either as a specific rate, or as a % point over the start rate.

As these loans tend to be pretty polarizing in terms of the way people view them, it’s important to consider some pros and cons associated with ARMs.

Some pros to deciding to use an ARM include lower initial interest rates (decreasing monthly payments and keeping cash in your pocket), and allowing you to afford a more expensive home. In high interest rate environments in which you see multiple interest rate hikes in a short period (I’m looking at you 2022-2023), an ARM offers you the ability to lock in a lower rate for a given time period. Once you are closing in on the end of this time frame, or if interest rates drop a significant amount at any point in time during your initial rate lock period, you can refinance to a fixed rate loan and lock in a better long-term rate for you. Also, if you keep your ARM and rates drop after the initial fixed rate time period, your monthly payment would decrease anyway.

With that being said, there are cons to using an ARM. The most obvious and main con is the fact that your rate and thus monthly payments may rise after the initial rate period ends. This is why it’s paramount to determine what is the maximum amount your rate may be capped at and determine if that payment is something you can handle if it gets to that point. Be careful not to buy too much house as well. You may be attracted toward a more expensive home because your initial monthly payments may be less, only to be stuck in a challenging position once the rate adjusts.

Jumbo Loans

The last common loan program some home buyers will need to use is a jumbo loan. This type of loan is used when the loan amount exceeds the limit set by the government. This amount will typically vary from location to location, but is generally more than $726,200 in most parts of the U.S. The maximum size of a jumbo loan will also vary depending upon both your mortgage lender and location.

Because jumbo loans are considered non-conforming (i.e. not conforming to typical standards set out by guarantors such as Fannie Mae/Freddie mac and government backed agencies), their loan terms and borrower requirements tend to be more variable from lender to lender. For example, jumbo loans are known to typically carry higher interest rates than standard fixed rate conventional loans, FHA loans or VA loans. Minimum credit score may also vary more from lender to lender. Some lenders may require a minimum score of 680, while others require a minimum score of 700. Remember, this is different than a fixed rate conventional loan, which requires a minimum score of 620.

Other requirements for jumbo loans that differ from conforming loans include a higher minimum down payment (typically greater than 10%), lower DTI ratios, and a sizeable amount of liquid assets or cash reserves.

These loans are great for those looking to purchase a more expensive home above what a traditional mortgage would allow, but because you’ll require a higher credit score, larger annual income and need additional cash in the bank to cover payments, this type of loan may not be as common nor necessary for those looking to buy a house below that $726,200 threshold number.

Which Home Loan Should You Choose?

While this is a loaded question, I’m sure it’s one that you’re naturally arriving at after reading this. Of course it will be vary from person to person and from situation to situation, but there are a few common scenarios that may make certain loan programs more attractive than others.

To begin, for borrowers that would qualify, if you find yourself in standard to below average interest rate environments (i.e. you can get a normal rate or a very attractive, less than 4-6% rate), it is likely in your best interest to use a 30 year conventional fixed rate mortgage. It’ll offer you the most competitive loan terms, least amount of closing costs, and reduced monthly payments.

For borrowers that are either less likely to qualify for a conventional loan, or eligible for a loan such as a VA loan, government backed loans can be a great alternative to allow you to get your foot in the door and purchase a home. With lower down payment amounts and more lenient lending guidelines, the barrier to entry may be lower than you think when using one of these loans.

In higher rate environments, such as what we’re experiencing now, it may not be a bad idea to try something like an ARM. If you’re able to lock in an attractive fixed rate and refinance into a conventional fixed rate loan in the future if and when rates drop, you can find yourself keeping your rate and thus monthly payment below what you’d otherwise have had to pay using a conventional fixed rate loan.

Concluding Thoughts

As you can tell, there are a ton of loan options available for those looking to purchase a home. Don’t let your preconceived notions of what it might take to buy a home cloud your ability to judge whether or not you’d be able to do so. Because there are so many options, choosing the right loan may also seem confusing, especially when buying a home for the first time. It’s important to consult with someone like myself to go over some of the preliminary options for you, and to ultimately get set up with a lender who may go over what your best option truly is. Once this is done, you’ll be one step closer to getting a pre approval and ultimately getting the house you’ve been dreaming of. I’d love to help, and am always around to do so. Feel free to reach out today to begin exploring your options.