How to choose the best mortgage and decide between conventional or government-backed, fixed or adjustable rate

  • When choosing a mortgage type, the first decision you'll have to make is probably between a conventional or a government-backed loan.
  • There are two types of conventional mortgages: conforming loans meet standards set by the Federal Housing Finance Agency, and nonconforming loans are for amounts that exceed the FHFA's limit.
  • Government-backed loans are insured by the government and come with more lenient requirement surrounding credit scores, down payments, and debt-to-income ratios than conventional loans.
  • You'll also need to decide between a fixed-rate mortgage that locks in your rate for the entire life of your loan, or an adjustable-rate mortgage that changes periodically.
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Buying a home is a huge life step. But there's another major step you have to take first: Deciding which type of mortgage you want to apply for.

Yes, there are different types of mortgages. Your decision will likely come down to which you qualify for, but there's a little strategy involved, as well.

  • 1. Conventional mortgage vs government-backed mortgage
  • 2. Conforming vs nonconforming mortgages
  • 3. Government-backed mortgages: FHA, VA, or USDA loan
  • 4. Fixed-rate vs adjustable-rate mortgages

1. Conventional mortgage vs government-backed mortgage

The first decision you'll have to make is probably whether you want a conventional or government-backed mortgage.

A conventional mortgage is a loan from a private lender, or from federal companies Freddie Mac or Fannie Mae, that isn't insured by the government. Depending on the lender, you'll need a certain credit score, down payment, and debt-to-income ratio to receive a mortgage.

In many cases, government-backed mortgages are for people who don't qualify for a conventional mortgage. They can also be for certain groups of people, such as military veterans or people with low-to-moderate incomes.

You'll still apply for a government-backed loan through a private company, but it will be insured by the government. This makes it less risky for lenders to give you a loan if you don't meet conventional loan requirements.

If you have a good credit score, some money for a down payment, and a debt-to-income ratio of 36% or less, then you'll probably want a conventional loan.

Otherwise, you can look at government-backed mortgages. These can be great mortgage options, but some are only for specific groups of people. And some come with drawbacks, including higher mortgage premiums and borrowing limits.

2. Conforming vs nonconforming mortgages

If you're looking at conventional mortgages, you'll choose between either a conforming or nonconforming loan. The main difference between these two types is the amount of money you need to borrow.

A conforming mortgage meets the standards set by the Federal Housing Finance Agency (FHFA). The FHFA sets the limit for conforming loans every year, and in 2020, the limit is $510,400 in most parts of the US. In areas with a higher cost of living, such as Alaska, Hawaii, Guam, and the US Virgin Islands, the limit has been bumped up to $765,600.

A nonconforming mortgage is for an amount that exceeds the FHFA limit. You also might hear it referred to as a jumbo loan.

To qualify for a nonconforming mortgage, you'll likely need a higher credit score, bigger down payment, and lower debt-to-income ratio than you would for a conforming loan.

If you a) need more money than allowed by the FHFA, and b) can qualify for the loan, then a nonconforming mortgage may be for you. If not, then you'll want to go with a conforming mortgage.

3. Government-backed mortgages: FHA, VA, or USDA loan

Government-backed mortgages are issued by the federal government. They typically have looser requirements surrounding credit scores, down payments, and debt-to-income ratios.

You'll still go to a private lender to get a government-backed loan, but you should specify that you want a government-issued mortgage.

There are three common types of government-backed loans:

  • Veterans Affairs (VA) loans: You may be eligible if you're affiliated with the military.
  • United States Department of Agriculture (USDA) loans: You must have a low-to-moderate income level and buy a home in a rural or suburban area.
  • Federal Housing Administration (FHA) loans: The rules concerning who qualifies for an FHA loan is broader than with VA and USDA loans. You may qualify if you aren't eligible for the other two, but you'll likely need to have more for a down payment than you would for the others. Many VA and USDA loans don't require a down payment at all, but you'll need a 3.5% down payment for an FHA loan. You can't borrow as much for an FHA loan as you can for a conventional loan. Your limit will depend on where you live. FHA loans also require a 1.75% mortgage premium upfront, and you'll keep paying a smaller premium each year.

4. Fixed-rate vs adjustable-rate mortgages

Once you've decided on which type of conventional or government-backed loan you need, you have to choose between two more types of mortgages: fixed-rate or adjustable-rate loans. These two options have to do with the interest you pay on your loan.

fixed-rate mortgage locks in your rate for the entire life of your loan. Although US mortgage rates will increase or decrease over the years, you'll still pay the same interest rate in 30 years as you did on your very first mortgage payment. The most common term length for a fixed-rate mortgage is 30 years, but you may choose from 20 years, 15 years, or another term. 

An adjustable-rate mortgage, or ARM, keeps your rate the same for the first few years, then periodically changes over time — typically once a year.

With an ARM, your rate stays the same for a certain number of years, called the "initial rate period," then changes periodically. For example, if you have a 5/1 ARM, your introductory rate period is five years, and your rate will go up or down once a year for 25 years. Most lenders offer 7/1 or 5/1 ARMs, but different lenders offer various terms.

You may like a fixed-rate mortgage if you plan to stay in the home for a long time, but an ARM if you plan to move before the initial rate period ends.

Why? Because of risk.

A fixed-rate mortgage is much safer. Paying the same rate for 30 years gives you stability and makes it easier to plan your budget.

However, the variable rate on an ARM means the interest rate could rise, meaning you can only predict your mortgage costs for that initial period. During the introductory period, an adjustable rate is lower than a fixed rate. So if you're going to move before the intro rate ends, then you'll get a good deal with an ARM. But the rate could spike once the introductory period ends, so you risk paying more in the long run.

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