6 common types of home loans and how they work
April 6, 2023 9 min read
When you’re deciding whether to purchase a home, you’ll likely have plenty of questions. And like many prospective buyers, you may want to first determine the type of loan you’ll use to finance your new home.
There are a variety of home loan options available to prospective homebuyers. Each has its own requirements and pros and cons. And there may be some overlap between the different types of loans too. Check out some of the common types of home loans—and discover how they work.
- There are different types of home loans, each with its own pros and cons to consider.
- Some of the common home loans include conventional loans, jumbo loans, government-backed loans, fixed- and adjustable-rate mortgages, and construction loans.
- Keep in mind, there may be overlaps with loan programs. For example, both conventional and government-backed loans offer fixed- and adjustable-rate mortgages.
- The best home loan for a potential buyer can depend on their eligibility and the loan program’s specific requirements, advantages and disadvantages.
1. Conventional loans
A conventional loan is a mortgage that isn’t backed by any government program. Instead, conventional loans are typically backed and serviced through private lenders like banks, online lenders and credit unions. According to the Consumer Financial Protection Bureau, conventional loans might cost less than other types of loans, but they tend to have stricter requirements.
Conventional loans usually fall into two categories, conforming and nonconforming:
- Conforming loans: This type of loan has a maximum loan amount—referred to as the conforming loan limit (CLL) value—set by the Federal Housing Finance Agency (FHFA). For example, in 2023, the CLL value for a one-unit property across most of the U.S. is $726,200.
- Nonconforming loans: These loans—also known as jumbo loans—are less standardized than conforming loans. They don’t have to meet requirements set by the FHFA, but they have their own guidelines. Nonconforming loans are typically reserved for buyers looking to purchase a higher-priced home or for those with unique financial circumstances.
Conventional loan requirements
The requirements for a conventional loan can vary, but here are some common factors that lenders may consider when approving a potential homebuyer:
- Minimum credit score requirement: Typically the credit score needed to buy a house with a conventional loan is 620 or above. But some lenders may have more stringent credit score requirements. Keep in mind, a higher credit score can result in receiving a lower interest rate on the loan—potentially lowering the monthly payments.
- Predetermined debt-to-income (DTI) ratio: Lenders might also take into account an applicant’s DTI ratio—or the total debt an individual has compared to their gross monthly income. Lenders will usually require an applicant to have a DTI of 43% or less. Some lenders may make an exception for a higher DTI, while others might require a lower DTI.
- Set down payment: Most lenders will require a potential homebuyer to make a down payment when securing a conventional loan. In some circumstances, the minimum requirement on a conventional loan is 3%. But if the down payment is less than 20%, private mortgage insurance (PMI) is typically required until 20% equity has been reached in the home.
- Limit on amount financed: The amount a buyer is borrowing can dictate the type of loan that can be secured. For example, if an applicant is looking at a home with a sticker price higher than FHFA borrowing limits, they’ll likely need to choose a jumbo loan instead.
2. Jumbo loans
A jumbo loan is a type of nonconforming conventional loan. Jumbo loans are used to finance homes that cost more than the limits set by the FHFA. These types of loans tend to be more common in areas with a higher cost of living, like New York City or San Francisco. Their interest rates are similar to those of conforming conventional loans, but depending on the lender, they usually have stricter requirements, including:
- A down payment of at least 10% to 20%
- Proven reserves in cash or a checking or savings account
- A DTI ratio that’s below 45%
- A credit score of at least 700
3. Government-backed home loans
Government-backed loans refer to mortgages that are insured by a government agency—the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA) or the U.S. Department of Agriculture (USDA). Each type of loan has individual requirements.
Government-backed loans often have less strict qualification requirements than other types of home loans, so it might be easier to be approved for them than for a conventional loan.
An FHA loan is backed and regulated by the FHA and offered by FHA-approved lenders. And it may be easier to qualify for an FHA loan because the credit score and down payment requirements aren’t as high as for other loans. Here are some of the main considerations for FHA loans:
- Applicants with a minimum credit score of 580 can be eligible for an FHA loan with a down payment of 3.5%.
- The credit score requirement can be lower than 580 with a down payment of at least 10%.
- Homebuyers with a previous bankruptcy or foreclosure may still be able to qualify for an FHA loan. That’s if enough time has passed, they have rebuilt their credit and they can show a reliable payment history for financial obligations.
- While conventional loans require PMI on a mortgage with less than 20% down, an FHA mortgage requires an upfront mortgage insurance premium, on top of an annual mortgage insurance premium.
- The FHA has lending limits that are updated annually depending on the type of home—single, duplex, triplex or fourplex—and where it’s located. For example, in 2023, the loan limit for a single-family home in a low-cost area is $472,030, but $1,089,300 in a high-cost area.
The VA provides a path to homeownership for service members, veterans and eligible surviving spouses through VA home loans. The VA backs some of the loan, but it’s provided by private lenders. Here are some of the main considerations for homebuyers that may be eligible for a VA loan:
- VA loans don’t require a down payment unless the specific lender has its own requirement.
- There isn’t a maximum loan amount or a maximum DTI ratio. But a DTI over 41% may require compensating factors—or having something to offset the higher ratio, like excellent credit history.
- Lenders will consider an applicant’s full loan portfolio since VA loans don’t have a minimum credit score requirement.
- VA loans can be used as many times as an eligible applicant purchases a home.
- PMI isn’t typically required, but there may be a one-time VA funding fee that can be rolled into the loan.
USDA loans are offered by approved lenders so that low- to moderate-income buyers can purchase homes in eligible rural locations. Potential borrowers generally must meet certain qualifications set by the USDA. Here are some of the factors to consider for a USDA loan:
- A down payment isn’t typically required, and interest rates are based on the current market rate.
- The USDA can provide payment assistance to help applicants pay back the loan. Homeowners receiving payment assistance can also have the interest rate reduced to as low as 1%.
- Loan limits generally depend on the applicant’s individual financial circumstances.
- The loan term is usually 33 years—or 38 years for lower-income applicants.
- USDA loans don’t require mortgage insurance, but an annual fee is typically assessed on the loan. In most cases, the fee is included in the monthly mortgage payment.
4. Fixed-rate mortgages
As its name suggests, a fixed-rate mortgage features an interest rate that stays the same over the course of the loan. This means the borrower can expect to pay the same monthly principal and interest payment. Both conventional and government-backed loans offer fixed-rate programs. The loan terms for fixed-rate mortgages are often 15 or 30 years, but this can vary depending on the lender.
Compared to adjustable-rate mortgages (ARMs), fixed-rate mortgages tend to have higher interest rates. And if interest rates fall, borrowers will have to refinance their mortgage if they want to get a lower rate on the loan. But homebuyers looking for a consistent payment—and who plan to stay in their home for at least five to seven years—may opt for this type of mortgage.
5. Adjustable-rate mortgages (ARMs)
ARMs offer interest rates that can change depending on market conditions. This means that when interest rates go up, monthly mortgage payments will likely increase.
ARM mortgages typically begin with a lower introductory interest rate for a few years. For example, an ARM can be expressed as “5/1 ARM,” meaning the interest rate will be fixed for the first five years and can change each year after that. Homeowners who don’t plan on staying in their home for a lengthy period of time may opt for an ARM to take advantage of the initial lower interest rates.
Conventional loans and government-backed loans may offer ARMs. And the lenders might set minimum and maximum interest rates so that the borrower knows ahead of time the most or least they could pay in interest.
6. Construction loans
Construction loans are short-term loans used to fund properties that are being built. They’re typically secured by a builder or a homebuyer who’s building their own home. The loan term is usually for a year, while the home is being built. Applying for a construction loan generally involves submitting building plans to the lender, including the projected timeline and costs.
The interest rates for construction loans can fluctuate based on the prime rate. Construction loans tend to be riskier for lenders because there isn’t collateral built into the loan like with a conventional or government-backed mortgage. That’s why the interest rates on construction loans are usually higher than on traditional mortgages. And it’s also why the requirements may be stricter.
After the project is completed, the borrower may be able to refinance the construction loan into a traditional mortgage. Or they can get a new loan and roll the construction loan into the payment—also referred to as an “end loan.”
Types of home loans in a nutshell
There are various types of home loans, each with its own requirements, pros and cons. The option that makes the most sense for you can depend on different factors specific to your situation and the terms of a potential loan. And depending on your circumstances, you may be eligible for programs that can help offset some common costs associated with buying a home, like down payment assistance.