Mortgage Basics: What is a Mortgage? How Do I Know Which Type of Mortgage is Right For Me?

For most homebuyers, a mortgage is the key to homeownership.

A mortgage is a type of loan that homebuyers use to purchase or refinance a property. Without one, most people could not afford a home.

What's in this article?

How does a mortgage work?
Types of mortgages
How do I know which loan type is right for me?
Find your ideal home loan with Compass Mortgage

There are several types of mortgages, each with various terms and conditions which are based on the type of loan, the lender and the borrower’s unique situation.

Read on to learn more about how mortgages work and how you can choose the right mortgage for your home purchase.

How does a mortgage work?

A mortgage is a legal agreement between a homebuyer and a lender stating that the lender will provide the funds for a borrower to purchase a property as long as the borrower repays the loan.

Home loans come with terms and conditions, including the loan duration, interest rate, repayment schedule and fees. Repayment terms commonly are 15 years or 30 years.

A mortgage is secured by the property, meaning if a borrower fails to repay the loan according to the set terms, the lender can begin the process of repossessing the property.

Fortunately, this isn’t a common occurrence because lenders take certain steps to ensure a borrower’s ability to repay.

Borrowers must be able to qualify for a loan based on their credit, income, assets, employment status and monthly debt.

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Types of mortgages

There are various types of mortgage loans available to borrowers. The type of mortgage that is right for you will depend on your goals and financial circumstances. Let’s take a look at the main types of mortgages available to borrowers.

Fixed-rate mortgages and adjustable-rate mortgages

Interest rates for mortgages can be fixed or adjustable, thus the term “fixed-rate” or “adjustable-rate” mortgage.

Fixed-rate loans are the most common type of mortgage because they offer borrowers predictable, stable monthly payments throughout the life of the loan.

If interest rates fall throughout the loan term, the borrower can refinance their loan to access a lower rate and lower monthly payments.

An adjustable-rate mortgage (ARM) can be beneficial during periods of higher interest rates because the borrower can access a lower initial rate for a set period of time and then rates will fluctuate based on market conditions.

The lower, initial fixed-rate period usually ranges from three to 10 years, which can be helpful for borrowers who only plan to stay in the home for a short period of time or who plan to refinance to secure a fixed rate before the period is up.

While ARMs have more risks involved, for the right borrower they can offer flexibility and lower overall costs.

Conventional loans and government-backed loans

Conventional loans are the most popular loan option among homebuyers.

Conforming conventional loans conform to the requirements established by government-sponsored enterprises Fannie Mae and Freddie Mac.

Borrowers must meet certain requirements set by their lender to qualify for a conventional mortgage, including:

  • Credit score of 620 or higher
  • Debt-to-income ratio (DTI) at or below 50%
  • Down payment of 3% or more
  • Private mortgage insurance (commonly called PMI; payments required unless the borrower makes a 20% down payment or until their home equity reaches 20%)

The credit score requirement can make qualifying for a conventional loan more difficult; but in exchange, borrowers have more flexible loan options.

Another bonus of a conventional loan is the ability to get rid of PMI with a down payment of 20% or more, which results in additional savings over the life of the loan.

Government-backed loans

As the name suggests, government-backed loans are insured or guaranteed by agencies of the federal government. This government endorsement protects lenders and offers borrowers more flexible options.

Two of the most popular government-backed loans are FHA and VA loans.

FHA loan

FHA loans are insured by the Federal Housing Administration, which protects lenders in case a borrower defaults on the loan.

In exchange for the added lender protections, borrowers can qualify for an FHA loan with a lower credit score and a lower down payment. This makes FHA mortgage loans ideal for first-time buyers.

FHA loan requirements include:

  • Home you want to purchase must be your primary residence
  • Home must meet minimum property standards
  • Credit score of at least 580 or higher, depending on other qualifying factors
  • Down payment of 3.5% or higher (gift payments are allowed)
  • Must move into the home within 60 days of closing
  • Must not have experienced a foreclosure in the past three years
  • Must pay upfront and annual mortgage insurance premium (MIP)
  • DTI at or below 50%

MIP can be eliminated after 11 years if the borrower makes a 10% down payment or more. Otherwise, it must be paid throughout the life of the loan unless the borrower refinances into a conventional loan.

VA loan

VA loans are insured by the U.S. Department of Veterans Affairs and are available exclusively to active-duty service members, veterans and surviving spouses.

VA loans offer amazing benefits to those who have served our country, including the potential for no down payment.

To qualify for a VA loan, borrowers must meet the following requirements:

  • Obtain a Certificate of Eligibility (COE) via the U.S. Department of Veterans Affairs
  • Credit score of 580 or higher
  • DTI at or below 60%
  • One-time VA funding fee, which can be rolled into your mortgage payments
  • Home must be a primary residence and meet minimum property standards

If you qualify, you can use a VA loan for every home purchase you make— not just your first purchase. Your full eligibility will be restored when you pay off or sell your existing property.

How do I know which loan type is right for me?

The right loan for you depends on your financial situation, personal goals and short-term and long-term plans.

  • If you have a higher credit score and lower DTI ratio, a conventional loan may offer you lower interest rates
  • If you have a lower credit score and need to make a smaller down payment, an FHA loan may be the best option for you
  • VA loans are only a solution for those who are serving or have served our country and their surviving spouses

Work closely with a mortgage lender experienced in a range of loan types, such as the experts at Compass Mortgage, to help you choose the best and most affordable financing option.

Find your ideal home loan with Compass Mortgage

The mortgage process begins with pre-approval.

Start here to provide our team with basic information about your potential home purchase. Then, we’ll work with you to discuss your finances and loan options.

Compass Mortgage offers our borrowers an exclusive program known as Get Committed®. Get Committed® provides a fully underwritten loan commitment and locks in your interest rate before you even find the property you want to buy.

This isn’t your standard pre-approval; a comprehensive loan commitment—Get Committed®—essentially has the power of a cash offer, showing the seller you’re fully approved financially and that your deal isn’t likely to fall through.

Compass Mortgage values your financing needs. Together, we’ll find the most affordable loan for your home!

Photo by Mikhail Nilov