Homebuyers' Walkthrough: Which Type of Mortgage Is Best?

Most homebuyers need a mortgage to finance their homes. A mortgage, in simple terms, is a loan that is used to purchase a house. The lending climate changed following the late 2000s financial crisis, making it more difficult to get approved for a mortgage. Many lenders today require higher credit scores and higher down payments than they did pre-crisis. Still, homebuyers have many choices when it comes to mortgage types. (See also: Mortgage Broker vs. Direct Lenders: Which is Best?)

Fixed-Rate Mortgages

A fixed-rate mortgage (sometimes called a "plain vanilla" mortgage) is one that has a set (or fixed) rate of interest for the entire loan term. It’s the traditional loan used to finance a home purchase, and the type that most people think of when referring to mortgages.

Fixed-rate mortgages allow you to spread out the costs of buying a home over time, while making predictable payments each month. The term of the loan varies, though 15-year and 30-year fixed-rate mortgages are the most common. Borrowers can normally make extra payments to shorten the loan term without incurring any prepayment penalties (this is highly recommended if you can swing it since it can shave thousands of dollars in interest off your debt).

Shorter-term fixed-rate mortgages incur less interest over the life of the loan, but have higher monthly payments. Conversely, longer-term loans have higher overall interest costs, but smaller monthly payments.

A disadvantage of fixed-rate mortgages is the interest rate on the loan doesn’t change – even if interest rates fall significantly. If this happens, it might be financially beneficial to refinance the loan.

Fixed-rate loans are ideal for buyers who have a steady source of predictable income and intend to own their homes for a long time.

Variable-Rate Mortgages

Variable-rate mortgages are also called adjustable-rate (ARM) or floating-rate mortgages. The interest rate charged for this type of loan changes periodically to reflect current interest rates, and generally rises over time. The introductory loan interest rate – called a teaser rate – is often lower than the rate available on a fixed-rate mortgage. As a result, variable-rate mortgages can make it easier to qualify for a larger loan due to the lower initial monthly payments.

One disadvantage is the payment shock that happens when the interest rate increases. These sudden and sometimes sizable increases in the monthly mortgage payment can cause financial hardships for unprepared borrowers. Realizing that rates may rise at any time following the introductory period and planning ahead for any increases can help you stay in control of your mortgage.

Variable-rate mortgages are typically the recommended option for borrowers who anticipate declining interest rates (to avoid being locked in to a higher interest rate with a fixed-rate mortgage), who plan on living in the home for a limited number of years or who expect to be able to pay off the mortgage before the interest-rate adjustment period is reached. (See more: Mortgage Basics: Variable-Rate Mortgages.)

FHA Loans

Many first-time homebuyers qualify for a Federal Housing Authority (FHA) backed mortgage, which typically has less-rigid borrower requirements:

• low minimum down payment (3.5% if your FICO score is 580+ or 10% if your score is less than 580)
• reasonable credit expectations
• more flexible income requirements

In general, the property financed with an FHA loan must be your primary residence and be owner-occupied – FHA loans can’t be used for investment or rental properties. The maximum loan size is the lesser of:

• the statutory limit for the geographic area where the home is located (FHA sets different limits depending on the local real estate market/prices)
• the maximum loan-to-value ratio