Advantages and Disadvantages of Conventional and ARM Loans

March 6, 2023

by Christian Phillips

Whether you are a first-time homebuyer or searching for a second home, the mortgage experts at Frandsen Bank & Trust can walk you through the advantages and possible disadvantages of conventional and adjustable-rate mortgages. As well as some other considerations to help you through the process.

[Definition]
  • What is a Conventional Loan? A conventional loan is a type of mortgage loan that is not government-backed. What does this mean? Government-backed loans are subsidized and protect lenders against defaults on payments. Conventional loans are originated and serviced through private lenders, such as banks and other financial institutions.
Conventional Loan Advantages: Combined with flexible repayment timelines of 15, 20, and 30 years, conventional loans are an option for homebuyers searching for primary residences, investment properties, and vacation homes. Furthermore, borrowers do not have to retain Private Mortgage Insurance (PMI) for the loan period, which PMI increases monthly mortgage payments. Borrowers can cancel PMI when 20 percent equity is invested in the home. The general affordability and flexibility of conventional loans offer prospective homebuyers various financing options.

Conventional Loan Disadvantages: Conventional loans tend to have strict requirements. For example, mortgage lenders typically look for a debt-to-income ratio under 42 percent; anything over will decrease the buyer’s probability of approval. Those with past hardships will also be faced with difficult challenges. For instance, homebuyers with foreclosures on their credit report will have issues qualifying for a conventional loan for approximately 7 years. 

[Definition]
  • What is an Adjustable-Rate Mortgage? An adjustable-rate mortgage (ARM) is another type of home loan with an interest rate that changes periodically. How does this work? Interest rates on ARMs are fixed for specified periods, then change at yearly or monthly intervals. Dependent on the market status, a borrower’s monthly mortgage payment and interest rate can either increase or decrease after the fixed period ends. 
ARM Advantages: The probability of locking in a lower interest rate for the initial fixed period means the borrower(s) can apply more toward the principal each month. ARMs also offer flexibility for individuals who intend on reselling their homes before the loan reprices. This option allows homeowners to exploit the market when rates become more favorable.

ARM Disadvantages: Homeowners with fixed budgets could experience temporary financial strain with the fluctuation of interest rates. Refinancing to a fixed-rate mortgage (FRM) can be an option, but the homeowner must pay closing costs, ranging between 2 and 5 percent of the loan amount. So, a home loan of $325,000 will cost between $6,500 and $16,250. The cost can be paid upfront or charged to the homeowner’s new loan.  

A few things to consider:
Prospective homebuyers with favorable credit scores and reports are likelier to receive lower interest rates. The credit score requirement for a conventional and adjustable-rate mortgage loan is generally 620 or higher. Homebuyers will notice that credit score requirements vary by bank. For reference, credit scores are generated based on the disclosed information in the credit report. Lenders will measure a borrower’s creditworthiness after analyzing the report.

Debt-to-Income Ratio factors in each debt the borrower is responsible for paying each month, such as credit cards, student loans, and auto loans. The process indicates how much an individual’s monthly income goes toward debt repayment. Depending on the financial institution, mortgage lenders may require DTIs to fall within predetermined ranges. This requirement will be discussed in the beginning stages of the home-buying process.

In addition, mortgage lenders may require borrowers to provide a down payment of at least 3 percent. Some homebuyers may be eligible for down payment assistance to help meet or exceed this requirement. Qualifications are often dependent on income, location, and time of application. 

[Final Thoughts]
Understanding your complete financial picture will help determine whether a conventional or adjustable rate mortgage best suits your situation. To learn more, contact a Frandsen Bank & Trust mortgage expert today.

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