Types of Real Estate Loans

Why This Matters

Real estate loans aren't just about borrowing money—they're financial tools designed to solve specific problems for specific borrowers. When you're tested on loan types, you're really being assessed on your understanding of risk allocation, borrower qualification, and market segmentation. Lenders structure products differently based on who bears the risk (borrower, lender, or government), what collateral secures the debt, and how interest rate exposure is managed over time.

The key to mastering this material is recognizing that every loan feature exists for a reason. Government-backed loans expand access by shifting default risk away from lenders. Adjustable rates transfer interest rate risk to borrowers in exchange for lower initial payments. Equity-based products unlock wealth tied up in property. Don't just memorize the names and terms—understand what problem each loan type solves and who benefits from its structure.

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Government-Backed Loans: Expanding Access Through Risk Transfer

These loan programs exist because the private market alone would exclude many creditworthy borrowers. By having government agencies insure or guarantee loans, lenders can offer more favorable terms since their default risk is reduced or eliminated.

FHA Loans

• Insured by the Federal Housing Administration—the government covers lender losses if borrowers default, enabling access for lower-income and first-time buyers
• Down payments as low as 3.5% with more flexible credit requirements than conventional loans
• Mortgage Insurance Premium (MIP) required for the loan's life—this is the trade-off for the lower barriers to entry

VA Loans

• Available exclusively to veterans, active-duty military, and eligible National Guard/Reserve members—a benefit earned through service
• Zero down payment required and no PMI—the VA guaranty replaces traditional risk mitigation tools
• Competitive interest rates result from the government backing, not borrower credit strength alone

USDA Loans

• Designed for rural and suburban homebuyers meeting income limits—promotes homeownership in underserved geographic areas
• 100% financing available with no down payment, similar to VA loans
• Property location and income eligibility restrictions define who qualifies—it's geography-based, not just credit-based

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Conventional Loans: Market-Based Lending

Conventional loans operate without direct government insurance or guarantees. Lenders bear more risk, so they impose stricter qualification standards and price that risk into loan terms.

Conventional Loans

• Not government-insured or guaranteed—lender assumes default risk, requiring stronger borrower profiles
• Conforming loans meet Fannie Mae/Freddie Mac guidelines and can be sold on the secondary market; non-conforming loans don't qualify
• Higher credit scores and larger down payments required—typically 620+ credit and 5-20% down, with PMI required below 20%

Jumbo Loans

• Exceed conforming loan limits set by Fannie Mae and Freddie Mac (currently $766,550 in most areas for 2024)
• Cannot be sold to GSEs, so lenders retain more risk and require stronger qualifications
• Higher interest rates and stricter underwriting—expect 700+ credit scores and 10-20% down payments

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Interest Rate Structures: Managing Rate Risk

How a loan handles interest rates determines who bears the risk of market fluctuations. Fixed rates protect borrowers from rising rates; adjustable rates shift that risk to borrowers in exchange for lower initial costs.

Fixed-Rate Mortgages

• Interest rate locked for the entire loan term—borrower is protected from market rate increases
• Predictable monthly payments simplify budgeting and long-term financial planning
• Common terms: 15, 20, or 30 years—shorter terms mean higher payments but less total interest paid

Adjustable-Rate Mortgages (ARMs)

• Initial fixed period (typically 3, 5, 7, or 10 years) followed by periodic rate adjustments tied to a market index
• Lower initial rates than fixed-rate loans—the discount compensates borrowers for accepting rate risk
• Rate caps limit adjustment amounts but payments can still increase significantly after the fixed period ends

Interest-Only Mortgages

• Borrower pays only interest for an initial period (typically 5-10 years), deferring principal repayment
• Lower initial payments improve cash flow but build no equity during the interest-only phase
• Payment shock occurs when principal amortization begins—payments can jump 50% or more

Balloon Mortgages

• Small regular payments followed by a large lump-sum "balloon" payment at term end
• Short-term financing tool—borrower must refinance, sell, or pay off the balance when the balloon comes due
• Significant refinancing risk if property values decline or credit conditions tighten before maturity

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Equity-Based Financing: Unlocking Property Value

These products allow homeowners to borrow against accumulated equity. The home serves as collateral, creating a secured loan with rates lower than unsecured debt but putting the property at risk.

Home Equity Loans

• Lump-sum loan secured by home equity—borrower receives full amount upfront and repays over a fixed term
• Fixed interest rates and fixed payments provide predictability, similar to a traditional mortgage
• Often used for major expenses like renovations, education, or debt consolidation

Home Equity Lines of Credit (HELOCs)

• Revolving credit line allowing borrowers to draw funds as needed up to an approved limit
• Variable interest rates mean payments fluctuate with market conditions
• Draw period followed by repayment period—flexibility during draw phase, but payments increase when repayment begins

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Specialized Purpose Loans: Solving Specific Problems

These loan types address situations where standard mortgage products don't fit. Each solves a particular timing, property type, or qualification challenge.

Bridge Loans

• Short-term financing to "bridge" the gap between purchasing a new property and selling an existing one
• Higher interest rates and fees reflect the short duration and lender's increased risk
• Typically 6-12 month terms—designed for temporary cash flow needs, not long-term financing

Construction Loans

• Finances new construction or major renovations with funds disbursed in stages as work progresses
• Requires detailed plans, budgets, and timelines—lenders monitor construction milestones before releasing draws
• Typically converts to permanent financing (construction-to-perm) or requires payoff upon completion

Commercial Real Estate Loans

• Designed for income-producing properties: office, retail, industrial, multifamily (5+ units)
• Underwriting focuses on property cash flow (DSCR, NOI) as much as borrower creditworthiness
• Shorter terms (5-20 years) with larger down payments (typically 20-35%) than residential loans

Hard Money Loans

• Asset-based lending from private investors—approval based primarily on property value, not borrower credit
• Fast funding (days vs. weeks) makes them useful for time-sensitive deals like auctions or distressed properties
• High interest rates (10-18%) and short terms (1-3 years)—expensive but accessible when traditional financing isn't available

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Quick Reference Table

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Self-Check Questions

1. Which three loan types allow for zero down payment, and what distinguishes who qualifies for each?

2. Compare the risk allocation in a fixed-rate mortgage versus an adjustable-rate mortgage—who bears interest rate risk in each structure, and why might a borrower choose to accept that risk?

3. A borrower has strong income but a credit score of 580. Which loan type would most likely approve them, and what trade-off will they accept for that access?

4. Explain why jumbo loans typically carry higher interest rates than conforming conventional loans, even when the borrower has excellent credit.

5. A real estate investor needs to close on a property in 10 days but doesn't qualify for traditional financing. What loan type would solve this problem, and what costs should they expect?