When you’re looking for a loan to purchase a home, you have several options available, including mortgages backed by the government and so-called conventional loans. Conventional loans aren’t guaranteed or insured by the federal government, but they can be the right financing option depending on your goals, your budget, and other factors.
Today, let’s break down conventional loans in more detail and explore their requirements so you know whether they’ll be a good financing choice for your home purchase.
What is a Conventional Loan?
In a nutshell, a conventional loan or conventional mortgage is a homebuyer’s loan not secured (or offered) by the federal government (or any government entity, including state governments).
In contrast, conventional loans are offered by private lenders like banks, credit unions, and mortgage companies. Although they are not backed by the federal government specifically, conventional mortgages may be guaranteed by Fannie Mae and Freddie Mac: a pair of government-sponsored financing enterprises.
Conforming vs. Non-Conforming Loans
Conventional mortgage loans also come in two subsidiary types: conforming loans and non-conforming loans.
Conforming loans are mortgages that conform to lending standards set by the above-mentioned Fannie Mae and Freddie Mac. Without getting too technical, this means that either of the enterprises will purchase the loan from the lending organization. This benefits the lender since they don’t have to wait 30 years to collect the full amount and benefits the borrower since Fannie Mae and Freddie Mac are insured by the government in practice, if not in writing.
Nonconforming loans don’t conform to the lending standards of Fannie Mae or Freddie Mac. As a result, they aren’t sold by lending institutions as often. Therefore, the lenders have to hold the loans for longer and assume more risk. For a prospective homeowner, that just means credit score requirements and interest rates are usually higher.
In other words, conforming loans are more accessible and usually have lower interest rates. Nonconforming loans are less accessible and typically have higher interest rates.
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How Conventional Mortgage Loans Work
A conventional mortgage loan is both originated and serviced (i.e., held and collected by) any private mortgage lending institution, such as a bank or credit union.
Prospective homeowners apply for conventional loans in the same way as they would for a federal loan. Prospective borrowers apply for a mortgage, cooperate with a loan officer to complete the application, and offer any relevant financial documents.
If a conventional mortgage lender approves the application, they issue a mortgage lien against the home in question. This secures their interest in the property. The homeowner or borrower then pays a principal minimum amount plus interest toward the lender for the loan term until the mortgage is fully paid off.
Conventional Mortgage vs. Government Loan
There are several key differences between conventional mortgages and government-backed loans aside from the fact that the latter is insured and/or offered by the federal government. Here’s a breakdown of these differences:
FHA loans are special loans offered by the Federal Housing Administration and are broadly intended for first-time homebuyers. They have very low credit score and down payment requirements, making them ideal for folks with subpar credit or not a lot of cash saved up.
VA loans are those exclusively backed by the Department of Veterans Affairs. Naturally, they are intended for use by military veterans, spouses, and other beneficiaries. These loans don’t require down payments and don’t charge private mortgage insurance or PMI.
USDA loans are insured by the US Department of Agriculture. They are intended to help low-income homebuyers buy a home in eligible rural areas, particularly if they plan on farming. They are accessible since they don’t require a down payment and are fairly flexible in terms of credit scores.
Each of the above loan types is insured by the government. However, private lenders offer them to borrowers. Indeed, private lenders like banks and credit unions provide conventional and government-backed loans all the time.
Compared to federally backed loans:
Conventional loans don’t have strict eligibility requirements, so homebuyers with reasonable credit and some cash saved up may find them easier to qualify for
Conventional loans don’t come with as many perks as federally backed loans
Conventional Loan Requirements
Because conventional loans aren’t backed by the federal government, the lending institutions that offer them assume greater risk with every loan they underwrite. To offset this risk, most conventional loans have a list of requirements that prospective borrowers must meet in order to qualify. These requirements include:
A minimum down payment
Private mortgage insurance
A credit score at a certain level or higher
A debt to income ratio of a certain percentage
A property appraisal
Loan size limitations
No matter your credit score or other factors, you’ll need several pieces of documentation to qualify for a conventional mortgage loan. Lenders use these documents to verify your identity and make sure you make enough money to pay for your loan.
In total, you’ll need seven pieces of documentation:
A photo ID like a driver’s license or state ID
Several pay stubs from the last month – two is standard
Your tax returns for the last two years
Documentation that shows how you will make your down payment (i.e. pay stubs or bank account pages)
A financial statement that shows your assets and liabilities
A credit report. Your lender will order the report for you
An appraisal document that verifies the value of the property you wish to purchase
Minimum Down Payment
To become a homeowner, you’ll also need a down payment. A down payment is a lump sum payment you put against the principal mortgage amount. Some lenders have down payment percentage requirements as proof that you make enough money to afford the mortgage for the duration of the loan’s term.
Down payment requirements can vary dramatically:
If you’re a first-time homebuyer, you may be able to get a conventional mortgage with a down payment of as low as 3%
If you aren’t a first-time homebuyer or make a certain amount of money, you might face higher down payment requirements, such as 5%
If you’re buying a multifamily property, your down payment requirement may be 15%
Most second-home purchasers need to put 10% down at minimum
Most adjustable-rate mortgages require down payments of 5%
If purchasing a home with a jumbo loan, your down payment requirement could range from between 20% and 40%
All told, it’s a good idea to do a lot of research into conventional lenders as down payment requirements can vary and may affect what type of home you can afford.
Private Mortgage Insurance
Almost all conventional loans in which the borrower pays less than a 20% down payment also require private mortgage insurance or PMI. In brief, PMI protects the lender in case the borrower defaults on the mortgage.
Private mortgage insurance costs can vary depending on the loan type, credit score, and down payment size. To keep things simple, PMI is usually included as part of your monthly mortgage minimum, although some lenders require buyers to pay for PMI upfront as an ancillary closing cost. Other lenders may attach private mortgage insurance to the loan as an increase in interest rate.
Fortunately, homeowners don’t need to pay private mortgage insurance forever. You’ll only pay it until you pay down 20% of your home’s value or reach 20% equity.
Most conventional loans require a credit score of at least 620, which is defined as fair to good depending on which credit score system the lender uses. Fannie Mae and Freddie Mac both maintain this minimum credit score requirement, though some lenders want a higher credit score for extra security.
In general, it’s a good idea to raise your credit score as much as you can before applying for a loan. The higher your credit score is, the lower your interest rate will likely be.
A borrower’s debt-to-income ratio or DTI tells lenders how much of the borrower’s income is used to pay off debts every month, including credit card payments, utility bills, student loans, and more.
The lower your DTI, the more money you have to pay toward your mortgage. Therefore, conventional lenders want a debt-to-income ratio of no more than 45% for most mortgage loans. If your DTI is higher than this, you can reduce it by paying off existing debts like credit cards or car payments before applying for a mortgage loan.
A certified property appraisal inspects a home and verifies that it is of the value listed by the realtor or seller. In essence, it ensures that the lender isn’t overpaying for a property that isn’t worth what it was listed for.
Not just anyone can make a property appraisal. An appraisal has to be completed by a certified home appraisal company or agent, and the report must be sent to the lender before they will draw up a loan deal.
Most conforming conventional loans also have loan limits or size requirements. Loan size limits can change annually. For example, 2020’s loan limit for conventional conforming loans was $510,400. In 2021, this rose to $548,250.
Loan size limitations can also vary by state. For example, Hawaii and other high-cost areas in the US may have higher loan limits, such as over $800,000 for 2021.
Therefore, only some properties can be purchased with conventional loans.
What Are the Types of Conventional Loans?
Aside from being conforming or non-conforming, conventional loans are also offered in several types by banks, credit unions, and other financial institutions.
Conforming Conventional Loans
A conforming conventional loan is any loan that adheres to the Fannie Mae and Freddie Mac standards. These are the most common conventional loans you’ll find as they are the most secure for lending institutions.
Remember that loan limits can vary from place to place.
Jumbo Conventional Loans
On the other hand, Jumbo conventional loans allow you to borrow more than the lending limits you’ll find with traditional conforming loans. Naturally, these loans require higher credit scores since the lender takes out additional risk. Most borrowers also need to have lower debt-to-income ratios and need to put down higher than average down payments.
Portfolio loans are any conventional loans that lenders choose to keep instead of selling them to Fannie Mae, Freddie Mac, or another loan holder. Portfolio loans allow lenders increased flexibility when underwriting the loan, so they may be offered to prospective homebuyers that have lower than average credit scores or high DTIs.
Accordingly, many portfolio loans also have higher than average interest rates and may not be as secure for borrowers compared to other conventional loans.
Subprime Conventional Loans
Subprime conventional loans are ideal for individuals who don’t have a credit score of 620 or higher. Subprime conventional loans are nonconforming and often include high interest rates and closing costs. But they may allow you to purchase a home without having to go through extensive financial rehabilitation beforehand.
Amortized Conventional Loans
Amortized conventional loans are fully amortized, meaning that homeowners have a set monthly payment every month from beginning to end. They are easy to grasp and plan for financially, and they may have fixed or adjustable mortgage rates.
Adjustable Conventional Loans
Lastly, adjustable conventional loans have adjustable interest rates after an introductory timeframe of 3 and 10 years. After the initial timeframe, the interest rate for the loan can fluctuate based on current market factors, like the prime rate.
Adjustable conventional loans can be attractive at first with their hypothetical lower interest rates. But keep in mind that they can also charge homebuyers higher interest rates if the market’s mortgage rates also increase over the loan’s term.
What Are the Advantages of Conventional Loans?
Despite lacking the perks of federally backed loans, conventional loans nevertheless come with several advantages to keep in mind when deciding whether to pursue one for your home purchase.
Greater range of property types available. Conventional loans can be used for investment properties or second homes, whereas federally backed loans normally cannot be.
Greater control over mortgage insurance. Once your principal loan balance is 70% of your home’s value, you can cancel your PMI. Federally backed loans don’t allow you to do this.
Few program-specific fees. If you can qualify for and afford a conventional loan, you may end up paying fewer extra closing costs or fees in exchange.
Greater variety in loan structure. For example, there are 15 or 20-year loans, adjustable-rate mortgages, and other options available in the conventional loan market.
What Are the Disadvantages of Conventional Loans?
That all said, conventional loans do have some disadvantages to keep in mind when choosing them over federally backed loans.
Higher credit score requirements on average. Remember, you need a credit score of at least 620 to qualify for most conforming conventional loans. Federally backed loans don’t always have these requirements.
Higher down payment requirements on average. These requirements force you to save up more money before you can purchase your home.
More qualifying guidelines. Lenders are free to require more things from their borrowers before underwriting a loan since they take on additional risk.
Alternatives to Conventional Loans
If your credit score is below 660 or so, you may still need to find an alternative to a conventional loan since the conventional loans available to you may not be ideal.
For example, you could try federally backed loans like FHA, VA, and USDA loans. Or you could look into mortgage lending organizations that offer homebuying programs with special requirements or mortgage limitations but which may nonetheless allow you to buy a home with subprime credit.
Ultimately, conventional loans are the most common way for Americans to buy property. They are flexible, come in a wide range of limits and types, and can be used to purchase practically any type of property you want to buy, provided you have good credit and enough cash for a sizable down payment.
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