What is a Conventional Loan?
02/27/2017 Kristin Demshki
A conventional loan is a type of mortgage that is not part of a specific government program, such as Federal Housing Administration (FHA), Department of Agriculture (USDA) or the Department of Veterans’ Affairs (VA) loan programs. However, conventional loans are commonly interchangeable with “conforming loans”, since they are required to conform to Fannie Mae and Freddie Mac’s underwriting requirements and loan limits.
There are two primary categories of conventional mortgages:
- Conforming: A conforming mortgage follows the guidelines put in place by Freddie Mac and Fannie Mae, including loan limits.
- Non-conforming: These mortgages include both “jumbo loans” which exceed the loan limits imposed by government-backed agencies, niche products for unusual circumstances and riskier products that are much less common these days.
Why Choose a Conventional Loan?
Most homebuyers choose conventional mortgages because they offer the best interest rates and loan terms — usually resulting in a lower monthly payment. And since most people choose a fixed-rate loan over an adjustable-rate mortgage, they don't have to worry about rising mortgage rates, which makes it easier to budget.
What are Non-Conventional Loans?
Examples of non-conventional loans include all government-backed loans and loans that do not meet Fannie Mae or Freddie Mac’s requirements. Government backed loans include the FHA, VA, or the USDA. Jumbo loans are also non-conventional because they are not required to follow the guidelines and exceed the loan amounts set by Fannie Mae, Freddie Mac, FHA, VA, and USDA. In general:
- FHA loans are aimed at borrowers who can’t afford a sizeable down payment, have high debt-to-income ratios or less than stellar credit.
- VA loans are reserved for active-duty military and veterans.
- USDA loans are for low to moderate income borrowers living in rural areas.
- Jumbo loans are intended for excellent borrowers with excellent credit looking to finance loan amounts greater than the amount allowed by Fannie Mae or Freddie Mac.
How Do I Qualify for a Conventional Loan?
Without the backing of the government, conventional loan borrowers pose a bigger risk to the institutions who issue the mortgage. As such, borrowers must meet three basic requirements.
1. Make a sizeable down payment
The standard down payment for a conventional loan is anywhere between 3 and 25 percent of a home's value depending on the borrower's credit and financial condition. For example, a $100,000 home could require a $20,000 down payment.
However, depending on a lender's unique specifications, a borrower may be able to put down as little as 3 percent at closing. Just keep in mind, this option is typically only available to those who meet additional requirements, like being a first-time homebuyer. Remember, with a larger down payment, homeowners also enjoy immediate equity in their home.
2. Prove a stable income
To qualify for a conventional loan, your monthly mortgage payments and monthly non-mortgage debts must fall within certain ranges. For instance, a lender may require your monthly mortgage payments (which may include taxes and insurance) not exceed 28 percent of your gross monthly income. In addition, your monthly mortgage payments, when combined with your other monthly debt payments (car loans, student loans, credit card bills, etc.), may be limited to a maximum of 36 percent of your gross monthly income.
3. Have a good credit score
Your credit score also plays an integral role when qualifying for a conventional loan. In fact, most lenders require a minimum FICO credit score of around 620 to obtain approval.
Benefits of Conventional Home Loans
While there are several benefits to securing a conventional mortgage, the type of loan you receive will be driven by factors that may not be in your control — such as FICO scores and other factors described above. However, if you have the option to choose your loan type, there are key advantages. For example:
Faster Home Loan Processing
Conventional loan processing tends to be more streamlined since the borrower deals directly with the lender and isn't dependent on government approvals. As a result, conventional loan applications typically have shorter and less complicated approval processes.
Reduce or Avoid a Mortgage Insurance Premium
It's more likely that you can avoid mortgage insurance premiums (MIPs) with conventional loans than with government insured loans, largely because conventional loans require higher down payments. However, when you put down less than 20%, you will still need mortgage insurance (MI). The amount may be less than what you would pay for a government loans with the same down payment, depending on your credit profile, and other factors.
Lower Mortgage Interest Rates
Private lenders may compete for your business if you are deemed a good credit risk because of income, credit score and other factors. Because of this, you may be able obtain a more attractive interest rate.
Compare Lender Fees
Conventional loans are offered through private lenders and the fees are not set by the government. This means the fees can vary widely among lenders — not necessarily a bad thing since you might save money. The key is to educate yourself and comparison shop.
Is a Conventional Home Loan Right for You?
The bottom line is that conventional loans are really only available to borrowers with good credit and some available cash for down payment. If you are fortunate to be an attractive borrower, then you might have the ability to obtain a loan at a lower cost and have it processed faster than with a government insured loan.
However, before you decide to apply for a conventional loan, make sure to speak with at least a few mortgage professionals. Remember, each lender offers different rates, terms and fees, so it's best to receive a Loan Estimate (LE) prior to committing to one institution. This additional research will help you secure the best mortgage terms possible for your future home loan.