Conventional loans stand out in the mortgage landscape as a preferred choice for many homebuyers due to their versatility and the array of options they provide. These loans are particularly attractive because they are not bound by the stringent requirements and limitations of government-backed mortgages, giving lenders the freedom to offer a variety of terms and conditions. This flexibility often translates into more competitive interest rates and a broader range of loan amounts, making conventional loans especially appealing to borrowers with strong financial backgrounds.
Unlike loans backed by government agencies like the FHA, VA, or USDA, conventional loans are subject to market conditions and lender standards rather than government stipulations. This means that borrowers can often negotiate better terms based on their credit history, employment record, and financial stability. The absence of a government guarantee on these loans encourages lenders to carefully assess the borrower's ability to repay, which is why conventional loans typically require a higher credit score and a more substantial down payment. However, this rigor also benefits borrowers by potentially lowering their borrowing costs and giving them access to larger loan amounts for more expensive properties or those in higher-value areas.
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How Conventional Loans Work
- Application. The first step is applying for the loan. This involves submitting financial information to a lender, including income, assets, debts, and credit history.
- Eligibility Assessment. The lender assesses your eligibility. They will check your credit score, evaluate your debt-to-income ratio, and consider your employment history. This determines whether you qualify for the loan and under what terms.
- Loan Type Determination. Decide whether you want a conforming or non-conforming loan. Conforming loans meet the standards of Fannie Mae and Freddie Mac, including loan amount limits, while non-conforming loans do not.
- Down Payment and Loan Terms. Determine your down payment, which typically ranges from 3% to 20% or more. Also, decide on your loan term and whether you want a fixed or adjustable interest rate.
- Underwriting. Your mortgage lender underwrites the loan. This involves verifying your financial information and ensuring the property’s value is sufficient to secure the loan.
- Private Mortgage Insurance (PMI). If your down payment is less than 20%, you’ll likely need to pay for PMI, which protects the lender in case of default.
- Closing. Once the loan is approved, you’ll proceed to closing. This involves signing a lot of paperwork, paying closing costs and fees, and finalizing the loan agreement.
- Repayment. You start repaying the loan according to the agreed terms. Mortgage payments typically include principal, interest, and possibly escrow for taxes and insurance.
- Property Ownership and Management. You own the home and are responsible for its upkeep, property taxes, and homeowner’s insurance.
- Loan Completion. The process concludes when you either pay off the loan, refinance it, or sell the property.
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Types of Conventional Loan Programs
Conforming Loans
Mortgages that adhere to the limits set by the Federal Housing Finance Agency (FHFA) are known as conforming loans. These loans qualify for purchase by Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs), in the secondary mortgage market. By offloading these loans to Fannie Mae and Freddie Mac, mortgage lenders replenish their funds, enabling them to issue new mortgages.
Jumbo Loans
Mortgages that surpass the conforming loan limits are categorized as jumbo loans. As a variety of nonconforming loan, jumbo loans are ineligible for purchase by Fannie Mae and Freddie Mac. Nevertheless, they remain accessible to well-qualified borrowers seeking more expansive financing options. Historically, interest rates for jumbo loans have been higher than those for smaller mortgages, although this difference has been diminishing in recent years.
Non-Qualified Mortgages
Non-qualified mortgages, or non-QM loans, are another type of loan that Fannie Mae and Freddie Mac do not purchase. These loans cater to individuals who can afford a mortgage but might not meet the standard credit or debt-to-income (DTI) criteria. These borrowers often don’t fit within the “ability to repay” standards set by the Consumer Finance Protection Bureau following the 2008 financial crisis, which assess a borrower’s likelihood of repaying a mortgage.
An example of a non-QM loan is a portfolio loan. In this arrangement, the lender retains the mortgage in its own portfolio instead of selling it. This exemption from conforming loan requirements allows lenders greater flexibility in qualifying borrowers. However, it’s essential to recognize that non-qualified mortgages typically carry higher interest rates.
Non-Traditional Income Verification Methods
What sets non-QM loans apart is their acceptance of non-traditional income sources for qualification. This is particularly advantageous for self-employed individuals, entrepreneurs, or those with irregular income. Methods of verifying income for these loans include bank statements (personal or business) to assess cash flow, Debt Service Coverage Ratio (DSCR) for real estate investments, no income verification loans (also known as “no-doc” or “stated income” loans), Profit & Loss Statements (P&L) for demonstrating business financial health, Written Verification Of Employment (WVOE), and 1099 statements for contractors or freelancers. These diverse income verification options make non-QM loans more accessible to a wider range of borrowers, bridging the gap left by traditional mortgage criteria.
Choose a mortgage individually
See today’s best mortgage rates, and compare the total cost over the initial term of different mortgages. A couple of disclaimers: first, we can’t guarantee you’ll be eligible for every deal in this table. Second, deals change constantly, so what you see here might not be available by the time you apply
Conventional Loan Requirements
To secure a conventional mortgage for home buying, you must meet specific criteria. Here’s an overview of the requirements for this type of loan:
Down Payment
- First-time homebuyers can access conventional mortgages with as little as a 3% down payment.
- Non-first-time buyers or those earning no more than 80% of their area’s median income generally need a 5% down payment.
- Purchasing a multi-unit property (more than one unit) typically requires a 15% down payment.
- For second homes, a minimum of 10% down is necessary.
- If opting for an adjustable-rate mortgage, the minimum down payment is usually 5%.
- A mortgage calculator can be useful in understanding how the down payment affects monthly payments.
Private Mortgage Insurance (PMI)
- Less than a 20% down payment on a conventional loan necessitates PMI, which safeguards lenders in case of default.
- The cost of PMI varies, depending on the loan type, credit score, and down payment size.
- PMI can be paid monthly, upfront, or via a higher interest rate.
- PMI is not permanent and can be removed once you attain 20% equity through regular payments. Reaching 20% equity through increased home value may require a new appraisal. At 22% equity, PMI is typically automatically removed.
Credit Score
- A minimum credit score of 620 is often required.
- Lenders will assess your credit history to evaluate loan eligibility.
Debt-to-Income Ratio (DTI)
- DTI, calculated by dividing total monthly debt payments by gross monthly income, should generally not exceed 50% for loan approval. A lower DTI can improve your chances.
Loan Size
- The loan must be within Fannie Mae and Freddie Mac limits. For 2024, this limit is $766,550 for a single-family home, with higher limits in places like Alaska, Hawaii, and other high-cost areas, up to $1,149,825.
- Visit the Federal Housing Finance Agency website to check limits in your area.
Advantages and Disadvantages of Conventional Loans
Advantages
- Lower Costs with High Credit Scores. If you have a strong credit score, you’re likely to secure a lower interest rate on a conventional loan. Additionally, once you achieve an 80% loan-to-value ratio, you can request to cancel the private mortgage insurance (PMI), potentially reducing your costs further. This contrasts with FHA loans, where mortgage insurance premiums might extend for the loan’s entire duration, and USDA loans, which include a guarantee fee.
- Higher Loan Limits. Conventional loans provide more leeway with loan amounts. While conforming loans have set limits, jumbo conventional loans allow for larger borrowing amounts, offering more flexibility than you might find with government-insured loans.
- Increased Flexibility for Lenders. Lenders dealing with conventional loans generally enjoy more flexibility compared to when they issue government-insured loans. This is because conventional loans are not bound by the stringent guidelines of government agencies, allowing for more adaptable lending practices.
Disadvantages
- Higher Credit Score Demands. Conventional loans typically require a minimum credit score of 620, which is more stringent than some government-backed loans. This higher credit threshold can make qualifying more challenging for some borrowers.
- Increased Down Payment Expectations. While some conventional loan options allow minimal down payments (as low as 3%) for first-time homebuyers, a standard expectation is a 5% down payment. This is in contrast to FHA loans, which require a minimum down payment of 3.5%, and USDA and VA loans, which often have no down payment requirement.
- More Rigorous Qualification Criteria. The qualification process for conventional loans can be stricter than for government-insured loans. Since the lender bears more risk with a conventional loan, they may examine your financial situation more closely. Government-backed loans, in contrast, offer more security to lenders, potentially making them easier to qualify for if you meet the specific agency requirements.
How to Apply for a Conventional Loan
- Check your credit. Check your credit report, looking for any errors or missing information. Also, review your credit score and take steps to improve, such as paying down debts.
- Save for a down payment. Conventional loans require a minimum of 3 percent down. For a $300,000 mortgage, that’s $9,000. Remember, the higher the down payment you have, the more likely you are to get a better deal on your mortgage rate.
- Review your debt-to-income (DTI) ratio. Your DTI ratio is a measure of how much income you have versus how much debt you owe every month. A good DTI is 36 percent or lower. Some lenders will allow you to have up to 50 percent DTI, but most set a cap of 43 to 45 percent.
- Get pre-approved. Before shopping for a home, you’ll need to get pre-approved for a loan. A lender will perform an initial credit check and assessment of your income, assets, and debt. Pre-approval is an agreement in principle to loan you a certain amount of money.
- Get an offer on a house accepted. Find a home you like, submit an offer, and get a signed purchase and sale agreement.
- Go through underwriting. The time between having your offer accepted and closing on your home is for underwriting. This is the process in which you are formally reviewed for the mortgage — a specific sum on a specific property. Your lender analyzes all of the documentation you submitted for the preapproval — sometimes requiring additional information — along with getting the home appraised.
- Close on the house. The final step is to meet the seller and the lender at the closing table, where you finalize your home purchase and the mortgage, pay your closing costs, and get the keys to your home.
Conventional Loans vs FHA Loans
Conventional loans and FHA loans are two prevalent mortgage options, but they differ significantly in their requirements and features. Understanding these differences is crucial for homebuyers deciding which loan type best fits their financial situation and homebuying goals.
Conventional Loans
Conventional loans are not insured by the government, which generally leads to stricter credit and income requirements. To qualify for these loans, borrowers typically need a credit score of 620 or higher. Down payments can be as low as 3% for first-time homebuyers, but more commonly range from 5% to 20%. One of the benefits of conventional loans is the ability to remove Private Mortgage Insurance (PMI) once you reach 20% equity in your home. These loans have higher loan limits compared to FHA loans and are less restrictive about property conditions, offering more flexibility in property choice.
FHA Loans
FHA loans, insured by the Federal Housing Administration, are more accessible for those with lower credit scores and incomes. They accept credit scores as low as 500 (with a 10% down payment) or 580 (with a 3.5% down payment). However, FHA loan borrowers are required to pay a Mortgage Insurance Premium (MIP) for the loan’s duration, making them less favorable long-term for those who qualify for conventional financing. FHA loans also have lower loan limits and stricter property condition requirements, which may limit property choices. Notably, FHA loans have a very limited list of approved condominiums, restricting options for those looking to purchase a condo with an FHA mortgage.
Choosing Between the Two
The choice between a conventional and an FHA loan depends on individual circumstances. Conventional loans are generally better for those with higher credit scores and larger down payments, offering potentially lower costs over the life of the loan. FHA loans, on the other hand, are more suitable for borrowers with lower credit scores or limited funds for a down payment. Each type of loan has its advantages and disadvantages, so it’s essential for potential homebuyers to consider their financial situation, long-term plans, and the specific requirements of each loan type before making a decision.
FAQ
Is a conventional loan good?
A conventional loan can be a good option for many homebuyers, particularly those with a strong credit history and the ability to make a substantial down payment. Conventional loans often offer more competitive interest rates, higher borrowing limits, and the possibility of avoiding mortgage insurance if a 20% down payment is made. Additionally, they provide more flexibility in terms of property types and are not bound by some of the stricter requirements and limitations of government-backed loans. For borrowers who meet the qualifications, conventional loans can offer a cost-effective and flexible path to homeownership. However, the suitability of a conventional loan depends on individual financial circumstances, credit health, and long-term housing goals.
Is a conventional loan better than an FHA loan?
Whether a conventional loan is better than an FHA loan depends largely on the borrower’s individual circumstances.
Conventional loans are typically more suitable for borrowers with higher credit scores and a larger down payment. They offer the advantage of lower interest rates, no mortgage insurance requirement with a 20% down payment, and higher loan limits. This can make them more cost-effective over the long term for those who qualify.
On the other hand, FHA loans are designed for borrowers with lower credit scores or smaller down payments. The minimum credit score for an FHA loan can be as low as 500 (with a 10% down payment) or 580 (with a 3.5% down payment). FHA loans are particularly advantageous for first-time homebuyers or those with limited credit history. However, they require mortgage insurance for the life of the loan if the down payment is less than 10%, which can add to the overall cost.
Why would I not qualify for a conventional loan?
There are several reasons why you might not qualify for a conventional loan, most of which relate to your financial profile and the lender’s risk assessment criteria. One primary reason is a low credit score. Conventional loans typically require a minimum credit score of 620, and a higher score is often needed to secure more favorable interest rates. If your credit history shows late payments, bankruptcies, or high credit utilization, it might negatively impact your credit score and make it difficult to qualify. Additionally, a high debt-to-income (DTI) ratio – the percentage of your monthly income that goes towards paying debts – can be a disqualifying factor. Lenders usually prefer a DTI ratio of 43% or lower, as a higher ratio suggests that you might struggle to manage additional loan repayments.
Another reason for not qualifying for a conventional loan could be insufficient funds for the down payment and closing costs. Conventional loans often require a minimum down payment of 3-5%, and a down payment of less than 20% typically requires you to pay Private Mortgage Insurance (PMI), adding to the loan’s monthly cost. Furthermore, if you have a history of unstable employment or inconsistent income, lenders may question your ability to consistently make mortgage payments. Also, the property itself can be a factor; if it doesn’t appraise for the purchase price or has significant issues, lenders might be hesitant to approve a loan. Each of these factors plays a role in the lender’s assessment of your creditworthiness and ability to repay a conventional loan.
What credit score do you need for a conventional loan?
For a conventional loan, the minimum credit score requirement is typically around 620. However, it’s important to note that while a credit score of 620 might be the baseline for qualifying, higher scores are often necessary to secure better interest rates and loan terms. Lenders use credit scores as a key factor in determining a borrower’s creditworthiness and risk level. Therefore, a higher credit score not only increases the likelihood of loan approval but can also significantly impact the interest rate offered, ultimately affecting the overall cost of the mortgage. Borrowers with scores well above 620 are generally in a stronger position to negotiate more favorable loan conditions.
