Shopping for a mortgage? Now’s the time to familiarize yourself with one of the most popular types of home loans: a conforming loan. It’s the go-to mortgage for borrowers with solid credit and enough cash or home equity for a sizable down payment. In a marketplace with lots of mortgage options, a conforming loan is the standard, and a good place to start when looking for financing.
What is a conforming loan?
Conforming loan definition
A conforming loan is a mortgage eligible to be purchased by Fannie Mae and Freddie Mac, the government-sponsored enterprises, or GSEs, because it meets — or conforms — to their standards, including limits on the amount of the loan.
The 2020 conforming loan limit for a single-family home is $510,400 in most housing markets and $765,600 in higher-cost areas.
A common example of a conforming loan is a mortgage with a 20 percent down payment, a 15- or 30-year term, monthly principal and interest payments, no prepayment penalty, no balloon payment and no private mortgage insurance.
What are conforming loan standards?
Fannie Mae and Freddie Mac buy conforming loans from mortgage lenders and package them together to create mortgage-backed securities (MBS), which are then sold to investors. By selling conforming loans to Fannie Mae and Freddie Mac, lenders can obtain new capital to fund additional mortgages.
As such, a mortgage has to adhere to certain standards in order to be considered conforming and able to be purchased by the enterprises. Mortgages that conform to Fannie Mae and Freddie Mac requirements are easy for investors to buy and sell because they meet these standards, which include:
- Loan limit – $510,400 for a single-family home in most markets and $765,600 in higher-cost areas
- Credit score – At least 620
- Debt ratios – Ideally, a front-end ratio of 28 percent or less and a back-end ratio, also known as the debt-to-income (DTI) ratio, of 36 percent or less
- Down payment/equity – Ideally, at least 20 percent down for a purchase or 20 percent equity for a refinance; however, Fannie and Freddie also back conventional loans with as little as 3 percent down
- Loan-to-value (LTV) ratio – Ideally, 80 percent or lower; again, Fannie and Freddie also back conventional loans with an LTV max of 95 percent to 97 percent, depending on whether it’s an adjustable- or fixed-rate mortgage
A conforming loan can have a lower down payment as long as the borrower pays private mortgage insurance, or PMI. (In effect, you swap a big down payment for backing by a strong third party.) By paying for PMI, you can get a conforming loan with just 5 percent down in many cases, or as little as 3 percent down if you have a Conventional 97, Fannie Mae HomeReady or Freddie Mac Home Possible mortgage.
With a 20 percent down payment, however, there’s much more cushion for the lender if something goes wrong with repayment. In the event of a default, the lender can sell the home for as little as 80 percent of its value and still break even.
Because a bigger down payment reduces their risk, lenders are willing to accept a borrower with a credit score as low as 620 for a conforming loan — but with two important caveats:
- Individual lenders can and do have their own often higher credit standards, in addition to Fannie Mae and Freddie Mac requirements.
- A 620 credit score generally will not be enough to get the lowest interest rate. When offering the best rate possible, lenders look for borrowers with higher credit scores, who represent less risk. If your credit score is 780 or higher, you’ll be much more likely to get the best available rate.
To qualify as a conforming loan, lenders will also look to make sure you can afford your monthly mortgage payments by evaluating your debt ratios. There are two measures, sometimes expressed as 28/36:
- Front-end ratio: The front-end ratio measures how much of your gross monthly income is allocated to your mortgage, including the monthly payment (principal and interest), property taxes, insurance and HOA fees (if applicable). Traditionally, lenders look for a front-end ratio of 28 percent or less. For example, if your gross monthly income is $8,000, your allowable mortgage cost would be no more than $2,240 to be considered a conforming loan.
- Back-end ratio: The back-end ratio includes the front-end ratio plus other monthly debt obligations, such as auto loan, student debt, personal loan and credit card payments. To be considered a conforming loan, the maximum back-end ratio is 36 percent. If your gross monthly income is $8,000, your allowable debt payments would be no more than $2,880.
It’s possible to get a conforming loan with higher debt ratios, but lower is generally the better scenario.
One of the unmovable standards for conforming loans is the loan limit — you can only borrow so much and no more. Loan limits are generally adjusted each year, with higher limits for properties with two, three and four units (as long as you live in one of the units).
Keep in mind that requirements can vary in other ways, as well. For example, standards might be stricter for a cash-out refinance than for a rate-and-term refinance.
What are the benefits of a conforming loan?
A conforming loan can be attractive for several reasons:
- If you make at least a 20 percent down payment, that means there is less money for you to borrow and more home equity at the time you purchase your home. The result is that your monthly payments are lower compared to a loan with less money down.
- If you do put at least 20 percent down, you won’t need to pay for private mortgage insurance, which represents significant monthly savings. Depending on your loan amount, PMI can cost a few hundred dollars per month.
- If you can put 20 percent down and have good credit and strong reserves, you’re likely to be looking at the lender’s best rate and the lowest monthly payments overall.
Conforming vs. non-conforming loans
- A conforming loan conforms to, or meets, Fannie Mae and Freddie Mac standards pertaining to the borrower’s credit, down payment and other factors like loan size.
- A non-conforming loan does not conform to, or meet, Fannie Mae and Freddie Mac standards. For example, a jumbo loan is a non-conforming loan because the amount borrowed exceeds the Fannie Mae and Freddie Mac limit. The fact that a loan is non-conforming doesn’t mean it’s bad, however; it simply means that it doesn’t meet the criteria to be purchased by the enterprises.
What are conforming loan rates?
You can find conforming loan rates through Bankrate, which provides mortgage rates for both 30-year and 15-year loans daily. When comparing mortgage rates, consider the following:
- If you think interest rates will rise in the coming month or so, you might prefer to lock your rate to ensure the lowest rate possible.
- Beware of rates that seem too low to be true given your financial position. Currently, some lenders are advertising rates as low as 2 percent, but the average is closer to 3 percent. If you do encounter a low rate, it may be that the value of the low rate will be offset by bigger upfront costs. Be sure to evaluate the complete cost of the loan carefully.
- Different lenders have different funding available and different costs. For this reason, it pays to shop around for the best rates and terms.
Applying for a conforming loan
There are a number of steps you can take that can help you get the best conforming loan for your circumstances.
1. Check your credit report
As much in advance as possible — several months if doable — check your credit reports at AnnualCreditReport.com. Due to the coronavirus crisis, credit reports are now available at no charge on a weekly basis from Experian, Equifax and TransUnion through April 2021. Check your reports carefully for things such as out-of-date items and factual errors. Dispute any errors you spot, because even minor issues can result in a lower credit score.
2. Get your documents in order
Next, get your paperwork together so you’re prepared for the mortgage application process. Lenders can now get a lot of information directly from banks and the IRS, but it’s still a good idea to have documents like payroll stubs, bank statements, retirement accounts, W-2 forms and tax returns handy.
3. Get preapproved
Once you find a lender you’re interested in working with, you can get preapproved for a loan, which can help expedite the financing process and uncover any issues related to your credit before they show up when you formally apply for a mortgage. Getting preapproved can also help demonstrate to a home seller that you’re a serious buyer, which could give you an edge over others.
4. Avoid excessive spending
Lenders can check and re-check your credit report and score and various financial accounts right up until your mortgage closing date. Think of the time between when you apply for a loan and when you close as a “quiet” period, when you spend as little as possible. While your mortgage application is in process, don’t apply for any new credit, such as a credit card or personal loan, and avoid spending on things you don’t really need. This will help ensure the closing process goes smoothly and you receive the financing you’re expecting.