What is a conventional loan?

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If you’re buying a home, there’s a good chance you’ll need a mortgage. One type of loan many borrowers start with is a conventional loan, which can be a cost-efficient option depending on your creditworthiness and financial situation.

What is a conventional loan?

In short, a conventional loan isn’t guaranteed by the government. Instead, it’s available and guaranteed through the private sector. Conventional loans account for a large portion of purchases and refinances.

Government-insured loans, by comparison, are backed by a government institution. These include FHA loans, USDA loans and VA loans.

Conventional loans are commonly fixed-rate or adjustable-rate, meaning that the interest rate will either remain the same (fixed) throughout the loan term or change with market conditions, respectively. With an adjustable-rate mortgage, your monthly mortgage payment can potentially become higher in the future.

In general, borrowers choose conventional mortgages because of better interest rates compared to other kinds of loans, as well as accommodative down payment options.

Conventional loan requirements

Conventional loans generally have stricter credit and income requirements than government loans, but also accept a down payment as low as 3 percent. To avoid paying private mortgage insurance (PMI) on a conventional loan, however, you’ll need to make a down payment of at least 20 percent.

  • Conventional loan credit score: 620 at minimum
  • Conventional loan debt-to-income (DTI) ratio: No more than 43 percent

There are some lenders that bend these rules, but by doing so, they aren’t able to sell the loan to Fannie Mae or Freddie Mac (more on that below). There’s an exception, though: There are some conventional loans where the borrower qualifies with a 50 percent DTI. These loans can still be sold to Fannie or Freddie.

“For the most part, if you get a conventional loan that doesn’t fit the requirements for Fannie and Freddie, you’ll probably have higher interest rates, or you’ll need a higher down payment,” says Casey Fleming, a mortgage advisor with C2 Financial Corporation and author of “The Loan Guide: How to Get the Best Possible Mortgage.”

Conventional loan types

Conforming loans

Each year, the Federal Housing Finance Agency (FHFA) issues loan limits for every county in the country. Mortgages that fall within these limits are called conforming loans, able to be bought by Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs), through the secondary mortgage market. By selling these types of loans to Fannie Mae and Freddie Mac, lenders have the capital to continue to make new mortgages.

Conforming loan limits are often similar across the majority of counties, but there are also some high-cost areas where the conforming loan limit is higher.

Jumbo loans

Mortgages that exceed conforming loan limits are called jumbo loans or nonconforming loans. These are loans that can’t be sold to Fannie or Freddie, but they are still available to well-qualified borrowers needing a more flexible conventional loan option.

“In order to get these larger loans, you usually need to show that you have the assets or income to justify it,” explains Fleming. “You might need a bigger down payment, and the credit requirements can be harder to meet.”

Additionally, jumbo loan rates tend to be higher than what you’d see with a smaller mortgage.

Non-qualified mortgages

Non-qualified mortgages, or non-QM loans, also can’t be purchased by Fannie or Freddie, but they can be an option for those are able to afford a mortgage but maybe are unable to meet the credit or DTI requirements. These borrowers tend to fall outside of the “ability to repay” guidelines established after the 2008 housing crisis, which indicate whether a borrower is likely to repay a mortgage.

One type of non-QM loan could be a portfolio loan. With this kind of loan, a lender keeps the mortgage on its books, rather than sell it to Fannie or Freddie. Because it doesn’t have to meet conforming loan standards, the lender can be more flexible when qualifying a borrower.

Conventional vs. FHA loans

Many borrowers compare conventional loans to FHA loans when assessing their options. Unlike conventional loans, FHA loans are guaranteed by the Federal Housing Administration. Depending on your credit and finances, it could be easier for you to qualify for an FHA loan, although you might end up paying more in the long run, because FHA loans come with FHA mortgage insurance.

Here are some of the basic differences between a conventional and FHA loan:

Conventional loan FHA loan
3% down payment minimum 3.5% down payment minimum
Can cancel mortgage insurance Can’t cancel mortgage insurance
620 credit score minimum 580 credit score minimum (500 with 10% down)
43% DTI maximum (up to 50% in some cases) 50% DTI maximum

One key consideration: With a conventional loan, PMI is automatically cancelled once your loan-to-value ratio reaches 78 percent. With an FHA loan, you’re stuck with mortgage insurance through the life of your loan, regardless of your level of equity.

Conventional loan rates

Conventional mortgage rates can be based on economic and market conditions as well as your lender’s overhead, and change daily. The rate you get will primarily be determined by your financial picture, and you’re most likely to get the best rates if you have good credit.

Currently, the 30-year conforming conventional loan purchase rate is 2.960%.

Bottom line

The best way to qualify for a conventional loan is to have your income and assets in order and your credit score in shape. If you can make a down payment, show adequate income to meet your obligations and have a qualifying credit score, you’re likely to be able to get a loan.

While some lenders are flexible, you usually need to compensate for a deficiency in one area. For example, if you have a lower credit score, you usually need a bigger down payment and a higher income.

“These are the three legs of the mortgage stool,” Fleming says. “If you need help figuring out how to qualify, consider talking to a mortgage professional who can help you.”

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