What is a conventional loan? Everthing to know about America’s favorite mortgage
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When you start shopping for mortgages to buy a home, you’ll encounter a range of options, including conventional loans. They’re the most common kind of home loan out there, available from virtually every type of mortgage lender.
But what is a conventional mortgage (another term for conventional loan), exactly? Here’s everything you need to know about Americans’ favorite tool for financing a home purchase.
What is a conventional loan?
A conventional loan is a mortgage that’s available through and backed by a private sector lender. Government-insured loans, by comparison, are backed or guaranteed by a federal institution or agency. These include FHA loans, VA loans and USDA loans.
Conventional mortgages account for a large portion of home purchases and refinances, and are available through different types of mortgage lenders, including banks, credit unions and online mortgage companies. They come in two main types: fixed-rate or adjustable-rate.
With a fixed-rate mortgage, your interest rate never changes. With an adjustable-rate mortgage, you’ll have a fixed introductory rate for the first three to 10 years of the loan. Then, the rate will change at preset intervals, such as every year or six months, based on an index rate plus a margin determined by the lender.
Conventional loan requirements
To be approved for any type of mortgage, you’ll need to meet the lender’s requirements, which include parameters for your credit score, level of debt, income and more. Conventional loan requirements tend to be stricter than government-backed loan requirements.
- Credit score: Mortgage lenders require a minimum score of 620 to qualify for a conventional loan — but that’s the minimum only. To secure the lowest interest rate and the best deal, you’ll want a much better score, generally 740 or higher.
- Debt-to-income (DTI) ratio: Your DTI ratio factors in other debts you have to pay each month, such as auto loans, student loans and credit card debt. Most lenders don’t want this ratio to exceed 45 percent, although some might make an exception and allow up to 50 percent. Others, still, might limit it to 36 percent.
- Down payment: Unlike some government-insured loans, a lender isn’t going to give you 100 percent of a home’s purchase price in a conventional loan — you’ll need to be able to make a down payment. While 20 percent down is the standard, many fixed-rate conventional loans for a primary residence (not a second home or investment property) allow for a down payment as small as 3 percent or 5 percent. If you’re taking out a 3-percent conventional loan to buy a house that costs $350,000, for example, you’ll need to put at least $10,500 down.
- Private mortgage insurance: The ability to put down just 3 percent is an appealing benefit of conventional mortgages, but that small down payment comes with a drawback: private mortgage insurance (PMI). Because you didn’t make a 20 percent down payment, PMI helps protect the lender in case you default. Until you accumulate 20 percent equity in the home — either by paying down your mortgage or upping your home’s value — you’ll need to pay the additional cost of PMI.
- Loan size: Most conventional loans are also conforming loans: that is, they conform to Federal Housing Finance Agency (FHFA) limits on how much you can borrow. These limits vary based on where the property is located. In the majority of the U.S., the limit for 2023 is $726,200. Certain states (like Alaska and Hawaii) and higher-priced areas (including parts of California) have limits of $1,089,300.
Types of conventional loans
Conforming loans
Mortgages that fall within the FHFA’s limits are called conforming loans. This means that they are 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 obtain the capital to continue to make new mortgages.
Jumbo loans
Mortgages that exceed conforming limits are called jumbo loans. A type of nonconforming loan, these are loans that can’t be sold to Fannie or Freddie, but they are still available to well-qualified borrowers who need a more flexible financing option. Jumbo loan rates tend to be higher than what you’d see with a smaller mortgage, though the gap has been closing in the last few years.
Non-qualified mortgages
Non-qualified mortgages, or non-QM loans, also cannot be purchased by Fannie or Freddie, but they can be an option for those who 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 financial 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. It’s important to note, though, that non-qualified mortgages often come with higher interest rates.
How do conventional loans differ from government loans?
Conventional vs FHA loans
FHA loans — insured by the Federal Housing Administration — are ideal for borrowers with less-than-perfect credit, but they come with a less-than-ideal cost: mortgage insurance that cannot be removed – unless you make a down payment of 10 percent or more. Even then, you’ll have to wait 11 years until you can cancel it. (This applies to loans originated after 2013. The rules are different for older loans).
| Conventional loan | FHA loan |
|---|---|
| 3% down payment minimum | 3.5% down payment minimum |
| 620 credit score minimum | 580 credit score minimum with 3.5% down (500 credit score minimum with 10% down) |
| 45% DTI maximum (in most cases) | 50% DTI maximum |
| Can cancel mortgage insurance with 20% equity | Mortgage insurance includes one-time premium upfront and annual premiums |
Conventional vs VA loans
VA loans — guaranteed by the U.S. Department of Veterans Affairs — are available to military service members, veterans and eligible spouses. There are some additional steps to obtaining this type of mortgage, though, including getting your certificate of eligibility from the VA.
| Conventional loan | VA loan |
|---|---|
| 3% down payment minimum | No down payment required |
| 620 credit score minimum | 620 credit score or higher (depends on lender) |
| Can cancel mortgage insurance with 20% equity | Must pay VA funding fee ranging from 0.5% to 3.6% |
| Can be used for second or vacation homes and investment or rental properties | Can only be used for primary residences |
Conventional vs. USDA loans
USDA loans — guaranteed by the U.S. Department of Agriculture— can be a viable option if your annual income doesn’t exceed a certain amount and you’re looking to buy a home in an area that meets USDA guidelines.
| Conventional loan | USDA loan |
|---|---|
| 3% down payment minimum | No down payment required |
| Available to anyone who qualifies, regardless of income | Available to low- to moderate-income borrowers (in most counties, the income limit is $90,300) |
| Can cancel mortgage insurance with 20% equity | Must pay 1% guarantee fee upfront and annual fees (currently 0.35%) |
| Property can be located anywhere | Property must be located in a USDA-approved area |
Advantages of a conventional loan
- Cancellable mortgage insurance: One of the big pros of a conventional loan is that, even with a small down payment, you won’t have to deal with PMI for the duration of the mortgage. Once you have 20 percent equity in the home, you can request to cancel PMI. Also, your mortgage lender or servicer must automatically terminate PMI when your mortgage balance drops to 78 percent of the home’s purchase price or at the halfway point of your loan’s amortization schedule.of your house.To compare, if you had a 30-year FHA loan and made a down payment of less than 10 percent, you’d be paying those insurance premiums for the full three decades (unless you sell the home or refinance into a conventional loan).
- Flexible repayment timelines: When you’re browsing conventional loans, the most common loan terms you’ll find are 15-year and 30-year payback periods. However, some lenders have conventional loan programs, known as flexible-term or flex-term loans, that allow you to choose from a wider range of time frames, typically eight years to 29 years.
- More financing and property types: While government-backed mortgage programs tend to come with the owner-occupied requirement (in other words, you have to live in the home), conventional loans are available for second homes and investment properties. Plus, the fact that jumbo loans fall into the conventional loan bucket means that highly-qualified candidates can manage to borrow high sums of money.
Drawbacks of a conventional loan
- Rigid requirements: One of the biggest downsides to a conventional loan is the requirement that the borrower has a credit score of at least 620. (Some lenders ask for even higher.) If your credit could use some work, a conventional loan won’t be an option for you until you improve your score. Likewise, lenders tend to stick to that 43 percent DTI ratio limit with a conventional loan, which might shut you out of getting one. Some other loan types, in contrast, have more wiggle room with the DTI ratio.
- Scrutiny of past hardship: If you have a foreclosure on your record, you’ll need to wait a longer period of time to apply for another conventional loan compared to other types of mortgages. For conventional loans, the timeline is seven years after the foreclosure; for government loans, it’s two years or three years.
- PMI: Although PMI does get canceled eventually, the fact remains you’ll still need to pay the premiums (and hence, a bigger monthly payment) if you put down less than 20 percent. Generally speaking, PMI on conventional loans tends to be more expensive than the MIP on FHA loans (though there’s a lot of variance).
Conventional loan rates
Conventional mortgage rates are 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 the current economic environment. You’re most likely to get the best rates if you have good credit.
Conventional mortgage rates also tend to run a bit higher than rates for government mortgage rates. However, given the various fees that some — particularly FHA loans — charge (including MIP), the government loans often end up having a higher APR.
Bottom line on conventional loans
A conventional loan is what most people think of, when they think “mortgage.” You have a lot of options for a mortgage, but a conventional loan can be a wise choice for keeping costs low, and is one of the more popular options for borrowers.
Conventional loans can seem tougher to get, with more exacting standards, but that’s not necessarily so. The best way to qualify for a conventional loan is to have your credit, income and assets in order. Keep in mind that while some lenders are willing to be flexible, you usually need to compensate for a deficiency in one area when qualifying for a conventional loan. For example, if you have a lower credit score, you usually need a bigger down payment and higher income.
Overall, if you can make a down payment, show adequate income and have a qualifying credit score, you can likely get a conventional loan.
Additional reporting by Taylor Freitas
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