What Are Conventional Mortgage Loans?
Mortgages can be a tricky subject, especially when your lender throws around terms like conventional, FHA, and Jumbo loans without even pausing.
This article will break down all loan types and focus on the most common loan type, the aptly named “conventional loan.”
What Are Conventional Mortgage Loans?
- Conventional loans are any loans that are not government-backed.
- There are many types of conventional loans, including conforming, non-conforming, jumbo, portfolio, and sub-prime loans.
- If your credit score is less than 650 or you'd like to pay a down payment of less than 5%, you'll probably need to seek a government-backed loan.
- Government-backed loans have stricter property requirements and are usually limited to primary residences for first-time buyers.
- While getting a conventional mortgage with less than the traditional 20% down payment is possible, you may be forced to purchase Mortgage Insurance to protect your lender.
- Shopping around for a mortgage is highly advisable, but researching different lenders or working with a mortgage broker. Your day-to-day bank may not have the best offers or customer service.
What is a Conventional Loan?
A conventional loan is any loan not backed by the government.
That means a conventional loan can be a number of different kinds of loans, as long as the loan isn’t insured or guaranteed by the government.
We will get back into what makes a loan conventional, but for now, let’s go over what government-backed loans look like.
What Types of Mortgage Loans are Government-Backed?
Government-backed loans are loans that the government insures or guarantees in the case of foreclosure.
If the government insures your loan, they will partially repay the lender if the borrower defaults.
If the government guarantees your loan, then they will fully repay the lender.
Because these loans come with certain securities from the government, lenders are willing to lend money to borrowers who they otherwise would have turned away.
A number of different loans are considered government-backed. We have a breakdown for each kind of loan below.
FHA
FHA loans are insured by the Federal Housing Authority (FHA) and generally offer more flexible borrower guidelines.
FHA loans are great for borrowers who don’t have a ton of cash on hand, as they offer down payments as low as 3.5%.
They also allow credit scores that would not be approved for a conventional loan, down to 500.
One other major difference between FHA and conventional is the addition of a mortgage insurance premium (MIP).
MIP is added to your monthly mortgage bill, sometimes greatly increasing the cost.
The government can draw from the collected MIP to help pay back lenders in the case of foreclosure.
FHA loans are by far the most common form of government-backed loans, and they are great options for new home buyers who are light on cash.
VA
The Veterans Administration (VA) offers loans to veterans and their spouses that feature exceptionally flexible guidelines and in some scenarios, a 0% down payment.
VA loans also have comparatively low-interest rates and no mortgage insurance, though they do have the strictest property condition requirements (a clear termite report is required) of any typical mortgage type.
VA loans are guaranteed by the Veterans Administration, unlike FHA loans which are insured by the government.
This means that VA loans will be completely assumed by the government in the case of a foreclosure.
USDA
USDA loans are backed by the U.S. Department of Agriculture. They are offered as part of an effort to help support the sagging rural real estate market.
The loan offers 0% down payments and low-interest rates.
Since this loan is focused on rural markets, it isn’t very applicable to the real estate market of New York City.
What are the Types of Conventional Loans?
Conventional loans are not government-backed, but they are subject to credit score and down payment guidelines established by the quasi-government agencies Fannie Mae and Freddie Mac.
They also follow loan limits established by the Federal Housing Finance Agency (FHFA).
So though conventional loans are not guaranteed or insured by the government, they still play by the government’s rules (with a few exceptions).
Conforming loans
Conforming loans conform to the mortgage guidelines established by Fannie Mae and Freddie Mac, the government entities that buy up the majority of the mortgages on the secondary market.
In order to qualify as “conforming,” the loans must fit within specified loan limits.
These loan limits vary based on where you live.
For example, the loan limits in San Francisco and New York City allow loans up to $765,600, whereas more rural areas, like Cayuga, have a loan limit of $510,400.
If your loan exceeds the loan limit, you cannot qualify for conforming loan interest rates, which tend to be lower than loans with larger amounts.
If your loan exceeds the loan limit, you have the option of putting more money down in order to bring your loan under the limit.
Non-conforming loans
Non-conforming loans exist outside of the box that Fannie Mae and Freddie Mac have created.
Things like a large mortgage size, high debt-to-income ratio, and a poor credit score can force borrowers into a non-conforming loan.
They offer borrowers and lenders more flexibility, but that flexibility often comes at a price.
Jumbo loans
Jumbo loans are non-conforming because their mortgage amount exceeds the regional loan limit.
Because the loan size is larger than a conforming conventional loan, jumbo loans are generally subject to more stringent borrower guidelines, like higher minimum credit scores, more required liquid funds, and lower debt-to-income ratios.
They also usually have a higher interest rate than conforming loans.
Portfolio loans
So far all of the loans we have discussed have one thing in common—they are all eventually sold on the secondary market.
The secondary market is where banks sell the loans it has financed in order to make a profit and free up their budget to fund more loans.
A portfolio loan is not sold on the secondary market. Instead, the lender keeps the loan on its own books.
This means the lender can follow its own guidelines for approving which borrowers to lend to.
Whereas Fannie Mae and Freddie Mac would never purchase a loan with a borrower who has bad credit and no funds, a lender can make the choice to give them a portfolio loan, if they think it is a good deal.
These loans typically have heavy fees associated with their origination and feature interest rates much higher than you would see in other types of loans.
Origination loans are helpful for borrowers in unique financial situations.
Sub-prime loans
The infamous sub-prime loans, caught in the center of the 2008 financial crises, have garnered a reputation worse than they deserve.
Like origination loans, sub-prime loans are an avenue for homeownership for borrowers with poor credit and little to no extra funds.
Basically, they’re loans for people with financial histories that would never be approved by Fannie Mae and Freddie Mac.
Because the borrowers on sub-prime loans are more likely to default, the interest rate is higher and is often adjustable, the repayment period is longer than the traditional 30 years, and there are higher fees, like origination fees and late fees.
Pros and Cons of Government-Backed and Conventional Loan
There are a lot of differences between a government-backed loan and a conventional loan, which makes it difficult to get a clear picture of how they stack up.
We will break these very different loan types into their core differences and give you the full picture.
Down payment
Traditionally, your lender will tell you that government-backed loans, like FHA loans, are a good fit for borrowers with limited cash for a down payment.
FHA loans allow for a 3.5% minimum down payment, much lower than the standard 20% necessary for a conventional loan.
FHA’s lower down payment requirement makes qualifying for a mortgage much more feasible for the average potential homeowner, which means its an especially good option for new home buyers.
It is possible to obtain a 3% conventional loan, but the qualifications are stringent. Even some borrowers with great financial portfolios will have trouble qualifying.
Other government-backed loans, like the VA loan, offer down payments as low as 0% in some cases.
Property requirements
Government-backed loans impose stricter property requirements than you would find in a conventional loan.
Most mortgages require an appraisal report to be completed to verify the home’s market value.
Part of an appraisal is an in-person visit to the property.
Government-backed loans require the appraiser to follow stricter guidelines when reporting the condition of the house. If any issues are found, it could mean the mortgage won’t be approved.
You can purchase a townhome or a condo with both a government-backed loan or a conventional loan.
But it can become complicated with a government-backed loan.
All condo complexes must be approved by their respective governing agency before they will finance a mortgage in that complex.
Occupancy
Occupancy refers to whether you are purchasing the property as a primary residence (you live there full-time), or as a secondary house (you only stay there in the summer, for example).
Most government-backed loans do not allow you to purchase a secondary or vacation home. You can with a conventional, but purchasing a secondary home means you will face stricter guidelines.
Mortgage insurance
A major difference between conventional and government-backed loans is mortgage insurance.
Conventional loans do have mortgage insurance, but if you put down a down payment of at least 20%, the insurance will be waived.
This is not the case with government-backed loans.
The mortgage insurance will be included in your mortgage payment no matter the amount you put down.
Credit Score
If you have lower credit, a government-backed loan is likely the way to go.
For example, FHA loans allow for credit scores as low as 500, though you are much more likely to be approved with a credit score of around 580.
What Credit Score Do You Need for Conventional Loans?
Lenders offering conventional financing typically require a credit score between 620-640. The requirement can vary based on mortgage size, location, and other elements of your financial portfolio.
The higher your credit score, the lower your interest rate. Lenders view your credit score as your overall grade as a borrower.
If you have a high credit score, lenders view you as dependable.
If you have a low credit score, lenders see you as a possible foreclosure risk.
What's the Minimum Down Payment for a Conventional Loan?
There is a myth that conventional loans require a 20% down payment, but in reality, the minimum down payment required for a conventional loan is 5%.
If you do put down less than 20%, your mortgage will be saddled with a private mortgage insurance payment.
The good thing, and a major difference from government-backed loans, is this mortgage insurance can be removed from your loan once you have made enough mortgage payments to have reached an equity level of 80%.
What Minimum Income Do You Need for a Conventional Loan?
Lenders look at your proof of income to verify your ability to repay your loan.
Lenders will analyze your bank statements to verify regular deposits, they will verify what percentage of your income is bonus or commission-based, and more.
Proving your income can be an extensive process, so make sure you have recent pay stubs, bank statements, and tax forms on hand.
Once your lender verifies your proof of income, they will calculate your debt-to-income ratio. T
his ratio is where your minimum income becomes important. Lenders do not have rules that you have to make a certain amount per year in order to be approved for a mortgage.
They do, however, have requirements on the ratio of your overall monthly debt payments (mortgage, school, car, credit card, etc.) to your monthly income.
Your debt-to-income ratio is not a ratio of your total debt and your yearly income.
It only looks at the minimum payments you owe on your debt.
So if you have a $10,000 student loan debt and the minimum monthly payment is $100, only the $100 factors into your debt-to-income ratio.
Conventional lenders can reach up to a 45% or 50% debt-to-income ratio in certain cases, but the more standard ratio is 36%.
Where Can You Apply for a Conventional Mortgage Loan?
The easiest decision is to apply for a loan with whatever institution manages your Checking or Savings account.
Your provider will already have an understanding of your financial history, which makes the pre-approval process much easier.
However, just because you have banked at an institution for years does not mean they will offer you the best rates, credits, or even the best customer service.
This is because the checking/savings accounts division of a financial institution is completely separate from the one governing mortgages.
It's important to shop around for the best rates, closing costs, and customer service.
Since conventional mortgages are a very common mortgage type, any lender will be able to offer it for you.
You can go to a bank, credit union, mortgage lender, or mortgage broker.
They will all be able to get you pre-qualified and set up to get a conventional mortgage.
Working with a mortgage broker can help you shop around in one spot since they usually work with a few different lenders and can tell you what each may be able to offer.
In addition, do not overlook the importance of customer service!
A lender or mortgage broker that offers good customer service will help you avoid any confusion or ambiguity, lag in loan approval or closing, and overall help facilitate your deal.
You can search online and make comparisons, but sometimes the best way to go is to ask friends, family, or colleagues if they have a good recommendation.
How Much Can You Afford?
Now that you know which mortgage is the best fit for your unique situation, it’s time to determine what you can afford.
Property Nest offers a simple and robust Mortgage Affordability calculator that takes the guesswork out of determining your budget.
Click here to access PropertyNest’s Mortgage Affordability Calculator.
