Conventional Loans: Everything You Need to KnowNovember 03, 2021 by X2 Mortgage
Buying a home is a big financial decision that requires adequate planning. But with so many different types of mortgages, with unique terms and rates, it can be challenging to know which one is the right choice for you. Conventional loans are an excellent way to finance your home projects. They offer flexible terms and low-interest rates. However, like anything, there are also downsides to these loans.
So let’s take a look at everything you need to know about conventional loans—from how they work to their pros and cons, and what’s the best way to apply.
What Is A Conventional Loan?
A conventional loan is a mortgage that is not government insured. Instead, it is available through lenders, such as banks, brokers, credit unions, and mortgage companies.
While government-insured and regulated loans such as FHA, VA, and USDA are subject to specific guidelines, conventional loans have their loan terms, including eligibility requirements, interest rates, down payment requirements, and payment schedules.
Conventional mortgages are the most common type of home financing option. Apart from offering flexible rates, they provide buyers with a wider range of options. According to a US Census Bureau survey, conventional mortgages account for more than 76 percent of new home purchases.
However, despite their flexibility, conventional loans are more challenging to qualify for. In comparison to government-insured loans, lenders face greater risks associated with borrower default. Hence, potential borrowers must show high credit scores of at least 620, have a good credit history, and have a debt-to-income ratio of at the very most 50% to qualify for the loan. We will go into the details shortly.
How a Conventional Mortgage Works
Conventional mortgage applications could take weeks to get initially approved. As with any mortgage, there will be a lot of paperwork and supporting material that you have to prepare to gain approval. However, if you know what you're doing ahead of time, it's much easier.
A lender typically requests relevant financial documents and information such as a valid means of identification, bank statements, recent pay stubs, documentation showing how you will pay the down payment, and in some cases your tax returns. This is to certify that you have a steady income and can afford a monthly mortgage repayment.
For a conforming conventional loan, you can get approved with a credit score of 620. But this is largely dependent on the lender. It's highly recommended to have a score of a 660 or more. Otherwise, an FHA loan might be a better option.
You must have a steady income, be within the maximum allowed debt-to-income ratio, and have a good credit score. You should also have sufficient savings to cover the closing costs, reserve, and down payment (Your down payment will range from 3% to 20% of the purchase price depending on your specific situation.
Lenders require a down payment of as low as 3% for fixed-rate loans and a minimum of 5% for ARMs (Adjustable-Rate Mortgages). However, because lenders are at risk if you default, you must pay Private Mortgage Insurance (PMI) if you put less than a 20% down payment. However, the PMI can be canceled if a homeowner has accumulated 20% equity in their home - without the need of a refinance.
The PMI costs can range depending your credit score, number of borrowers on the loan, and your loan to value ratio (how much your down payment is). Due to how many variables, the PMI costs can generally be between 0.15% and 2.5% of the loan annually. The larger the down payment, the better. Of course, a down payment of at least 20% of the home price eliminates the need for private mortgage insurance.
The interest rate for conventional loans varies and is heavily determined based on credit score and loan term. The higher your credit score, the better your interest rate is. In addition, the shorter your loan term (10yr, 15yr, 20yr, 25yr, 30yr, etc.), the better your rate.
What Are the Types of Conventional Loans?
A Conforming Conventional loan adheres to Fannie Mae and Freddie Mac standards. To be clear, those are not the names of specific individuals. Federal National Mortgage Association is abbreviated as Fannie Mae, and Federal Home Loan Mortgage Corporation is abbreviated as Freddie Mac.
Both are government-sponsored enterprises (GSEs) created to stabilize the housing market by maintaining affordable mortgages. These two home financing corporations purchase mortgages from lenders. By selling their loans to Fannie Mae and Freddie Mac, lenders have access to additional financing.
These lenders must conform to guidelines governing maximum loan amounts, debt-to-income ratios, credit scores, and acceptable property requirements. The maximum loan amount for conforming loans varies by area and is updated annually.
For example, as of 2021, the maximum loan amount for single-family homes is $548,250, while the maximum loan amount in higher-cost areas is $822,375.
These loans do not meet the Fannie Mae and Freddie Mac loan requirements and cannot be purchased by them. Most of the time when referring to a "non-conforming" loan, it's due to the loan amount. This is when they are referring to jumbo loans because they exceed the prescribed loan limit.
Other features of jumbo loans include; bigger down payment, higher credit score requirement, and higher loan rates. In addition, non-conforming loans are available to well-qualified borrowers who need more flexible mortgage loan options.
Non-Qualifying Mortgage (Non-QM)
It is a subset of non-qualified conventional loans. Private lenders choose to hold on to their own book rather than sell their mortgage to Fannie Mae and Freddie Mac or other investors.
This allows them to set more flexible guidelines and requirements and make it easier for borrowers to qualify. For instance, a lender might let a borrower pledge a down payment using investment funds without actually withdrawing or making a cash deposit. These loan programs do come at much higher interest rates due to the added risk.
Do Conventional Mortgages Have Good Rates?
Contrary to popular belief, conventional loans have a slightly higher interest rates than FHA and VA loans. However just because the rate is slightly higher, that doesn't mean your payment is higher. In fact, Conventional mortgages generally have lower monthly payments than FHA mortgages due to the higher mortgage insurance that is required on all FHA mortgages. With conventional mortgages, the interest rate you get depends on several factors such as:
Credit Score: The better your credit score (620 and above), the lower your interest rate.
Type of Home: Single family residences have the best rates while condos, multi-units, and manufactured homes are at a premium.
Loan Duration: Long-term mortgages such as 30years loans have higher interest rates than short-term mortgages of 15 years.
Size of Down Payment: Generally, a larger down payment means a better interest rate, and a smaller down payment means a higher interest rate.
Fixed-Rate or Adjustable-Rate Mortgage: The type of conventional loan you choose can also affect the interest rate you get.
Can First-Time Home Buyers Qualify For a Conventional Loan?
Yes, these loans are available to first-time home buyers and ensure your buying process is easier and affordable. First-time homebuyers can get a conventional loan by fulfilling the following requirements.
Requirements for Qualification
A credit score gives the lender an idea of how a borrower manages debt and loan repayments. Having a good credit score puts the lender at ease and lowers risk. Calculating credit score involves putting together several aspects of credit history, such as payment history, amount of debt, type of debt, amount of credit used, etc.
FICO credit scores range from 300 to 850. In most cases, you’ll likely need a credit score of at least 620 to get approved for a conventional mortgage, and that's just the minimum. To get a better interest rate, you will need a higher credit score of about 740 or more.
Lenders want to ensure that you are gainfully employed and have sufficient income to handle the monthly mortgage payment, as well as any other debts you may have. Therefore, most lenders will verify your employment status by contacting your employer or requesting special documentation if you are self-employed.
For example, you might be asked to provide tax returns for recent years and bank statements to verify your earnings.
Debt-to-Income (DTI) Ratio
This is the percentage of your monthly income that goes into the payment of debts. To calculate your DTI, add your expected new mortgage payment, plus your average monthly payments (credit cards, auto loans, and student loans), and then divide it by your gross monthly income.
To be qualified for a conventional mortgage, your DTI must be 50% or lower. However, some lenders will want a ratio that does not exceeds 43% on a Conventional loan.
Is A Conventional Loan A Better Option Than Other Loans??
In general, a conventional loan (if you qualify) involves fewer complexities than other types of loans and is considered the one of the best types of mortgages available. These loans are available to anyone who meets the qualification criteria. Additionally, they provide buyers with a wider range of options and can be utilized to purchase a second/vacation home or investment property. Let's compare conventional loans to other loan options.
Conventional Loans vs. FHA Loans.
FHA loans are government-insured loans regulated by the Federal Housing Administration. Here are some key differences between FHA loans and conventional loans.
- FHA loans are easier to qualify for, and this is because they have lower credit score requirements than conventional loans. For example, with a minimum credit score of 580, you can be eligible to make a 3.5% down payment for an FHA loan. On the other hand, conventional loans require a minimum of 620 credit score or higher, but allow a lesser minimum down payment of 3%.
- FHA allows for a debt-to-income ratio to go as high as 57% while conventional loans accept a debt-to-income ratio (DTI) of 50%. However, most lenders will not approve your conventional mortgage if your DTI exceeds 43%.
- A major advantage of Conventional loans over FHA is the mortgage insurance payment. You must pay Private Mortgage Insurance (PMI) when you put less than 20% down payment with conventional loans. But its typically less expensive and as soon as you cross the 20% equity threshold, your PMI is canceled. Whereas, in FHA loans, your Mortgage Insurance Premium (MIP) cannot be removed (no matter how much equity you have) until you pay off your loan or refinance into a conventional loan.
- Both FHA loans and conforming conventional loans have maximum loan limits. This regulation changes annually. In 2021, the FHA loan limit is $356,362 for low-cost areas.. For conventional loans, the limit is $548,250 for low-cost areas. However, non-conforming or jumbo loans may offer amounts exceeding the mortgage threshold set by the Federal Housing Finance Agency.
- Conventional loans can purchase a second or vacation home and an investment property, but FHA loans are only available for primary residences.
Both are great options! Just depends on your specific scenario on what is right for you.
Conventional Loans vs. VA Loans
VA loans are special types of loans created for military service members, veterans, and their spouses. The U.S Department of Veteran Affairs backs them. VA loans come with some unique benefits; they don't require any down payment or mortgage insurance payment.
Here are some critical differences between VA loans and conventional loans.
- VA loans are for primary residence only, whereas conventional loans can purchase primary and secondary homes (such as vacation and investment properties).
- Conventional loans are available to all persons; VA loans are restricted to service members, veterans, and spouses.
- VA loans don't require a down payment or mortgage insurance, but you are required to pay a funding fee. It's a one-time upfront charge which is between 1.4% and 3.6% of the loan amount. So while a down payment may reduce your VA funding fee, it doesn't eliminate it unless the veteran is more than 10% disabled. Whereas, with 20% down on a conventional loan, you won't have to pay PMI.
When it comes to primary purchases, VA loans are arguably the best loan option available. Conventional loans do offer more flexibility though.
Conventional Loans vs. USDA Loans
USDA loans are government-subsidized mortgage programs backed by the U.S. Department of Agriculture to assist rural homebuyers. USDA loans are a very affordable loan option that requires zero down payment.
Here are some key differences between USDA and conventional loans.
- USDA loans are restricted to certain rural areas, unlike conventional loans, which are available in every area of the country.
- USDA Loans can only be used to fund primary homes, but conventional loans don't have this restriction.
- To qualify for USDA, your household income limit cannot exceed 115% of the area's median income. For conventional loans, there is no limit.
- Conventional loans require the payment of PMI from borrowers who put less than 20% down payment. PMI ranges from 1% to 1.5% of the unpaid loan amount. USDA loans require you to pay a guarantee fee, 1% of the total loan amount when paid upfront. But when paid as part of the monthly repayment, guarantee fees are similar to PMI, although with a lesser rate.
It's rare for an individual to be able to qualify for a USDA loan which is why Conventional loans are far more popular. If a USDA loan works for your scenario, then great!
Final Note: Get in Touch with an Expert to Make the Best Decision.
Conventional loans are an excellent option for first-time homebuyers as well as second-home buyers. This guide should give you sufficient information to make an informed decision about whether Conventional Mortgage Loans are suitable for you. However, if you require more information and guidance to make a decision, you should get in touch with a professional mortgage broker to get the best deals that best fit your financial goals.