What’s a Conventional Loan?

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Category: Loans
Posted on: 07/27/2021
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As defined by Investopedia, a conventional loan is a homebuyer’s loan that’s “not secured by a government entity,” meaning it’s a mortgage for homebuyers not backed by the Federal Housing Administration (FHA), the U.S Department of Veterans Affairs (VA), or the USDA Rural Housing Service. Instead, a conventional loan is secured by a private lender—banks, credit unions, or mortgage companies.

Knowing the Difference: Government-Backed Loans vs. Conventional Loans

Loans secured through the FHA, VA, or USDA share a similar goal of making homebuying affordable to low-to-middle income families. These government-guaranteed loans have more flexible lending criteria, so lower-income families saddled with a bad or no credit score can still have an opportunity at a home loan. Down payments requirements aren’t as high as conventional loans, and the rates are more competitive.

The VA and USDA differ in terms of eligibility. The VA issues loans for active military and veterans only and USDA loans are supported by the U.S. Department of Agriculture, aiming to provide loans specifically for rural property buyers.

Conventional loans offered by banks, credit unions, and private financial institutions have a different set of requirements. You can also acquire a conventional loan through the two well-known government-sponsored companies, Freddie Mac and Fannie Mae. Lenders who issue them view conventional loans as riskier, and so the lending criteria are more stringent. Borrowers will need to have a good to excellent credit score, an untarnished credit history, and are traditionally required to put forth a down payment of up to 20%.  

If you’re looking at buying a home, chances are you’ll be acquiring a conventional mortgage to make this large investment. According to Investopedia, conventional mortgages make up about two-thirds of homeowners loans issued in the United States.

The Categories of a Conventional Loan

When researching conventional loans, you may come across the terminology “conforming” and “nonconforming.” These are the two categories that conventional mortgage loans fall into.

Conforming loans follow set guidelines established by two companies, Fannie Mae and Freddie Mac. Both of these companies are government-controlled and help provide funds for the U.S. housing market. For example, these companies set the well-known rule of loan size. In 2020, the conforming loan limit throughout most of the United States was capped at $510,400 for a single-family home, determined by the Federal Housing Finance Agency each year (FHFA). The cap is higher for more expensive states like Hawaii and Alaska, set at $765,600 for a single-family home.

Nonconforming loans are also called jumbo loans. These loans are for borrowers who don’t meet the qualifications for conforming loans because the loan size is larger than the cap established in that particular area. 

Nonconforming conventional loans are considered riskier by lenders due to their size and the fact that they don’t conform to the established guidelines.

Requirements for a Conventional Home Loan

Credit Score

Every lender is different and has its own set of specific requirements borrowers must meet to acquire a conventional loan. Most commonly, a score of 620 is the lowest credit score a lender will allow to obtain a conventional loan, but this low score will also generate a much higher mortgage interest rate. The minimum credit score to get a good mortgage rate is usually no lower than 740.

Down Payment and Private Mortgage Insurance

A down payment is an essential part of homebuying and a conventional loan. Making a sizable down payment will lower your monthly payments. 

Traditionally, lenders ask that you put down about 20%, but this can depend on your borrowing history, credit score, and other factors.  

Depending on how large of a down payment you put down, you’ll need to pay for private mortgage insurance (PMI). PMI is there to protect the lender in case you default on your loan. It adds to your monthly payments, but you can cancel your PMI when the principal loan balance drops to 78% of your home’s value—or when the borrower achieves 20% equity in the house (with an FHA loan, borrowers pay mortgage insurance premiums for the loan’s lifetime).

Debt-to-Income Ratio (DTI)

When you seek out a conventional loan, your private lender will want to know your DTI. It’s the sum of your monthly necessities compared to what you make—how much you need to spend on obligations weighed against your income. The number should be about 36%, but no more than 43%.

Documentation

Finally, when you go to apply for a conventional loan, your lender will require documentation. 

You’ll need to provide them:

  • Proof of income: pay stubs, federal tax returns, W-2 statements, and statements of all of your asset accounts
  • Proof of employment: pay stubs and employer contact information
  • Proof of identity: Social Security number, driver’s license, and signature

Interest Rates for Conventional Loans

Interest rates are always at the forefront of every borrower’s mind, no matter what type of loan they’re pursuing. Interest rates are typically higher for a conventional mortgage loan than a government-funded loan, like FHA loans. However, the catch with an FHA loan is that borrowers are mandated to pay mortgage insurance throughout the loan’s lifetime, which ends up costing the same as a conventional loan anyway.

Interest rates are determined by various factors, the most prevalent being the loan’s term length and size. Term lengths for conventional loans are usually 15, 20, or 30 years. Whether you opt for a fixed interest rate or an adjustable interest rate will determine how much you pay in interest overall.  

A fixed interest rate dictates that your payments remain the same no matter the market trends, but an adjustable interest rate could move your payments up or down depending on the market. Fixed interest rates are what most borrowers opt for in a conventional loan because of the larger size of the loan and length of the loan, where predictability means stability in monthly payments.

Your creditworthiness is another factor in deciding what interest rate you’ll be getting with your conventional loan. Lenders want to minimize risk, and if your financial profile presents a history of timely repayments, an excellent credit score, and you’ve made a sizable down payment, lenders will reward you with a reasonable mortgage rate.

Applying for a Conventional Loan

These days, you can apply for a conventional loan online or visit a financial institution and apply in person at a physical branch. Remember, you’ll need to come prepared—have your documentation ready when you go.

An ideal borrower should have:

  • A credit score over 700
  • A debt-to-income ratio of around 36%, no greater than 43%
  • A down payment of 20% of the home’s purchase price

Being creditworthy and having a 20% down payment means you’re a lower risk as a borrower, and to a lender, that’s immensely attractive. With a good financial standing, you can achieve a better interest rate for your conventional loan, too.

Conventional loans are what most homebuyers choose when purchasing what will perhaps be the most significant investment they’ll make in their lives. The majority of borrowers choose a fixed-rate, 30-year term. 

The predictability of repayments and steady interest rate means their budget will remain unchanged, and for homeowners, this stability of a conventional loan is financial security.

Finance Guru

Finance Guru