What is a Conventional Loan? 2021CASAPLORERTrusted & Transparent
What is a conventional loan and how does it work?
Conventional loans, also known as conventional mortgages, are a type of home loan which are not offered or insured by government agencies. Instead, they are backed by private lenders such as banks, credit unions, and mortgage companies. Conventional loans are not insured by the government and therefore have stricter eligibility requirements. Non-conventional loans are mortgages that are insured by the government.
The figure above shows the different mortgage types and their links. The two major subsets are conventional loans and non-conventional loans. Conventional loans are mortgages that are issued and guaranteed by private organizations. Conventional loans are further divided into conforming loans that meet the requirements set by Fannie Mae and Freddie Mac, and non-conforming loans that do not meet these requirements. Requirements include maximum loan limits, Debt-to-Income (DTI) ratio, credit score, and minimum down payments. Conforming loans can also be divided into standard loans that meet all the requirements and high-balance loans that meet some of the requirements. Non-conforming loans include jumbo home loans which are larger than the conforming loan limits.
Non-conventional loans are mortgages that are insured or backed by government agencies. It includes FHA loans which are insured by the Federal Housing Association (FHA), VA loans which are insured by the Department of Veterans Affairs, and USDA loans which are backed by the Department of Agriculture.
What is the current rate for conventional loans?
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The different types of Conventional Loans
There are two major types of conventional loans: conforming loans and non-conforming loans.
A conventional loan is a conforming loan when it meets the requirements set by the Federal National Mortgage Association (Fannie Mae) & Federal Home Loan Mortgage Corporation (Freddie Mac). These agencies purchase the loans from private lenders that meet their specific requirements and repackage them into investment products that are sold in the financial markets.
The major requirement that all conforming loans must meet is the loan limit requirement. The loan must be within the conforming loan limits set by the Federal Housing Finance Agency (FHFA). Loan limits are based on the county that you are located in, such that certain counties have different limits based on the cost of the homes in the area. The base loan limit for most counties in 2021 was $548,250 and the high-cost loan limit is $822,375. You can find the loan limit for your county on the FHFA page.
Non-conforming conventional loans are mortgages that do not meet the requirements set out by Fannie Mae and Freddie Mac. These loans are usually above the loan limit of the county and are known as jumbo loans. For example, if you are buying a $1.2 million home with a $300,000 down payment in New York City where the loan limit is $822,375, you would have to get a jumbo mortgage. Jumbo loans have stricter eligibility requirements due to the higher risk to the lender. Typically, you have a credit score greater than 700, a minimum down payment of at least 20%, and a debt-to-income (DTI) ratio no greater than 43%.
What are the eligibility requirements for conventional loans?
Eligibility requirements can vary from lender to lender, however, the basic requirements are as follows:
Minimum Down Payment
Conventional loan down payment requirement is 3% or an LTV ratio less than 97%, therefore, on a $300,000 home, you must provide an upfront sum of $9,000. Private mortgage insurance (PMI) will be required as the down payment is less than 20%. The minimum down payment is one of the lowest as compared to a majority of programs. However, you must be a first-time home buyer and be purchasing a single-unit family home. If you are not a first-time homebuyer or are getting an adjustable-rate mortgage, you must put at least 5% down. An adjustable-rate mortgage uses a variable mortgage rate which changes with a benchmark index like the prime rate along with an additional credit spread.
Minimum Credit Score
Your credit score must be greater than 620. The higher the credit score, the lower the mortgage rate will be as you will be seen as more creditworthy and less likely to default.
Maximum Debt-to-Income (DTI) Ratio
Your DTI ratio must be less than 50%, which means less than 50% of your monthly income should be going towards monthly debt and interest repayments. For example, if your monthly income is $5,000, less than $2,500 ($5,000*50%) should be spent on debt repayments.
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Conventional Loans Vs Government-insured Loans
Government-insured loans are backed by federal agencies, such that if the borrower ever defaults on their payments, the lender can recoup the loan. This is meant to increase the number of mortgages provided by the lenders and to make it easier to become a homeowner. Most government mortgage programs have several perks that can benefit a borrower if they are eligible for those programs.
Conventional Loan Vs FHA Loan
The FHA loan is insured by the Federal Housing Association and the main objective of the program is to increase homeownership among low to medium-income earners. FHA loans only require a minimum down payment of 3.5%, however, all FHA loans are required to get the FHA mortgage insurance premium (MIP). More information can be found on our conventional loan vs FHA loan page.
Conventional Loans Vs VA Loan
The VA loan is backed by the Department of Veterans Affairs and is applicable for eligible veterans and their spouses. VA loans do not have a minimum down payment or credit score requirement, however, all VA loans have an upfront VA funding fee. To calculate your monthly mortgage payment with the VA funding use our VA loan calculator.
Conventional Loans Vs USDA Loan
The USDA loan is insured by the Department of Agriculture and is aimed at individuals buying a home in a rural area. USDA loans also do not have minimum down payment requirements or credit score requirements, however, your income must be less than 115% of the median county income. In order to check if you are eligible for a USDA loan, check our USDA Eligibility Map page.
Advantages & disadvantages of conventional loans
Advantages of conventional loans
- All Types of Property – Conventional loans can be used for a variety of mortgages from the standard conforming loans to the Jumbo non-conforming loans. Mortgages for second homes, investment properties, farm-use, or multiple unit homes can be purchased using a conventional loan. Government mortgages are mostly for first-time home buyers and single-unit homes.
- Numerous Loan Structures – Conventional loans are flexible, you can get a mortgage for 10, 15, 20, 25 or 30 years and can choose between fixed and adjustable-rate. As compared to government-backed mortgages which mostly offer 30-year fixed loans only.
- Removal of Mortgage Insurance – Private mortgage insurance (PMI) can be removed once you attain an LTV ratio of 78%, or when you refinance your mortgage once you have at least 20% equity in the home.
- Down Payment Options – You can choose to benefit from a 3% down payment with PMI or choose to pay at least 20% down to avoid PMI. There is flexibility in deciding based on how much house you can afford.
- No Program Specific Fee – Lender fees are still there, however, there are no upfront program fees. Most government-insured programs have some upfront fee, for example, the VA loan has the VA funding fee.
Disadvantages of conventional loans
- Minimum Credit Score of 620 – Conventional loans are great if you have a credit score greater than 620 because most lenders will require at least 620 to accept your application. At 620 you will get a very high mortgage rate as lenders will not see you as creditworthy. Whereas government-insured loans have much lower credit score requirements, FHA at 500 and VA or USDA do not have a minimum credit score requirement.
- Higher rates with Lower Down Payment – Although you can get a mortgage with a down payment as low as 3%, the mortgage rate and PMI on the loan will be very large. Therefore, if you do not have savings for a larger down payment and can qualify for an FHA loan, that will be a more suitable option.
- Stricter Qualifications – As these loans are not insured by the government, lenders have to be careful who they give a mortgage to. Hence, the qualification process can be harder than government-insured programs that focus on increasing homeownership.