What Is a Conventional Loan?
The home-buying process is often rich in jargon and complex terms. If you have been shopping around for a mortgage, you are more than likely to have encountered the term "conventional loan" at least once, and you have probably wondered, "Exactly what is a conventional loan?"
In this guide, we will outline conventional loan lenders, rates, limits, and requirements, as well as the pros and cons of this mortgage financing method. By the end of reading it, you will have a better understanding of whether or not a conventional loan best suits your needs.
A Basic Understanding of Conventional Loans
A conventional loan, or conventional mortgage, is a type of home loan provided by lenders that federal government agencies do not back. Mortgages insured by government agencies refer to the loan programs under the Federal Housing Administration, Veterans Affairs, and the United States Department of Agriculture. Conventional loans, on the other hand, are available through a private lender or originate under the guidelines provided by the Fannie Mae and Freddie Mac government-sponsored enterprises. These mortgages can be either conforming or non-conforming loans, as well as can be used for both home purchasing and refinancing.
The Best Conventional Mortgage Lenders
Selecting a knowledgeable and experienced mortgage lender is key when applying for a conventional home loan. Banks, credit unions, and mortgage brokers are some of the most common sources for this type of loan. A reputable lender providing quality service with an excellent track record in their area is essential to consider.
Comparison shopping for the best rates and terms is also crucial to finding the loan that best suits your wants and needs as a borrower. Utilizing the services of a mortgage broker can aid in finding such optimal loan options.
What Are the Requirements for a Conventional Loan?
To qualify for a conventional loan, borrowers must meet specific criteria. These terms and conditions vary by lender but often include the borrower having an above-average credit score, an acceptable debt-to-income ratio, stable employment history, and several others. These factors, along with the purchased property's value, help lenders determine how much of a loan amount a borrower can afford to repay. Ideal candidates for conventional loans can expect the following requirements:
Credit Score Limits
Mortgage lenders offering conventional loans will consider borrowers with attractive credit reports and scores. Borrowers are required to have a credit score of at least 620 to qualify. Alas, that is just the minimum for conventional lending. The higher the borrower’s credit score, the better the deal and the lower the interest rates.
A conventional loan may not be for you if: You have a credit score below 620.
DTI Qualifications
Calculate your Debt-to-Income (DTI) ratio by adding up your monthly debts from credit cards and loan payments and then dividing that sum by your monthly income. For conventional lending, a qualifying DTI ratio is typically 36 percent or less and should never exceed 45 percent. Put simply, it is best to keep your monthly debt payments below 36 percent of your income.
A conventional loan may not be for you if: Your debt-to-income ratio is above 45 percent and you have no proof of regular employment/income.
Down Payment Minimum
A conventional mortgage requires a minimum down payment of three percent from a borrower under the Fannie Mae and Freddie Mac standards. However, those with low credit scores or high DTI ratios may be required to put down a more significant amount. A larger down payment may also be necessary for a jumbo loan, a loan for a second home, or an investment property. A down payment of less than 20 percent may result in an added expense of private mortgage insurance (PMI) until that same equity threshold is successfully achieved.
A conventional loan may not be for you if: You have minimal savings and cannot afford a down payment of at least three to ten percent.
Documentation Needs
There are many required documents for a conventional mortgage loan that serves as the borrower’s proof of identity, income, assets, employment, creditworthiness, and homeowners insurance coverage. While this list is not exhaustive and specific conditions vary, conventional home buyers should be prepared to furnish recent W-2 forms, tax returns, pay stubs, bank statements, credit reports, insurance declarations, and a government-issued photo ID.
Compare Conventional Mortgage Rates
Mortgage rates for a conventional loan vary depending on the lender, as well as the borrower's credit score and DTI ratio. Generally, the higher the credit score, the lower the rate. To get the best deal possible, shopping around and comparing rates and terms from many different lender options is crucial.
- Interest Rates: Vary based on several factors, such as the lender's pricing, the loan type, term length, and the borrower's financial information. In general, conventional loans offer lower interest rates than government-backed mortgages like FHA, VA, and USDA loans. Shop around and compare offers from multiple lenders to find the lowest rate.
- Annual Percentage Rate: APR is a more comprehensive view of the total cost of a conventional loan, represented as a yearly rate. It includes the interest rate along with additional charges such as points, insurance, and processing fees. APR provides a complete picture of the cost of a loan so that borrowers can better compare offers.
- Fees: Several fees are associated with the interest rate charged on a conventional mortgage loan, such as discount points, loan origination fees, and lender fees. Ask questions about unfamiliar charges when reviewing the loan estimate. The goal is to find a loan with a low-interest rate and minimal fees to secure a low overall cost of borrowing.
- Points: Discount points are fees paid upfront to the lender in exchange for lowering the interest rate on a conventional mortgage. One point equals one percent of the loan amount and can be purchased to reduce the interest rate by a set amount. This concept is often referred to as "buying down the rate."
What Are the Limits for Conventional Loans?
Lenders sometimes limit how much home buyers can borrow with a conventional mortgage. It is vital to consult about the maximum loan amount beforehand, which can vary based on the lender providing it, the borrower's credit standing, and the type of property purchased. See how conventional loan limits get broken down by location below:
County Limits
When it comes to conventional loan limits, the most critical factor is the county where the purchased property is located. Each county in the United States has its own loan limit based on its median home prices and set by the Federal Housing Finance Agency (FHFA), which is the governing body for the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal National Mortgage Association (FNMA).
As of 2023, the baseline limit for conventional loans is $726,200. These limits may be higher in certain high-cost areas, like major cities and surrounding suburbs, where home prices tend to be higher. To find the specific loan limit for a county, you can consult the FHFA's website or contact a local lender.
State Limits
In general, there are no state limits for conventional loans. The FHFA sets these limits for conventional loans, which apply to the entire country, regardless of the state in which the purchased home is located. The limits may vary by county based on local housing prices and the cost of living, but there is no difference in boundaries between states. However, loan limits may be higher in certain high-cost areas.
Loan limits for a conventional loan may differ for a second home or an investment property compared to a primary residence. It is essential to check with your lender for the specific loan limits that apply to your situation.
Federal Limits
Conventional loans have limits set by the FHFA that vary by county. These loan limits may be higher in certain high-cost areas. Additionally, conventional loans may have higher limits for high-balance or super conforming loans. Loan limits have risen to $726,200 throughout most of the U.S. in 2023, with high-cost areas reaching up to $1,089,300.
It is important to note that these loan limits apply to the mortgage amount, not the purchase price of the property. If the purchase price of the property is higher than the loan limit, a down payment will be required to make up the difference.
Conventional Loan Calculators
With conventional loans, there are a variety of calculators available to borrowers. These calculators help determine how much of a loan you can afford and what the monthly payments might look like. Potential home buyers can use them to determine the total cost of a loan, including its closing costs and all other fees. They also help borrowers decide whether or not they should pay points up front, which can lower their interest rate and save them money in the long run.
With a calculator, borrowers can get an idea of the amount of money they will have to pay each month before they even start the loan process. Wesley Mortgage offers a mortgage calculator, which provides estimated monthly payments and an amortization schedule for a potential home loan. Please note that these are only estimates.
Payment Calculators
Mortgage calculators are an essential tool to use when considering a conventional loan. With a mortgage calculator, borrowers can input their information, such as the loan amount, interest rate, and terms. It will then calculate the monthly payment, total interest paid, and total cost of the loan over the life of the loan. These calculators also allow borrowers to compare different loan scenarios and determine which offer is best for their situation.
Affordability Calculators
Affordability calculators are another great tool for potential home buyers. With these calculators, borrowers can input their income, debts, and other financial information to determine how much of a loan they can afford. These calculators can also help borrowers decide how much of a down payment they should make and how much of a monthly payment they can handle.
What Are the Advantages of a Conventional Mortgage?
Conventional loans have numerous benefits, making them a popular choice for many borrowers. These loans often have low-interest rates, flexible loan terms, and a variety of different loan types. Such advantages can help borrowers save money in the long run. Learn more below:
Lower Interest Rate
One of the most significant advantages of a conventional loan is the low-interest rates. Interest rates on conventional loans are often lower than those backed by government agencies, such as FHA and VA loans. Lower interest rates can help borrowers save money over the life of the loan, as it means that more of their monthly payment goes toward the loan's principal balance.
Flexible Loan Terms
Conventional mortgages offer various term options, from 10, 15, and 30-year terms, allowing borrowers to choose a payment plan that fits their budget. Some prefer a shorter loan term, which can help them save money on interest over the life of the loan. There is also the option to make extra payments, which can help them pay off the loan faster and save on interest.
Wide Range of Loan Types
Conventional mortgages offer an expansive list of loan types to accommodate the needs of different borrowers. A few of the most common types include: fixed-rate, adjustable-rate, jumbo, balloon, and piggyback mortgages. These loans also offer more flexible repayment options than other options. Borrowers may choose the loan type that best suits their financial situation.
What Are the Disadvantages of a Conventional Mortgage?
Along with the benefits, conventional loans also have some drawbacks that potential borrowers should consider. These loans often require higher down payments and credit score requirements than FHA and VA loans; sometimes, they even have added expenses such as mortgage insurance. Take the following disadvantages into account:
Higher Down Payment
One of the most significant drawbacks of a conventional loan is the requirement for a higher down payment. Most lenders require a minimum of five percent down for a conventional loan, but some may require as much as 20 percent. That can be a problem for some borrowers who don’t have the funds available for a large down payment.
Higher Credit Score
A lower credit score can make qualifying for a conventional loan more challenging. Most lenders mandate a minimum credit score of 620, but some may require an even higher score. That can be an obstacle for those with a lower credit score or who have had past credit issues. Even if the minimum score gets met, bad credit can put you at risk of a higher interest rate.
Private Mortgage Insurance
Unlike FHA loans, conventional mortgages do not offer mortgage insurance for loans with high loan-to-value (LTV) ratios, meaning borrowers with less than a 20 percent down payment will need to pay for private mortgage insurance (PMI). The premium is determined based on the loan-to-value, loan amount, and credit score.
Are There Alternatives to Conventional Loans?
Other loan types are available for borrowers who do not qualify for a conventional loan or want to avoid making a sizable down payment. FHA, VA, and USDA loans are all alternatives to traditional loans that may be more accessible to some borrowers.
FHA Loans
FHA loans are one of the most popular alternatives to conventional loans. These loans are backed by the Federal Housing Administration (FHA) and are available to borrowers with a lower credit score and a smaller down payment.
The minimum down payment for an FHA loan is 3.5 percent, and borrowers can have a credit score as low as 500. In addition, FHA loans are often easier to qualify for than conventional loans and may have more flexible repayment options.
VA Loans
VA loans are another alternative to conventional loans for borrowers who are eligible for them. VA loans are backed by the Department of Veterans Affairs and are available to veterans, active-duty military personnel, and their families to purchase a home or refinance an existing loan.
These loans are available with no down payment and more lenient credit requirements than conventional lending. Further, VA loans may offer more flexible repayment options than traditional financing.
USDA Loans
USDA loans are another alternative option to conventional loans to consider. Provided by the United States Department of Agriculture, these home loans get reserved for low to moderate income borrowers looking to purchase or refinance in rural areas.
USDA loans offer up to 100 percent financing options along with more relaxed credit scores and debt-to-income requirements than conventional mortgages.
What Is Private Mortgage Insurance?
One of the more considerable drawbacks of a conventional loan is that it may require the borrower to pay for private mortgage insurance (PMI) if they put down less than 20 percent of the purchase price upfront. This insurance is an additional cost that can add to the total loan cost.
PMI is intended to protect the lender if a borrower defaults on the loan, but it can be an added expense for the borrower until they meet the necessary equity threshold to remove it.
Requirements
Once the loan balance on a conventional loan reaches 80 percent of the original purchase price (or appraised value, if it is lower), the borrower may be able to cancel the PMI. That can help borrowers save money on their monthly payments, as they will no longer have to pay for the lender’s insurance. To cancel the PMI, the borrower must provide the lender with proof that the loan balance is below 80 percent of the original value.
Benefits
Although it is an additional expense that protects the lender, PMI can also offer several benefits to borrowers. That includes making homeownership more accessible through lower down payments, lower monthly payments, and allowing building up home equity quicker.
The most significant benefit, though, is that borrowers can cancel their PMI once they reach a certain level of their LTV ratio. Alas, borrowers should consider the cost and long-term impact of PMI before choosing to include it in their mortgage.
Costs
The cost of PMI varies depending on the loan size and the down payment amount. Generally, the cost of PMI is a percentage of the loan amount and gets paid in monthly installments. For example, a 10 percent down payment loan could have a PMI rate of 0.5 percent, adding $50 per month to the loan payment.
Conclusion
Conventional mortgages remain the most popular home financing option by a long shot in the housing market, making them an attractive option for most home buyers. By considering all of the factors mentioned above in this guide, potential borrowers can make an informed decision about the best loan option for their situation. Although they are still
If you're still unsure, reach out to Wesley Mortgage to find a solution that satisfies your financial needs! We have a team of dedicated advisors to help you find the best fit. Whether your goals are to reach homeownership quickly, obtain the lowest interest rate possible, or find a monthly payment that works for you, we can help, so reach out today.
