In this guide, we’ll provide information on the most common type of home loan: the conventional loan. A conventional loan is a type of mortgage that’s not backed by the government, but rather a private lender.
What are Mortgages?
A mortgage is a type of loan where a bank or financial institution lends money to a homebuyer for the purpose of purchasing a property; the lender uses the purchased property as collateral.
Types of Mortgages
There are three types of mortgages: conventional loans, FHA loans, and specialty loans. It’s important to consider the pros and cons of each before deciding which one is right for you, as the type of loan will affect how much money you’re eligible to borrow, the amount required for a down payment, and the total cost of the loan (with extra costs such as mortgage insurance or interest).
A conventional loan, or conventional mortgage, is the most common type of home loan. These loans aren’t part of any government program and aren’t insured by government entities. They can be lower in cost than FHA loans, but more difficult to qualify for. Additionally, if you don’t put at least 20% down, you’ll have to pay private mortgage insurance (PMI) every month.
Conventional mortgages can be used for a variety of purchases, including primary residences, vacation homes, and rental properties. We’ll dig into the details of conventional loans later in the guide.
FHA loans are insured by the Federal Housing Administration (FHA), a government agency, and must be used for purchasing a primary residence. The benefit of FHA loans is that they’re generally available to those with lower credit scores, and require a smaller down payment (between 3.5% to 10%, depending on the credit score). FHA loans have mortgage insurance premiums (MIP) that are similar to PMI.
Specialty loans are loans that are available to specific, qualifying groups. Examples include VA loans for veterans and USDA loans for those living in rural areas.
- Backed by the U.S. Department of Veterans Affairs
- Don’t require a down payment
- Won’t charge Private Mortgage Insurance (PMI)
- Backed by the U.S. Department of Agriculture
- Don’t require a down payment
- Are only open to people with certain income levels. Be sure to check the requirements before applying.
Loan terms are the length of time allowed to repay the loan — usually 15 or 30 years. This loan length affects a number of factors including interest rates, monthly payments, and the amount of interest paid over the life of the loan.
A shorter loan term will have a lower cost and lower interest rates, but a higher monthly payment amount. A longer-term will have lower monthly payments, but higher interest rates and a higher total cost over the course of the loan.
There are two types of interest rates: fixed and adjustable.
Fixed-rate loans are what the name suggests — an interest rate that’s fixed for the duration of the loan. This means your interest rate won’t change at all during the loan, and your monthly payments will stay the same.
Adjustable-rate mortgages (ARMs) offer an initial period of fixed interest rates followed by a change (increase or decrease) in the interest rate depending on the market at the time. While ARMs may be cheaper in the short term, they can fluctuate heavily based on how the market performs. Common fixed periods for ARMs include 3, 5, 7, and 10 years, followed by adjustable rates on a yearly basis.
Types of Conventional Mortgages
As mentioned above, conventional loans aren’t insured by the government. They fall into two categories: conforming or nonconforming.
Conforming conventional loans
Conforming conventional loans follow the regulations decided by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
You’ve likely heard the names Fannie Mae and Freddie Mac before in relation to the housing crisis of the early 2000s. While they technically aren’t government institutions, the companies have been in “conservatorship” with the Federal Housing Finance Agency (FHFA) since 2008. This means that the FHFA monitors the operation of Fannie and Freddie to ensure they do their part to build an efficient housing market and reduce taxpayer risk by adding private capital to the mortgage industry.
By following these rules, conforming conventional loans are eligible to be purchased by Fannie and Freddie from the lenders and resold to investors.
The most prominent rule for a conforming conventional loan is whether it exceeds the maximum loan amount or loan limit. For 2021, in most of the United States, the maximum conforming loan limit (CLL) for one-unit properties is $548,250. In high-cost areas of the U.S., the maximum CLL is $822,375. If you’re interested in a loan that exceeds those limits, some lenders offer jumbo-conforming conventional loans. Not sure what the loan limit is for your area? Visit the Federal Housing Finance Agency website for a list of limits for all counties in the U.S.
Non-conforming Conventional Loans
Non-conforming conventional loans, also called jumbo loans, don’t follow the rules set by Fannie and Freddie and are therefore not eligible to be purchased by them. Since jumbo loans carry a higher risk to the lender, they often have a down payment requirement of 20% or more, in addition to higher interest rates.
Private Mortgage Insurance
Since conventional mortgages are not backed by a government entity, the borrower is on the hook for insurance payments to the lender. In order to protect themselves, lenders such as banks, credit unions, and other financial institutions, require the borrower to pay Private Mortgage Insurance (PMI) on loans with less than a 20% down payment. In other words, PMI allows borrowers to qualify for a higher loan amount without having to put down as much money.
To be clear: This insurance does not protect you as a borrower — it’s to protect the lender if you fall behind on payments. Failure to pay your mortgage will result in penalties to your credit score and possibly foreclosure.
A benefit of conventional loans is that the PMI can be removed once you’ve paid down 78% of the value of your home. With an FHA loan, the insurance remains intact for the life of the loan if your down payment was less than 10%.
Pros and Cons of Conventional Loans
- Lower interest rates: since they are based on borrower’s credit scores
- Higher loan limits: conforming conventional loans offer a large limit and borrowers can utilize jumbo-conforming conventional loans if needed
- Flexibility: not having to adhere to the same regulations as government-backed programs
- No upfront mortgage fee: FHA loans require 1.75% of the mortgage amount
- Private mortgage insurance eligible to be removed after paying 78% of appraised home value
- High credit score requirement: 620 or above
- High down payment requirement: 20% to avoid paying PMI
- Rigid qualifying criteria: low debt-to-income ratio and proof of income for at least two years
Qualifying for a Conventional Mortgage
To qualify for a conforming conventional loan, be prepared to meet the following criteria:
A credit score of 620 or higher. The higher the credit score, the more favorable your interest rates will be. Work on your credit rating as much as possible before applying for a conventional loan.
A minimum down payment of 3% is required for conforming conventional loans. Keep in mind that any down payment under 20% will be subject to PMI. So if you’re able to save and put down 20% you can skip that extra monthly amount.
Debt-to-income ratio (DTI) of 36% to 45%. Ideally, no more than 36% of your monthly income would be paid toward debt. Some lenders will stretch that to 45% but Fannie Mae and Freddie Mac have a maximum DTI of 50% for conforming conventional loans.
Proof of income. Show that you’re making and saving the amount of money you say you are. Lenders will require tax returns, W-2s, and pay stubs for at least two years.