What Is a Conventional Loan?
A conventional loan is the most popular type of mortgage in the United States. In fact, conventional loans accounted for roughly 75% of the home loans that closed in October, according to Ellie Mae.
Backed by private lenders rather than the federal government, conventional loans can be used to buy or refinance homes.
Read on for more about conventional mortgages, including how they work and how to qualify – which could be more difficult during the coronavirus pandemic.
What Is a Conventional Loan?
A conventional loan is issued by a private lender, such as a bank, credit union or other financial institution. It typically has stricter credit requirements than a government-backed loan. That’s because the lender takes on more risk without a guarantee from a government agency if a borrower cannot pay.
Conventional loans fall into two categories: conforming or nonconforming.
- A conforming loan meets the requirements to be sold to Fannie Mae or Freddie Mac, the government-backed housing finance giants that buy mortgages from lenders and sell them to investors. Conforming loans must not exceed loan limits set by the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac. If you want a one-unit property, that amount in 2020 for most of the United States is $510,400 and $765,600 in high-cost areas.
- A nonconforming loan fails to meet criteria for purchase by Fannie or Freddie. A jumbo loan, for instance, is nonconforming because it exceeds the loan limits set by the FHFA.
Is a Conventional Loan Good?
A conventional loan can be a good choice, depending on your financial situation.
Generally, a conventional loan is best for a buyer with good credit who will put down more than 3% on a home, says David J. Wilk, assistant professor of finance and director of the real estate program at Temple University’s Fox School of Business. “It gives lots of people up and down the economic spectrum the opportunity to own their own home,” he says.
Conventional loans, unlike government-backed loans, do not have geographic limitations or special requirements. A conventional loan can be more flexible than a government-insured loan but harder to qualify for, especially as the coronavirus pandemic has made getting a mortgage even more challenging.
Which Is Better: Conventional or FHA Loan?
Your financial profile can help you figure out which mortgage is a better fit for you.
Overall, consumers may prefer conventional loans over Federal Housing Administration loans because FHA loans have additional restrictions and requirements, says Andrew Ragusa, CEO and broker at REMI Realty, Plainview New York.
“There’s a lot of little fine details that have to be crossed with an FHA (loan),” Ragusa says. “A conventional loan removes those concerns.”
Among these concerns: an upfront fee, a strict home appraisal process and a requirement for a mortgage insurance premium.
If you choose an FHA loan, you will pay an upfront fee of 1.75% of the loan amount and a mortgage insurance premium for the life of the loan if your down payment is less than 10%. When you put down more than 10% on a home, you can cancel the mortgage insurance premium after 11 years.
A 20% down payment on a conventional loan allows you to avoid private mortgage insurance, which isn’t an option on FHA loans. You can remove PMI once you reach 78% equity, and you will pay no upfront mortgage fee.
In addition, appraisal guidelines are more rigid for FHA loans than for conventional loans. A home must meet the agency’s minimum property requirements.
“If a house is 100 years old, the way it was built might not meet with today’s standards for an FHA house,” Ragusa says.
Still, an FHA loan can help if you are a first-time homebuyer, especially if you have fair credit and want to make a low down payment. An FHA loan cannot be used to finance a second home or an investment property.
How Does a Conventional Home Loan Work?
With a conventional home loan, you’ll borrow funds from a private mortgage lender to buy your home and pay back the loan over time with interest.
Before you apply for a loan, make sure you meet the requirements for approval, which include:
- A credit score of at least 620. If you’re getting a jumbo loan, the requirement will be higher: usually at least 680.
- A debt-to-income ratio limit of 45%. This means that no more than 45% of your total monthly take-home pay should go toward debt payments. Some lenders may allow up to 50% if you are making a very large down payment.
- Proof of income. Usually, you will need two years of documentation, including tax returns, W-2 forms or recent pay stubs, to show that you have ample, steady income to afford the loan payments.
- A down payment of at least 3%. You will have to submit bank and other asset statements to show how you’ll make your down payment.
Mortgage underwriting begins once you apply for the lender to determine the risk of offering you a loan. You may be asked for additional documentation about your finances along the way.
In the meantime, the lender will appraise the property to determine its value. You may also schedule a home inspection to identify any major problems before closing.
What Are the Pros and Cons of a Conventional Loan?
Conventional loans come with many benefits to borrowers and some downsides. Here’s a closer look at some pros and cons:
- Competitive interest rates. Typically, rates are lower for conventional loans than for FHA loans. Mortgage rates have hit record lows amid the coronavirus pandemic. “I never thought in my lifetime I would see conventional mortgage rates below 3%,” Wilk says. “We could look back and see that this was a once-in-a-lifetime opportunity.”
- Low down payments. You can get a conventional loan with as little as 3% down, Ragusa says. “A lot of people think it has to be 20%, and it doesn’t,” he says.
- PMI premiums can eventually be canceled. Once you’ve paid down 78% of your home’s appraised value, PMI can usually be removed.
- Choice between fixed or adjustable interest rates. A fixed-rate 30-year mortgage is the most common, whether you’re getting a conventional or government loan. A fixed rate can offer the advantage of locking in today’s historic low interest rates, but adjustable-rate mortgages are worth considering if you’re not planning to keep your mortgage for more than a few years.
- Can be used for all types of properties. Conventional loans can be used for a primary residence, vacation home or rental property, unlike FHA loans, which are limited to principal residences.
- Tougher credit score requirements than government loan programs. COVID-19 has made qualifying for a conventional loan harder than usual. Conventional loans often require a credit score of at least 620, which leaves out some homebuyers. Even if you qualify, you will likely pay a higher interest rate than if you had good credit.
- More stringent DTI requirements. Conventional loans typically demand higher DTIs than the guidelines for government programs. Expect to meet a standard of no more than 45% DTI.
- PMI premiums with a low down payment. You’ll still have to pay PMI if you put down less than 20%.
If you’re not sure whether a conventional loan is the right move, your real estate agent and loan officer can help, Ragusa says. They will be able to guide you to the most appropriate loan based on your financial situation and credit history.
“There’s a reason all the other loans exist,” he says. If your finances and the property meet the qualifications for a conventional loan, though, it can be a great choice.