Buying a home is more expensive than ever.
The median house price in the U.S. has increased by almost $100,000 in the last two years, according to economic data from the St. Louis Fed. This doesn’t necessarily mean you should wait to buy a house, but it does mean you’ll need to weigh all of your borrowing options and figure out what works best for you.
There are several loans available for potential buyers, so choosing the right one can be tricky. Conventional mortgages are the most common type of loan, accounting for about 80% of all mortgages closed as of March 2020, according to Ellie Mae data, a mortgage application software company. Other loan types include government-backed loans such as VA loans, USDA loans, and FHA loans.
One type of mortgage is not necessarily better than the other – it depends on your individual situation, says Walda Yon, chief housing programs officer at the Washington D.C.-based Latino Economic Development Center. If you’ve got a healthy cash cushion, solid credit, and want to purchase a home without any location restrictions, a conventional mortgage might be right for you. But if you’re looking for a product that allows you to purchase a home with little money down and lackluster credit, you might want to pursue other options. But what is a conventional loan? Here’s what you need to know.
How Conventional Loans Work
The term conventional loan means it is not associated with any government programs. They are secured by private lenders: banks, credit unions, or mortgage companies. Conventional mortgages typically require higher credit scores than government-sponsored loans. FHA loans and USDA loans, for example, are backed by the Federal Housing Administration and the U.S. Department of Agriculture. Since government loans have less-strict lending requirements, they tend to have higher interest rates and fees, but can be a path to homeownership to those who may otherwise not qualify by conventional standards.
Maximum loan amounts are set by the U.S. government, but other conforming rules and requirements are set by government-sponsored entities, such as Fannie Mae and Freddie Mac. Mortgages backed by Fannie Mae and Freddie Mac are more desirable to be sold off to investors. This process reduces lender risk and helps maintain loan affordability. Loans not guaranteed by Freddie Mac and Fannie Mae are seen as riskier and therefore more expensive.
Conventional loans can have a fixed interest rate or an adjustable interest rate. In the case of fixed-rate conventional loans, the interest rate does not change at any point during the loan term. Alternatively, the interest rate for variable-rate loans will vary over time depending on the market.
With a conventional loan, a borrower submits an application through a lender and is approved or denied based on a few key factors, including:
- Credit history
- Credit score
- Debt-to-income ratio
- Employment status and history
- Down payment amount
From there, if you’re approved, the lender will kick off the underwriting process and borrowers will go through a more rigorous round of vetting such as providing documentation. It typically takes between 45 to 60 days to close a conventional loan, from start to finish.
Requirements for a Conventional Loan
Each loan type has its own specific requirements or stipulations. Here’s what a conventional loan requires.
Once you have been approved by a lender for a conventional loan, you’ll be required to make a down payment. If your down payment is less than 20% of the loan amount, you’ll also have to pay private mortgage insurance, or PMI.
Conventional mortgages can be appealing to certain borrowers because they could have lower down payments and better interest rates than other loan types. While the minimum down payment requirement is 3% of the home’s purchase price, this amount will vary based on your personal circumstances, including your credit history, credit score, debt-to-income (DTI), and more.
Generally, either a lower credit score or a high DTI ratio will make your required down payment amount higher. Additionally, a higher down payment amount will likely be required if you’re applying for a jumbo loan, a loan on a second home, or investment property.
Private Mortgage Insurance (PMI)
If you have a down payment of less than 20% on your conventional mortgage, you will need to pay for PMI. PMI serves to protect your lender in the case that you default on your loan ensuring the lender will recoup some or all of the interest that would have been paid.
The average cost for PMI is between 0.58% to 1.86% of the loan amount each year. Like most requirements for a conventional mortgage, this percentage depends heavily on your credit history, credit score, and your down payment amount. PMI payments can be made monthly, in a lump sum at closing, or, depending on your lender, in the form of a higher interest rate.
There is some good news in terms of PMI, though. You can arrange with your lender to stop paying for PMI once you reach 20% equity in your home.
What Are the Types of Conventional Loans?
Conventional mortgages fall into two main categories: Conforming loans and non-conforming loans.
A conforming conventional loan meets guidelines set by Fannie Mae and Freddie Mac who are government-sponsored enterprises that purchase mortgage loans from lenders. The lenders can then use that money to issue other mortgages.
Fannie and Freddie only purchase loans that meet certain standards. The guidelines for Fannie Mae and Freddie Mac are virtually the same, says Anna DeSimone, author of “Housing Finance 2020.” The main rule to be aware of is the FHFA conforming loan limits, which all Fannie or Freddie loans must fall under. Conforming loan limits vary by location and typically change each year.
In 2022, the Federal Housing Finance Agency (FHFA) upped the maximum loan limit for a single-family home from $548,250 to $647,200 and up to $970,800 in high-cost areas.
Non-conforming loans, also known as jumbo mortgages, exceed the Federal Housing Finance Agency (FHFA) loan limits. Because Fannie Mae or Freddie Mac won’t purchase these loans, they are riskier for the lender and therefore harder to qualify for. To be eligible for a jumbo loan, you’ll need a higher credit score, bigger down payment, and more cash on hand compared to other types of mortgages. These loans also typically have higher interest rates than conforming conventional loans.
Adjustable Rate Mortgages (ARM loans)
Adjustable rate mortgages, or ARMs, is a type of conventional mortgage. ARMs have an initial fixed interest rate, but transition to variable interest rate after a specified period of time. Almost all ARMs have a 30-year payment schedule, but the period with the introductory interest rate (otherwise known as the teaser period with a lower fixed rate) can vary depending on the lender and chosen terms. For example, ARMs can have terms of 3/1, 5/1, 7/1, or 10/1. The first number represents the duration, in years, where the fixed “teaser” rate applies. The second number represents how often, in years, the variable rate will change after the teaser period ends. ARMs can be appealing because their introductory fixed rate is typically lower than the rate on a 30-year fixed rate loan, but they can also be risky because the variable rate will depend on market conditions, which can be unpredictable.
How Is a Conventional Loan Different From a Government-Backed Loan?
The biggest difference between conventional and government-backed loans is who actually “backs”, or secures, the loan. Conventional mortgages aren’t guaranteed by the government, which means lenders tend to be choosier when it comes to vetting applicants.
Government-backed loans, on the other hand, are backed by government entities which are on the hook if borrowers miss payments.
Since conventional mortgage lenders don’t have the promise of a government safety-net should the borrower fail to make payments, they need to be comfortable that borrowers are going to repay on time. That translates to tougher restrictions like higher down payment and credit requirements and sometimes higher interest rates.
While government-backed loans tend to be available to those with lower credit scores, they may have their own restrictions. For example, they may only be available for homes purchased in specific areas or certain property types.
Here’s a breakdown of how conventional loans compare to the others.
Conventional Loan vs. VA Loan
VA loans, backed by the U.S. Department of Veteran Affairs, are available for borrowers who have served in the military, are currently serving in the military, or are an eligible military spouse. There are several different types of VA loans, but they all have a few things in common. VA loans do not require a minimum down payment or mortgage insurance. In place of a down payment, VA loans require a VA funding fee between 1.4% and 3.6% of the loan amount to protect the lender in the case that the borrower defaults. VA loans are especially appealing because there is no minimum credit score required for approval, making them more accessible for borrowers with a credit score below 620. Some lenders, however, may set their own minimum credit score.
Another key difference between a VA loan and a conventional loan is that VA loans do not have amount limits like conventional loans. Additionally, they can only be used for primary residences, so, if you’re looking for a mortgage for a secondary home or an investment property, a conventional loan may be a better option.
Conventional Loan vs. FHA Loan
FHA loans are backed by the Federal Housing Administration and offer several benefits for people with a lower credit score than that which is required for a conventional loan. FHA loans require a minimum down payment of 3.5%. The amount you will be required to pay on a down payment will depend on your credit score, though. If you have a credit score of 500, 10% down will be required, whereas with a credit score of 580 or higher, 3.5% down will be required.
FHA loans do not require PMI, or private mortgage insurance. Instead, you will have to pay for MIP (mortgage insurance premium). MIP on an FHA loan is a 1.75% upfront payment and a monthly mortgage insurance premium of about 0.5% to 1% of the loan principal. If you want to get rid of an FHA loan’s mortgage insurance, typically the only way to do it is to refinance to a conventional mortgage once you’ve built up enough equity. Like a VA loan, an FHA loan must be used for your primary residence.
Conventional Loan vs. USDA Loan
A USDA loan is backed by the U.S. Department of Agriculture and can be beneficial for those in eligible rural areas who meet the income requirements set by the USDA. USDA loans, like VA loans, don’t require a down payment. This makes USDA loans a strong option for those who don’t have money readily available to make a down payment. Borrowers with a credit score of 640 are highly likely to be approved by the USDA, and those with a credit score between 600 and 640 may still be approved, but it could be a lengthier process.
A USDA mortgage has a similar mortgage insurance fee structure to an FHA loan, requiring an upfront fee and a monthly payment. If you’re considering a USDA loan, it is worth noting that the USDA specifies income requirements for borrowers. If your household income is greater than 115% of the median income in your area, you will not be eligible for a USDA loan.
How To Qualify for a Conventional Loan
To be approved for a conventional loan, you’ll likely need a credit score of at least 620, but those with higher credit scores (740 or above) may find lower interest rates and the option for a lower down payment. On top of considering your credit score, lenders will want to examine your credit history. If you have suffered bankruptcy or foreclosure within the past seven to eight years, lenders may require additional information before they approve your loan.
During the application process, lenders will also review your employment history, income, debts, and cash reserves to be sure you have a good chance at being able to afford your new mortgage payment if they approve you.
While there is no minimum income requirement to be approved for a conventional mortgage, you must demonstrate to your lender that you can afford the monthly payments of your loan. Lenders may evaluate your ability to make payments by considering your DTI, or debt-to-income ratio, which can be calculated by dividing your total monthly debts by your pre-tax monthly income. Conventional mortgage lenders will generally want to see a DTI of 36% or less, but they may accept a higher DTI in some circumstances.
Conventional mortgage lenders will likely require you to provide at least two years of employment history. When evaluating your employment history, lenders consider your frequency of job switches, career changes, and whether you get paid as a full-time employee (W-2) or as an independent contractor (1099). To strengthen your mortgage application, try to avoid switching jobs within six months of applying. This can both be a red flag to the lender that you’re not a stable applicant.
Advantages of a Conventional Mortgage
One big advantage of a conventional mortgage is the borrower has much more flexibility in what property they can purchase compared to a government-backed loan. For example, FHA loans are only available for homes that meet the FHA’s minimum property requirements. Other government-secured mortgages have even more specific limitations. U.S. Department of Agriculture (USDA) mortgages are only available for properties in designated rural areas, and only qualifying veterans and their spouses are eligible for Department of Veterans Affairs (VA) mortgages.
Conventional mortgages don’t have any of these sweeping limitations. You can even take out a conventional loan for an investment property or a vacation home. And conventional jumbo mortgages are an option if you need to borrow more than the FHFA loan limits for your area.
With a conventional mortgage you don’t need to pay for private mortgage insurance if you have a down payment of at least 20%.
Conventional loans can also have fewer fees than government-secured loans. If you do have to pay PMI, it can be pretty costly. Freddie Mac estimates PMI costs to be $30 to $70 per $100,000 added to a monthly mortgage payment.
If your down payment is 20% or more, you won’t be required to pay PMI, and being able to avoid PMI with a conventional loan can add up to significant savings over a government-secured mortgage. And even if you can’t put 20% down upfront, you can usually get rid of PMI once you’ve built up at least 20% in equity. That’s not the case with most government-backed home loans. An FHA loan has an upfront mortgage insurance fee and you’ll pay a monthly mortgage insurance premium no matter how much you put down, says Thomas Bayles, senior vice president at Los Angeles-based mortgage broker Mortgage Capital Partners.
Drawbacks of a Conventional Mortgage
Conventional loans may be more popular, but that doesn’t mean they’re for everybody.
There is a catch to the benefits of a conventional mortgage: you need a rock-solid financial profile. If you have a pristine credit score of 760+ and enough saved up for a 20% down payment, then you can qualify for the best mortgage rates and avoid paying for PMI.
But as your credit score and down payment decrease, your interest rate will go up. Your PMI premium can also increase with a lower credit score or smaller down payment.
Government-backed loans can be good options for first-time homebuyers because some of these programs, like USDA and VA loans, have no minimum down payment requirement.
It’s also harder to qualify for a conventional mortgage if you have blemishes on your credit report. The FHA lending guidelines have always been more flexible, and they are more lenient about past financial challenges like bankruptcies, DeSimone says. And it’s the only loan available to people with credit scores as low as 500, if they put 10% down, she says.
Pros and Cons of a Conventional Loan
Flexibility in the types of properties you can purchase
Option for a jumbo loan if you want to take out more than the FHFA limits
No mortgage insurance fees if you make a down payment of 20% or more
You’ll need a solid credit score to get the best rate
Down payment required, unlike some government-backed loans
More difficult to qualify for
How to Choose a Conventional Loan Lender
If you decide to pursue a conventional mortgage, it’s worth shopping around different lenders to find the best rate. It’s a myth that applying for loans with different lenders will hurt your chances of getting approved. In fact, this is one of the best ways to get a good deal on your mortgage rate as long as your mortgage applications are performed within a 30-45 day window.
Just as lenders will examine whether you are an eligible borrower, you should be considering if they are the best lender for you. Also, you’ll have more leverage if you can show prospective lenders the kinds of rates and deals you’re finding elsewhere.
When looking for a conventional loan lender, be sure to consider closing costs and lender fees. Several mortgage lenders may advertise the same or similar rates, but their closing costs can vary significantly.
In addition to considering a lender’s fees, you should pay close attention to their rates. By comparing each loan’s APR, you can get a better picture of the loan’s overall cost. To compare both fees and rates, you’ll need to submit applications to various lenders so that you can use their loan estimates.