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Conventional mortgages are the most popular type of home loan, and account for roughly 80% of all mortgages closed since March, according to Ellie Mae.
One reason for the popularity of conventional loans is they have fewer limitations than government-backed loans, which may be restricted by income level and property type. A conventional mortgage can also have fewer fees and therefore be cheaper overall.
But government-secured mortgages usually have better interest rates and may be easier to qualify for. 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 can qualify for a low-rate loan, now is a great time to take out a conventional mortgage. But if you don’t have a strong credit score it may not be the best option. Lenders have tightened their guidelines, and the best rates are only available if you meet the highest standards.
How Conventional Loans Work
Conventional mortgages aren’t guaranteed by the government. Some government-backed loans are only available for homes in specific areas or certain property types. So lenders have more flexibility with conventional loans. For this reason, they’re available to qualified buyers for nearly any property, with few limitations.
But because the government isn’t promising to pay up if a borrower doesn’t, these mortgages are more risky for a lender. Lenders offset this risk by requiring bigger down payments and a higher credit score to qualify for the lowest mortgage rates.
Conventional mortgages fall into two main categories: Conforming loans and non-conforming loans.
A conforming loan meets guidelines set by Fannie Mae and Freddie Mac. Fannie and Freddie are quasi-government agencies set up to provide stability to the housing market by keeping mortgages affordable. They do this by purchasing mortgage loans from lenders. The lenders can then use that money to issue another mortgage.
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 Federal Housing Finance Agency’s (FHFA) conforming loan limits, which all Fannie or Freddie loans must fall under. Currently the maximum conforming loan limit for a single-family home is $510,400 for most of the U.S. and up to $765,600 in certain high cost areas.
A non-conforming loan exceeds the FHFA loan limits, and is also known as a jumbo mortgage. Because Fannie Mae or Freddie Mac won’t purchase these loans, they are more risky for the lender, and 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 loans.
Across the board, the pandemic has caused lenders to increase mortgage lending standards, and jumbo loans have been hit particularly hard. Fewer lenders are currently offering jumbo loans, and those that are have made them tougher to get.
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 your only 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 have a down payment of 20% or more on a conventional mortgage, you won’t be required to pay what is known as private mortgage insurance (PMI). PMI typically costs anywhere from 0.5% to 2% of the loan amount each year. The median home price in the U.S. is over $300,000, so PMI could easily cost hundreds of dollars per month.
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.
An FHA loan’s monthly mortgage insurance premium is about 0.5% to 1% of the loan principal and the upfront mortgage insurance payment can be 1.75% of the loan amount. 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.
A USDA mortgage has a similar mortgage insurance fee structure, requiring an upfront fee and a monthly premium. VA loans don’t require mortgage insurance, but instead charge an upfront funding fee that can top 3% of the loan amount. So if you can avoid PMI with a conventional mortgage, you won’t have to spend thousands in unnecessary fees.
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’ve got a pristine credit score of 760+ and enough saved up for a big 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.
Some conventional loans allow for down payments of as little as 3% of the home purchase price, but many require 5%-20% down. This can be prohibitively expensive for first-time homebuyers that don’t have the proceeds from a current home sale to add to a down payment.
Government-backed loans can be good options for first-time homebuyers because some of them, like USDA and VA loans, have no minimum down payment requirement. Even if you can’t put down a full 20%, your loan will always be cheaper with a down payment of whatever you can afford, since you’ll be borrowing less money to buy the home.
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.
The FHA loan credit score requirement goes up to 580 with a 3.5% down payment, and VA loans and USDA loans don’t have minimum credit score requirements. For a conventional loan, credit score requirements typically start around 620-660.