What is a Conventional Loan? Everything You Need to Know

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Thinking about your first home can be exciting, but financing one can feel a little overwhelming at best. While there are several loan programs for first-time homebuyers offered by the federal government, many borrowers opt for conventional loans. Conventional loans tend to have higher credit score and financial qualifications than government-backed loans do, but they're a great option for borrowers with excellent credit, little debt and substantial savings.

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Private financial institutions fund conventional mortgage loans. A conventional loan is a good option for borrowers with an excellent credit score and sizeable savings for a down payment.

What Is a Conventional Loan?

Conventional loans are issued by private lenders, such as banks or credit unions. The federal government does not guarantee them. The lack of government backing places a private lender at higher risk if you miss payments and risk a foreclosure. Lenders can pursue foreclosure, which is a legal action to allow them to take control of the property. Foreclosures happen if you breach the loan contract by failing to make monthly payments or pay property taxes or other assessments.

Because conventional loans aren't guaranteed by a federal program and the lender takes on all the risk, a first-time homebuyer may have a more difficult time qualifying for one than for a government-backed option.

Benefits of Conventional Loans

Conventional loans are popular with both seasoned and first-time homebuyers. They offer flexible interest rates and loan term options. Unlike many government-backed options, conventional loans can also be used to purchase a variety of property types, including both the typical single-family home for first-time homebuyers but also vacation homes and luxury properties.

Conventional loans tend to have quicker loan processing times than loans from the Federal Housing Administration (FHA) because the borrower and lender don't have to go through a third-party government agency and the corresponding red tape.

Conventional Loan Requirements

While conventional loans are not backed by the government, they must still meet requirements set forth by the Federal National Mortgage Association (FNMA), also known as "Fannie Mae," and the Federal Home Loan Mortgage Corporation (FHLMC), also known as "Freddie Mac."

Congress chartered these organizations to stimulate homeownership by adding liquidity (capital) to the secondary mortgage market — a marketplace of banks, investors and financial institutions that trade mortgages and servicing rights. By buying and selling mortgages in the secondary marketplace, Fannie Mae and Freddie Mac allow lenders to buy and sell loans for cash more easily. This allows lenders to fund additional mortgage loans for low and middle-income Americans.

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Typical conventional loans come with some requirements:

  • A credit score of 620 is the minimum score to qualify for most conventional loans. If you have a good credit score (680 and up), you will qualify more easily and will likely get rewarded with a lower interest rate.
  • You will also need a low debt-to-income ratio. This is the sum of your monthly debt payments, such as credit cards and car loans, compared to your monthly income. Conventional loans typically go to those with ratios of 36 to 43 percent.
  • You can obtain a conventional loan with a down payment of as little as 3 percent for a fixed-rate loan or 5 percent for an adjustable-rate loan, but it's more common for a conventional loan lender to require a 10 to 20 percent down payment. Without a 20 percent down payment, you will be required to buy private mortgage insurance (PMI). PMI is used to cover payments if you default on a loan obligation.
  • If you've filed bankruptcy or had a prior property foreclosed, you'll most likely have to wait for a period of 36 to 48 months before a private financial institution will finance a conventional loan.

Government-Backed Loans: What's the Difference?

The federal government backs mortgages through the FHA, the U.S. Department of Agriculture (USDA) and the Department of Veterans Affairs (VA). These programs have different qualification requirements than conventional mortgages and can come with more strings attached, such as an insurance payment that lasts for the duration of the loan. Other restrictions may also apply, like what kind of property can be purchased.

FHA loans are prevalent among first-time homebuyers, especially those with less money in the bank for a down payment or a lower credit score, but your credit score may also determine what kind of down payment you're required to make. For example, if your credit score is between 500 and 579, you'll need to put down a 10 percent down payment. A credit score of 580 only requires a minimum of 3.5 percent down.

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The property being purchased on an FHA loan must also be your primary residence, unlike a conventional mortgage where that is not a requirement. A mortgage insurance premium is also required — unlike a conventional loan, where PMI is only required under a 20 percent down payment — which is used to pay the lender if you miss payments on the loan obligation.

The USDA provides zero-down-payment opportunities for low-income Americans residing in qualifying suburban and rural areas, which is a stark difference from a conventional loan, where there are no such restrictions. The USDA guarantees a mortgage issued by a local lender. It also loans money directly to qualifying low-income applicants. Income levels vary based on geographical region.

The VA also offers direct and government-backed loans. Unlike conventional loans, to qualify for a VA loan, a borrower or spouse must be a previous or active member of the United States Armed Forces or National Guard. While conventional loans tend to require some money up front, VA loans require no down payment. However, other fees may apply. Qualified borrowers must also meet the credit and income requirements outlined by the lender to receive financing.

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"Unconventional" Conventional Loans

There are types of conventional loans available to meet your needs that aren't as stringent as the traditional requirements. You may qualify for these if you have a lower credit score, a higher debt-to-income ratio or less money for a down payment (i.e. lower than 20 percent). To weigh the pros and cons of these versus a government-backed loan, it's a good idea to talk with your lender or your real estate agent.

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  • Conventional 95 Loans: If you have a credit score that is less than 620, you can qualify but are required to contribute a down payment of 5 percent, which means you'll have to finance and repay 95 percent of the loan balance.

  • Conventional 97 Loans: Only for primary residences, you must have a credit score of 680 to qualify for a Conventional 97. These loans require a 3 percent down payment, and you finance the remaining 97 percent. This is perfect for those who have great credit but not much in the way of savings.

  • Conventional Renovation Loans: Buying a fixer-upper is a way to get into homeownership on a budget and build "sweat" equity. CHOICERenovation and HomeStyle loans are conventional mortgages from Freddie Mac and Fannie Mae that let you finance a home purchase and funds for making renovations.

  • HomeReady and HomePossible Loans: Fannie Mae and Freddie Mac created these conventional loan programs to help low- and middle-income first-time homebuyers. To qualify, you must have a credit score of 620 and a 50 percent maximum debt-to-income ratio. The down payment can even be a gift from a family member or friend.

Conventional vs. Conforming Loans

Conforming loans are a type of conventional loan that meets underlying terms, conditions and funding criteria set forth by Fannie Mae and Freddie Mac. One of the main conditions is that lenders follow maximum loan dollar amounts set annually by the Federal Housing Finance Agency (FHFA). In most parts of the United States, conforming loan limits must not exceed $548,250 in 2020. Areas with a higher cost of living, such as Hawaii and California, may have higher loan baseline limits, however.

While conforming loans are conventional, some conventional loans aren't conforming. A jumbo loan — one that exceeds FHFA limits — used to fund luxury properties in competitive real estate markets is a type of conventional nonconforming loan. To qualify for a jumbo loan, you will need to have a high credit score, a low debt-to-income ratio (around 36 percent), a high down payment and assets in reserve, such as savings accounts, jewelry and other real property. These loans tend to come with interest rates that are 1 to 2 percent higher than a conforming loan.

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Conventional Mortgage Interest Rates

Conventional loan interest rates are typically higher than those for FHA loans. Private lenders set interest rates based on supply and demand for mortgage-backed security and the expectation of inflation. Lenders also consider your profile, including creditworthiness, assets and size of the down payment on the residence being financed.

There are two common interest rate options: fixed rate and adjustable. Fixed-rate mortgages have an interest rate that doesn't change throughout the loan term. The most common lengths are 10, 15 and 30 years. These loans are good for those looking for stable, predictable payments. The monthly payments tend to be lower. They are great for those planning to stay in the residence for at least seven years or more.

An adjustable-rate mortgage, or ARM, is also known as a variable-rate mortgage. After an initial fixed-rate period that can often be cheaper than a fixed-rate loan, adjustable-rate loans change based on a benchmark. For example, a one-year ARM would change annually, and a three-year ARM would adjust every three years.

Banks and other lenders base ARM rates on various indexes, such as United States Treasury bills. They also use the prime rate, or the rate that banks give their most creditworthy customers. If the prime rate rises, interest rates on adjustable-rate credit cards and mortgages tend to go up. Adjustable-rate conventional loans can be great options for those planning to pay off a mortgage loan quickly or sell their home quickly.

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Things You'll Need for a Conventional Mortgage

Since lenders usually give conventional loans to those with high credit scores, a key piece of information to review is your credit report. Your lender will order one to evaluate your creditworthiness and get your credit score. However, you can request yours for free annually from each of the three credit bureaus: Equifax, Experian and Transunion. Monitoring your credit report for fraudulent charges and errors and addressing them with the credit bureaus can improve your credit score.

Lenders will also request financial documentation. You'll want to have proof of income from a month of pay stubs (if you're a W-2 employee). Also, you'll provide two years of income tax filings as well as a financial statement showing your assets and liabilities (such as other loans for cars and credit card debt).

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Heidi Wachter is a Twin Cities based freelance writer and editor.