When you're planning to finance an investment property, you have many choices when it comes to different loan products. However, all can be placed into two broad categories: conforming loans and nonconforming loans.
While conforming loans generally offer lower interest rates than nonconforming loans, they can be rather difficult to get, especially for investors. With that in mind, here's a rundown of the differences between conforming loans versus nonconforming and how to determine could be the better choice for you.
What is a conforming loan?
A conforming loan or conforming mortgage is a loan used to buy real estate that has two basic characteristics:
- It meets the underwriting standards set by Fannie Mae and Freddie Mac. These are the two government-sponsored companies that buy mortgages, but they can only buy loans that "conform" to their standards, hence the phrase "conforming loan."
- It is equal to or less than the conforming mortgage loan limits, which are set by the Federal Housing Finance Agency (FHFA) each year.
With these two traits in mind, let's take a closer look at each one.
Conforming loan underwriting standards
Since this discussion is geared toward real estate investors, let's take a look at Fannie Mae's current underwriting standards for investment property mortgages. If you want to see the lending standards for owner-occupied properties, you can find them in Fannie Mae's Eligibility Matrix.
There are a few things Fannie Mae looks at when determining eligibility. Standards are based on a combination of the borrower's debt-to-income (DTI) ratio, the loan-to-value (LTV) ratio of the mortgage, the borrower's credit score, and how many months' worth of expenses the borrower has available in reserve.
For investment property purchase mortgages, here are the current standards if you have a debt-to-income ratio of 36% or less:
|Number of Units||Maximum LTV||Credit Score Requirements||Reserve Requirements|
|1 Unit||85%||680 if LTV >75%
640 if LTV ≤ 75%
|2-4 Units||75%||660||6 months|
With a DTI greater than 36% but less than or equal to 45%, the standards are a bit stricter in terms of the borrower's credit score:
|Number of Units||Maximum LTV||Credit Score Requirements||Reserve Requirements|
|1 Unit||85%||700 if LTV > 75%
680 if LTV ≤ 75%
|2-4 Units||75%||680||6 months|
Conforming loan limits for 2020
As mentioned, there is a maximum loan amount allowed for conforming loans, which changes annually and is set by the FHFA.
In most parts of the United States, the conforming loan limits are the same. However, limits are higher in certain high-cost areas. Here's a quick reference chart of the 2020 conforming loan limits, but if you want to know the exact limits in your area, you can find them on Fannie Mae's website. (Note: Some areas have loan limits that are between the standard and high-cost limits.)
|Number of Housing Units||Standard Limit||High-Cost Area Limit|
It's worth noting that these are the loan limits, not the purchase price limits. In other words, you can buy an investment property that exceeds these limits by a wide margin using a conforming loan, as long as you don't plan to borrow more than the corresponding limit.
Conforming loans vs. conventional loans
The terms conforming loan and conventional loan are often used interchangeably, but this is incorrect. A conforming loan is one that meets the standards described throughout this section. A conventional loan is one that isn't insured or guaranteed by the government. Fannie Mae and Freddie Mac purchase mortgages, but the government doesn't explicitly guarantee them. On the other hand, Federal Housing Administration (FHA) mortgages and Department of Veterans Affairs (VA) mortgages have a government guarantee and are therefore not conventional mortgages.
An important point is that both conforming and nonconforming loans can be conventional loans, as long as there is no government guarantee attached.
What is a nonconforming loan?
The term nonconforming loan is a broad term referring to any type of mortgage loan that doesn't meet the standards described in the previous section. This includes, but isn't necessarily limited to:
- Jumbo loans: A jumbo loan is one that doesn't qualify as conforming because it exceeds the applicable FHFA loan limit.
- Bad credit loans: There are investment property lenders that welcome borrowers with credit scores significantly lower than Fannie Mae's standards.
- Asset-based loans: In recent years, there has been a surge in asset-based lending. These loans are primarily based on the qualifications of the property, not the borrower. Typically, an asset-based lender will check the borrower's credit score, but factors like personal debts and income don't come into play.
- Low-down-payment loans: It's possible to find investment property mortgages for properties with two to four units with less than a 25% down payment, but these will be nonconforming.
- Loans to businesses: Conforming loans generally have to be made to you as an individual. If you want to borrow money through an LLC or other business entity, you'll likely have to pursue a nonconforming loan.
Which is better: conforming or nonconforming loans?
If you can qualify for a conforming loan, that is usually the best way to go. Origination fees tend to be lower than those charged for nonconforming investment property loans. And while investment property loan interest rates are almost always higher than you could get for a primary residence mortgage, you can expect a smaller difference if your investment property loan is conforming.
On the other hand, it can be difficult to get a conforming loan, especially if you're in a high-cost market. For example, if you want to buy a duplex in San Francisco, it can be very hard to find one for less than the $980,325 limit that applies to high-cost areas.
Debt-to-income is also a big obstacle for many borrowers. The 45% maximum debt-to-income ratio allowed by Fannie Mae's standards includes mortgage payments on your primary home (and any other real estate), as well as your other monthly debt obligations such as auto loans, student loans, credit cards, and other installment debts. You might be able to use some of the property's expected rental income for qualification purposes, but it's not likely to help tremendously.
On the other hand, it can be just as difficult (if not more so) to qualify for a nonconforming loan. In simple terms, if your loan is nonconforming for one or two reasons, the rest of your qualifications might need to be even better. For example, I know of an investment property lender that will make 80% LTV loans on 2- to 4-unit properties, but only for borrowers with credit scores above 720.
Plus, with a nonconforming loan, you can expect to pay a higher interest rate. As a personal example, at a time when 30-year fixed-rate mortgages on owner-occupied properties averaged a 3.7% APR, I received an offer for a conforming investment property mortgage with a 4.625% interest rate. Meanwhile, the best I found from an asset-based lender at the same time was 6.25%.
If you want to borrow through an LLC, your DTI is over 45%, or you want to buy a $2 million property, just to name a few examples, a nonconforming loan is obviously the better (and only) choice. On the other hand, if you can qualify for a conforming loan, it's likely to come with a lower interest rate, as well as an easier approval process. The bottom line is that there's no universal right answer to the "which is better" question. It depends on your situation.
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