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What Is a Conventional Loan?

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Conventional loans are the most common type of mortgage loans: They account for nearly 70% of all mortgages for new homes. You can apply for a conventional loan at any mortgage lender, including banks, credit unions, or online lenders.

There are two types of conventional loans. Conforming conventional loans apply to homes valued at under $510,400 (in most parts of the country). Jumbo non-conforming loans are for higher-priced properties.

Conventional loans are often a better deal than traditional home mortgages. However, this is one of the types of mortgages that can be difficult to qualify for. Keep reading to learn about the types of conventional loans, their benefits, and the application process.

What is a conventional loan?

A conventional loan is a type of home mortgage loan that is not backed by federal mortgage assistance. Many home buyers prefer conventional loans because they do not carry many of the fees charged with government-backed loans.

In a conventional loan, the lender risks losing their funds if the buyer is unable to pay off the loan. That's why it can sometimes be more difficult to qualify for a conventional loan.

By contrast, several federal programs offer loan insurance for non-conventional loans. The Federal Housing Administration (FHA), Veterans Administration (VA), and US Department of Agriculture (USDA) are just a few government agencies offering these types of assistance to lenders. Unfortunately, this added insurance for the lender often comes with an added cost to the home buyer. That's why traditional mortgages are often associated with more fees than conventional loans.

A conventional loan can be used to purchase a standalone home -- or, if you prefer, it can cover the cost of buying a condo or townhouse.

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Conventional loans vs. conforming loans

Conventional loans are often confused with conforming loans. A conforming loan is actually one of the two types of conventional loans:

  • A conforming conventional loan is a home mortgage for low-to-mid value homes. To qualify, a property's value must fall below the maximum limit set by Fannie Mae and Freddie Mac.
  • A non-conforming or jumbo conventional loan is a loan for higher-value properties. Homes falling into this category are valued higher than Fannie and Freddie's annual loan limits.

Fannie and Freddie are government-sponsored entities that purchase mortgage loans on the secondary market. As of 2020, their loan limits were $510,400 in most parts of the United States.

How does a conventional loan work?

There are a few important steps to take when opening a conventional loan. Fortunately, with the help of a loan provider, these steps are fairly straightforward.

Applying for a conventional loan

When you apply for a mortgage, your lender will discuss what type of home loan is best for you. You will probably need to submit proof of income and assets if you decide to apply for a conventional loan. The lender will decide whether to approve you based on this information. They'll also use this documentation to determine your interest rate.

Deciding between fixed-rate and adjustable-rate mortgages (ARM)

Conventional loans could have a fixed interest rate or an adjustable interest rate:

  • With fixed-rate loans, your interest rate remains the same from the time you borrow until your loan is paid off. Fixed-rate loans usually have a repayment term of 15 or 30 years, although other loan terms are possible. Your loan is amortized (broken up into equal monthly payments) over your repayment term. Your payments will go towards the principal and interest on your loan until your loan is fully repaid.
  • With adjustable-rate mortgages (ARMs), your interest rates that are tied to a financial index. The rate can change when the index does. Most ARMs keep your interest rate steady for an initial period of time, such as five years. After that the rate adjusts annually. A mortgage that has a steady fixed rate for the first five years and adjusts each following year is called a 5/1 ARM, while a mortgage that keeps the same fixed rate for seven years and then adjusts annually would be called a 7/1 ARM.

There are many factors lenders use to set your mortgage rate. These include:

  • The overnight rate set by the Federal Reserve (the rate that a bank is charged to borrow money from another bank overnight)
  • Projections for inflation
  • Investor interest in mortgage-backed securities
  • Your financial credentials, such as your credit score and income

You can also buy down your rate by paying points, or prepaying interest. Points cost 1% of your mortgage amount and each reduces your rate by 0.25%.

Comparing prices by getting pre-approved

Most lenders allow you to find out both your rate and the amount you can borrow before moving forward. This is called getting pre-approved. You can compare mortgage rates by applying for pre-approval with multiple lenders. When you find a loan that works for you, you can formally apply for a conventional loan. The lender will complete the approval process at that point. The formal process includes an appraisal of the home you're buying to ensure it can serve as collateral.

If all goes well, you'll close on your loan. The lender will provide detailed documents about the total repayment costs. You'll make monthly payments with your lender -- or to another loan servicer if your loan is sold -- until your home loan is fully repaid.

What are the requirements to qualify for a conventional loan?

Conventional loans often have stricter qualifying criteria for than government-guaranteed loans. This is because there's an increased risk of losing money if you default on your debt.

Qualifying criteria vary from lender to lender. Some common requirements include:

  • A home down payment: Most lenders traditionally require 20% down. However, it's sometimes possible to find a conventional mortgage with as low as 3% down. You can use a down payment gift to cover part or all of your down payment (depending on your circumstances).
  • A good credit score: Most lenders require a minimum credit score of at least 620 to qualify for a conventional mortgage. Some require higher scores. To get the most competitive rates, you'll want a score above 700.
  • A debt-to-income ratio below 43%: This is the percentage of your income that goes toward paying your monthly debt, including the new mortgage you're applying for. Many lenders set this ratio even lower at 36%.
  • Stable income: You'll need W-2s and other proof of income. Your lender will likely want to talk with your employer to verify you currently have a job. If you are self-employed or earn income from other sources, such as investments, you will likely need to provide even more documentation. This step is important to prove you have the money coming in to pay your future mortgage bills.
  • Proof of assets: Lenders will review bank and investment account statements to make sure you have enough for the down payment and closing costs. You may be required to have enough money in reserve to cover several months of loan payments.
  • A home inspection and appraisal: The appraisal value of your home must be high enough to guarantee the loan. It must also pass an inspection so lenders can count on it being in sound structural condition.
  • Title insurance: You'll need proof of clean title, which means there are no unexpected outstanding liens or other claims on the home. Title insurance is required in case there are encumbrances that did not show up on a title search and affect the home's ownership or usage.
  • Homeowner's insurance: You'll need proof of insurance to close on a mortgage. If your home is in a flood zone, you may also need a special policy to protect against flood damage.

Do conventional loans require private mortgage insurance (PMI)?

Most conventional mortgages require that you pay private mortgage insurance (PMI) if you don't put at least 20% down when you purchase your home. For example, you'd have to pay PMI if you buy a $400,000 home and borrow more than $320,000. PMI protects your lender from loss in case of foreclosure.

Although you pay for PMI, it benefits only the lender. If you can't pay your mortgage, PMI doesn't help you. Avoiding PMI is usually a good idea if you can. But if you do need PMI -- don't stress. It's not always easy to come up with a 20% down payment.

Private mortgage insurance is usually priced between 0.5% and 1% of the amount you borrow. This amount is added onto your mortgage payments, and you'll have to pay it until your lender automatically removes it. Usually, this happens once your home loan balance hits 78% of your home's original value. If your lender doesn't automatically remove it, you may need request to stop paying. You can usually ask for this after your balance hits 80% of your home's current appraised value.

There are some lenders who offer special mortgages without PMI insurance. PMI could potentially also be avoided if you take out one home loan for 80% of the home's value and then get a second loan to cover the 20% down payment (this is called an 80-20 loan)

Mortgage insurance isn't unique to conventional loans: It's required on some government-backed loans for less-qualified lenders as well. For example, the VA doesn't require mortgage insurance, but the FHA does. And unlike conventional loans, which usually only charge annual premiums paid monthly, on FHA loans you have to pay both an up-front and annual mortgage premium. FHA mortgage insurance may also be required for a longer period of time -- sometimes for the life of the loan, depending on the amount of your down payment.

Advantages of a conventional loan

There are some significant benefits to conventional loans, including the following:

  • You might qualify for a conventional loan faster than for you qualify for government-backed loans.
  • You may have more choices for lenders (not all lenders offer government-backed loans).
  • Conventional loans can be less expensive for well-qualified borrowers, since they don't require you to pay some of the fees often mandated on government-backed loans. (VA loans, for example, require up-front funding fees. FHA loans may mandate you pay mortgage insurance for a longer time.)
  • Conventional loans can be flexible. Most government-backed loans are available only for the purchase of a primary residence. By contrast, you can use a conventional loan to buy a vacation home or rental property.

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