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What is a Conventional Mortgage?
A conventional mortgage or conventional home loan is one that is not insured nor guaranteed by the United States government. Most conventional mortgages are conforming. This means that they meet the eligibility requirements necessary to be sold to Fannie Mae or Freddie Mac.
Fannie Mae is the Federal National Mortgage Association and Freddie Mac is the Federal Home Loan Mortgage Corporation. They are organizations sponsored by the federal government. They purchase mortgages from lenders then they sell them to investors. This will free up the lender’s funds which can help them get more buyers into homes. Conventional mortgages can also be non-conforming. This means that they do not meet the guidelines for Freddie Mae or Freddie Mac.
Types of Conventional Loans
There are a few different types of conventional loans that have different standards. It is important to know the differences so that you can plan for the one that suits your needs and eligibility.
Conforming Conventional Loans
These are the loans that follow the standards set by Freddie Mae and Freddie Mac. They have maximum loan amounts that must be adhered to. For 2021, the conventional loan limit is $548,250 for a single family home. It is important to note that the limit is higher in some high-cost areas. There is also an increased loan amount for multi-unit homes.
Jumbo Conventional Loans
Jumbo loans are non-conforming and may be a good option if you are looking to borrow more than the 2021 limit for your house. Typically, you will need a higher credit score for jumbo loans. Generally, you should have a credit score of 700 or higher, but may be able to work with them if you have other good eligibility factors or a larger down payment. Some lenders will require a substantially lower debt-to-income ratio for jumbo loans as well. Since the higher loan amount is a higher risk for the lender, the interest rate may increase when compared with a conforming conventional home loan.
A portfolio loan is a conventional loan where the lender of the mortgage keeps the loan in their own portfolio instead of selling it. This type will still have to meet the standards set by Freddie Mae and Freddie Mac.
Subprime Conventional Loans
If you have lower credit below 620, then you may still qualify for a subprime mortgage loan. These are non-conforming loans that often have higher closing costs and increased interest rates. They are still a good option if you wish to purchase a home before you improve your credit score.
Adjustable Conventional Loans
This type of loan has a fixed interest rate for a set period such as 5 years. After this period, the interest rate can change depending on the current housing market rates. These typically have lower interest rates at the beginning of the life of the loan than fixed conventional loans. However, this type of loan may have a higher overall cost if the market interest rates increase over the life of the loan.
Conventional Loans vs. Government-Backed Loans
Different loans are best for different home buyers. It is important to know the differences between conventional loans and loans that are backed by the federal government.
FHA loans can help you get into a home with a low credit score if you have a solid down payment. You may even be able to get into a home with a credit score as low as 500 if you have a 10 percent down payment. A 3.5 percent down payment will allow you to get into a house with a credit score of 580 or greater.
Also, you should also consider the cost of mortgage insurance before deciding between a conventional loan and an FHA loan. If you have less than 10 percent as a down payment for an FHA loan, then you will be required to pay a mortgage insurance premium for the life of the loan regardless of the amount of home equity you obtain. For a conventional loan, you will not have to pay for private mortgage insurance for a conventional loan if you reach 20 percent equity.
VA loans are designed for certain members and former members of the U.S. military. These loans do not require a downpayment and do not charge private mortgage insurance. You will, however, have to pay a funding fee to offset the cost to the taxpayers for the loan. Some limited groups like those on VA disability or Purple Heart recipients, do not have to pay the funding fee so it is important to see if you may be exempt as well. The funding fee will land somewhere between 1.25 and 3.3 percent of the loan amount depending on your down payment amount and a few other factors.
These loans are insured by the Department of Agriculture. They can help lower income homebuyers find their way into a home that is located in some rural areas. These loans do not require a downpayment and also have flexible credit score eligibility requirements.
Conventional vs. Government-Insured
When you are deciding what type of loan works best for your situation, it will likely depend largely on your finances and credit score. If you have a higher credit score above 740 and you can afford to put 20 percent of the home’s value down, then you may be able to get a lower interest rate and lower fees with a conventional loan. Also, USDA and VA loans have strict requirements that may make it easier to obtain a conventional home loan.
If you have a lower credit score, then your best option may be an FHA loan. You should take their mortgage insurance premiums into account before making a decision. This will include a fee that you will have to pay upfront in addition to the ongoing charges.
Conventional Loan Credit Score Requirements
In order to have a chance at approval for a conventional loan, you will need a credit score of at least 620. However, you will have a better chance and qualify for better terms if your credit score is higher. Typically, you should strive to reach a credit score of at least 680. This will help you get a better interest rate.
Conventional Loan Down Payment Requirements
The minimum down payment for conventional loans is only 3 percent. However, for any down payments that are less than 20 percent, private mortgage insurance is required (but can be removed once you hit 20 percent home equity).
The more you put down, the lower your loan costs will be. The down payment will help you determine your private mortgage insurance rate. This will end up changing your monthly payment amount and the amount you pay towards interest.
Private mortgage insurance for conventional loans can cost less than the insurance premiums on an FHA loan if you have good credit. This is because the PMI is based on risk so your premiums will be reduced if you have a good credit score. In turn, your monthly payments will be lower.
The interest rates will vary depending on the lender as well as the combination of your credit score and down payment. It is a good idea to be sure that the lender tries to find the best PMI cost for you.
Conventional Loan Debt-to-Income Ratio Requirements
This depends on the particular lender, but usually you can expect them to accept any below 36 percent. Some lenders have higher debt-to-income ratios even up to 45 percent. Additionally, if you have a great credit score, lots of assets, or a high down payment then a lender may make an exception for a higher DTI. Alternatively, you may have a lower DTI if you have lower credit. The lower your DTI, the more likely that you will be approved for the conventional loan.
Conventional Loan Income and Asset Requirements
To qualify for a conventional loan, you will have to provide documentation for your income and assets. You will likely have to provide two months worth of bank statements and a month's worth of pay stubs. In some cases you may have to prove more.
You will have to provide two years of W2 forms and if you collect retirement or a pension, or if you are self-employed, you will have to provide your two previous tax returns. Your lender may also ask for some additional documentation such as 1099s, retirement award letters, or rental agreements for investment properties.
Conventional Loan and Bankruptcy Requirements
Bankruptcy will not fully disqualify you for a conventional loan, but there are waiting periods that you will have to abide by in order to be eligible. Furthermore, you will have to prove that you have rebuilt your credit since you filed for bankruptcy.
If you filed for Chapter 7 or Chapter 11 bankruptcy, you will be required to wait 4 years. This is measured from the discharge or dismissal date. Also, if you can document extenuating circumstances then it may be possible to reduce the waiting period to 2 years instead of four. For example, you could show that unexpected job loss that is unlikely to happen again to get a reduced waiting period.
If you filed for Chapter 13, then the waiting period will be two years after the discharge date or 4 years after the dismissal date. Again, it is possible to get a waiting period reduced to 2 years if you have proof of extenuating circumstances.
Benefits of a Conventional Loan
There are some great benefits of a conventional loan that may help you determine if it is the right type of loan for you.
Low Interest Rates
The interest rate for a conventional loan will be determined by your credit and other conditions so you can get a good interest rate if your credit is good. This is preferable for some homebuyers than paying the insurance premiums for the life of an FHA loan.
High Loan Limit
You can go higher on your loan if you choose a jumbo conventional loan. Government backed loans typically do not have this type of flexibility.
You will have the ability to work with a private mortgage lender more than you would with a government-insured loan because they do not have to follow strict guidelines and standards that are set by federal agencies. You may be able to choose different term lengths, down payment options, and you may be able to do more with lower credit.
Downsides for Conventional Loans
A conventional loan is not for everybody and there are some downsides to check into.
Credit Score Requirements
Generally, you will need a higher credit score for a conventional loan than you do with an FHA loan. The minimum for a conventional loan is 620 and you can qualify for an FHA loan with a credit score as low as 500. Also, USDA loans have a minimum credit score requirement of 580 and you can also qualify with a lower score than that under certain conditions.
Higher Down Payment Requirements
While the minimum required down payment is low for a conventional loan, you will have to put down more for good terms. In addition, you have to put down at least 20 percent in order to avoid private mortgage insurance costs.
Since a conventional loan is placing a lot of risk on the lender, they may require you to have a better financial situation overall than a government-insured mortgage would need. They may scrutinize your credit, assets, finances, and more to determine your eligibility.