What is a Conventional Loan?
A conventional mortgage loan is considered a “conforming” loan because it satisfies the criteria established by Fannie Mae or Freddie Mac. Fannie Mae and Freddie Mac are entities sponsored by the government that acquire mortgages from lenders and then sell them to investors. This allows lenders to have more resources available to assist qualified buyers in purchasing homes.
Since there are various guidelines categorized as “conventional loans,” there isn’t a singular set of prerequisites for borrowers. Nonetheless, typically, conventional loans have more rigorous credit standards when compared to government-supported loans such as FHA loans.
Conventional Loan Requirements
1. Credit Requirements:
The first step in getting a conventional loan is lenders taking a look at your credit score. Mortgage lenders mandate a minimum score of 620 to qualify for a conventional loan. However, this score is just the bare minimum. To obtain the most favorable interest rate and optimal terms, you’ll need a substantially higher score, usually around 740 or more.
2. Debt-to-income (DTI) ratio:
The next step is the lenders looking at your debt-to-income (DTI) ratio. Your DTI ratio takes into account any additional monthly payments you must make for other debts, such as credit card debt, student loans, and car loans. The majority of lenders prefer this ratio to be no higher than 43 percent, although some may make exceptions and allow up to 50 percent. Alternatively, certain lenders may restrict it to 36 percent.
3. Down Payment:
Thirdly, unlike certain loans backed by the government, a conventional loan won’t provide you with 100 percent of a home’s purchase price, which means you’ll need to make a down payment. Many fixed-rate conventional loans for primary residences (not investment properties or second homes) allow for a down payment as low as 3 percent or 5 percent. For instance, if you’re obtaining a 3-percent conventional loan to buy a $350,000 house, you’ll need to put down at least $10,500.
4. Private Mortgage Insurance (PMI)
Although being able to make a down payment of just 3 percent is an attractive feature of conventional mortgages, this small deposit comes with a disadvantage: private mortgage insurance (PMI). Since you didn’t make a 20 percent down payment, PMI helps safeguard the lender in the event of loan default. Until you accumulate 20 percent equity in the property by either increasing your home’s value or paying down your mortgage, you’ll be required to pay the additional cost of PMI.
5. Loan Size
The last step in obtaining a conventional loan is determining the amount of money you need to borrow. The Federal Housing Finance Agency (FHFA) sets limits each year for conforming conventional loans, which differ based on the property’s location. In most regions of the U.S., the limit for 2023 is $726,200, while high-priced areas have limits of $1,089,300. If you require a loan larger than these limits, you’ll need to search for a jumbo loan.
Advantages of a Conventional Loan
- One of the significant advantages of a conventional loan is that you can opt for cancellable mortgage insurance. This means that you won’t be required to pay for PMI throughout the mortgage’s entire term. Once you achieve 20 percent equity in the property, you can request the cancellation of PMI. In comparison, if you obtained a 30-year FHA loan and made a down payment of less than 10 percent, you would have to pay the insurance premiums for the entire thirty-year period unless you sell the home or refinance it into a conventional loan.
- Conventional loans offer flexible repayment timelines, and the most common loan terms are 15-year and 30-year payback periods. However, certain lenders have flexible-term or flex-term conventional loan programs that provide you with a broader range of time frames, usually ranging from eight to 29 years, to choose from.
- Conventional loans offer more financing and property types compared to government-backed mortgage programs, as they are available for not just owner-occupied homes but also for second homes and investment properties.
Disadvantages of a Conventional Loan
- Even though you have the option to cancel PMI on a conventional loan when you reach 20 percent equity in your home, if you made a down payment of less than 20 percent, you will still need to pay the premiums. As a result, your monthly mortgage payment will increase.
- A significant disadvantage of a conventional loan is its strict requirements. A borrower must have a minimum credit score of 620, although some lenders demand a higher score. If your credit score is not up to par, you will need to improve it before becoming eligible for a conventional loan. Furthermore, lenders generally enforce the 43 percent DTI ratio limit, which could prevent you from qualifying for a conventional loan. Other loan types may be more lenient regarding the DTI ratio.
- If you have a previous foreclosure on your credit record, it will take longer to be eligible for another conventional loan compared to other mortgage types. With conventional loans, you’ll need to wait for seven years after the foreclosure, while with government loans, you’ll need to wait for two or three years.
The Bottom Line of a Conventional Loan
A conventional loan is a popular option among borrowers who want to keep costs low. To qualify for one, it’s important to have your credit, income, and assets in order. However, keep in mind that some lenders may require more compensation in one area if you have a deficiency in another. For example, a lower credit score may require a bigger down payment and higher income. As long as you can make a down payment, show adequate income, and have a qualifying credit score, you’re likely to be approved for a conventional loan.