What Is a Conventional Loan?
A conventional loan is a mortgage issued by a private lender, and is not insured by a government agency such as the Federal Housing Administration, Veterans Affairs, or U.S. Department of Agriculture. Conventional loans are the most common type of mortgage. They typically cost less than FHA loans, but the lending requirements are stricter, so they are more difficult to get.
How does a conventional mortgage work?
A conventional mortgage is, like most mortgages, used to buy or refinance a home.
The loan is a contract agreeing that the lender will advance money for the borrower to buy a home, and the borrower will repay that amount — along with interest — following a regular schedule of payments. If the borrower fails to pay as agreed, the lender can sell the property to cover its costs related to the loan.
Lenders offer a range of conventional mortgage rates, repayment terms, and other features that depend on the specific lender, the property, and the borrower’s financial situation and personal preferences.
Congress and government agencies such as the Consumer Financial Protection Bureau, Department of Housing and Urban Development, and Federal Trade Commission regulate mortgages in the United States. They prevent lenders from discriminating against borrowers based on race, color, religion, national origin, sex, marital status, age, or participation in an income assistance program. By law, mortgage approval decisions are to be based solely on objective criteria, including credit history, income, and existing debts.
Types of Conventional Loans
Conventional mortgage loans come in two main types: conforming and nonconforming.
Conforming loans meet federal requirements that allow government-sponsored enterprises — like Fannie Mae and Freddie Mac — to guarantee the loan. Fannie and Freddie do this by buying mortgages from lenders. They either hold those mortgages in a portfolio or repackage them into securities that are sold to investors on what’s called the secondary mortgage market. That frees up cash for lenders to make more home loans.
Nonconforming loans are mortgages that don’t meet federal requirements, usually by exceeding the maximum amount for conforming loans set by the Federal Housing Finance Agency.
The defining characteristic of conforming loans is they do not exceed the FHFA’s maximum loan amount, which is revised each year. The FHFA sets a default limit that applies to most places in the United States, and a high-cost limit for areas where market prices for homes are significantly higher.
In 2021, a conforming loan for a single-family home loan cannot exceed $548,250. Conforming loans in high-cost areas can be as much as $822,375 for a single-family home. Additional limits are set for homes with up to four units.
Fannie and Freddie also set eligibility standards for borrowers, including debt-to-income ratio, credit history, and credit score requirements. Lenders may have additional requirements and request other documentation as well.
Nonconforming loans are basically any conventional mortgages that aren’t a conforming loan. Lenders set their own terms, which will vary significantly from one to another.
Most nonconforming loans fall into the category of jumbo loans. They can go up to $2 million, though borrowers will need very good credit and a high income to qualify.
Some lenders offer specialized nonconforming loans for everything from large properties to self-employed or high-risk borrowers. Again, the terms are determined by individual lenders, and will vary widely based on your financial situation, the loan amount, and what you plan to do with it.
Conventional Loan Requirements: How Do You Qualify?
Lenders go through a detailed review process when approving new mortgages.
“Borrowers with good credit and a sizable down payment benefit most from conventional loans,” says Michael Anderson, a certified financial planner at Maranantha Financial in Ventura, California. “These borrowers usually get the best interest rates and terms.”
Below are some of the most important requirements for a conventional loan.
Your credit score is a number that represents your borrowing risk for lenders. Using the FICO system, credit scores range between 300 and 850. Borrowers need a credit score of at least 620 to qualify for a conventional loan, though scores as high as 720 are required in some cases. Individual lenders may have additional requirements.
Your debt-to-income ratio is a percentage calculated by adding up your monthly debt obligations and dividing the sum by your total monthly income before taxes.
A DTI of 50% is the maximum allowed for a conventional loan. If you earn $5,000 per month, for example, the total of your mortgage, student loans, credit cards, and other debt payments should be less than $2,500. It’s better to have a DTI under 45%, and a DTI of 36% or less will earn you more-favorable terms.
Your income is examined in multiple ways when you apply for a mortgage. In addition to DTI, lenders will look at your total income to determine whether you can afford the projected monthly payment. There’s no minimum income to qualify for a conventional mortgage, but it’s often easiest to get approved if you have W-2s from employers and several years of tax returns proving steady income.
Because a property secures a mortgage, the home itself is an important factor in getting approved for a loan. Lenders typically appraise a property to determine how much it’s worth — and therefore how much they will lend you. That in turn helps decide if the mortgage will remain within the FHFA limits for a conforming loan, as well as how much of a down payment is required to get the loan and avoid paying private mortgage insurance.
Conforming loans require borrowers to make a down payment. Fannie and Freddie both have programs that allow buyers to put down as little as 3%. If you don’t qualify, you’ll need to put down 5% or more. Exactly how much you need to put down varies by lender, but buyers who put down less than 20% of the sale price typically must pay for PMI.
A larger down payment reduces the amount you need to borrow to buy a home. If you’re struggling to get approval for a mortgage, consider saving up a larger down payment to increase your odds. Larger down payments also lower your monthly payment and may help you qualify for a lower interest rate.
What Are the Limits of Conventional Loans?
The limits for a conventional loan vary by location and property type. The FHFA issues a baseline limit and a high-cost area limit for single-family homes and for homes with up to four units.
Here are the conforming loan limits through the end of 2021:
FHA Conforming Loan Limits
|Type||One Unit||Two Units||Three Units||Four Units|
|High-cost area limit||$822,375||$1,053,000||$1,272,750||$1,581,750|
If the home you want to buy exceeds these limits, you’ll need a jumbo loan or other nonconforming loan.
A conventional mortgage calculator can help you understand your potential monthly payment based on the property price, down payment, interest rate, and other loan terms.
Advantages and Disadvantages of Conventional Loans
While conventional loans are the most common type of mortgage, they aren’t the best option for everyone. Consider the different pros and cons when shopping for a mortgage.
Advantages of a conventional mortgage
- Lower total cost: Conventional loans often are the most affordable option for homebuyers, since lenders can reduce their risk by selling conforming loans to Fannie or Freddie. One way to compare loan costs is using the annual percentage rate, which includes the interest rate and other fees. “Conventional loans are good because they can help you save money when you qualify for the best interest rate,” Anderson says.
- Some flexibility in terms: When choosing a conventional loan, you have some flexibility in payment terms, such as selecting a longer or shorter loan term, or a fixed-rate or adjustable-rate mortgage.
- Widely available: You can find a conventional loan through most major banks, credit unions, and online lenders.
Disadvantages of a conventional mortgage
- Higher credit score requirement: Conventional loans generally require higher credit scores compared with loans from government programs, including FHA and VA loans.
- Down payment requirements: Conventional loans require down payments of at least 5%, with 20% or higher suggested to avoid paying PMI. Some government-backed loans allow a lower down payment or no down payment.
Conventional Loans vs. FHA Loans
If you are on the hunt for a mortgage and don’t qualify for a VA or USDA loan, you may be deciding between an FHA loan and a conventional loan.
Conventional loans are often better for those who have good credit and a sizable down payment. FHA loans are often better for borrowers with lower credit scores and less saved up for a down payment.
Here are the significant features of FHA vs. conventional mortgages:
Conventional Loans vs. FHA Loans
|Feature||Conventional Loan||FHA Loan|
|Minimum down payment||5%||3.5%|
|Minimum credit score||620||500|
|Additional costs||PMI, if putting less than 20% down||Mortgage insurance|
For example, say you want to buy a house that costs $400,000, so you take out a 30-year, fixed-rate mortgage with a 3% interest rate.
For an FHA loan, the 3.5% minimum down payment comes to $14,000, so your loan will be for $386,000. The upfront mortgage insurance premium of 1.75% will add $7,000 for a total of $393,000. Your monthly payment for principal and interest will be $1,657. Over the 30-year term, you’ll pay $203,485 in interest for a total cost of $603,485.
For a conventional loan, a 5% down payment is $20,000. The monthly payment for principal and interest is $1,602, with an average PMI rate of 1.24% adding $413 for the first 82 payments. The interest paid comes to $196,754 for a total cost of $596,754 — saving $6,731 compared with the FHA loan option.
If you’re able to make a larger down payment, you can do even better. If you put down 20%, or $80,000, that means you’re borrowing $320,000 and avoiding PMI. Your monthly payment will be $1,349. You’ll pay $165,688 in interest for a total cost of $565,688 — a savings of $37,797, or $1,260 a year for 30 years, versus the FHA loan option.
The FHA loan is easier to get, which means it’s a good option for first-time homebuyers, but making a larger down payment with a conventional loan saves money in the long run.
How To Apply For a Conventional Loan
You can find a conventional loan by working directly with a lender or mortgage broker, and use online tools to help you evaluate multiple loan options at once.
Every homeownership journey is different, but there are some standard requirements for conventional loan applications. For an initial loan estimate, plan on submitting the following:
- Social Security number.
- Property address.
- Estimate of property value.
- Anticipated loan amount.
You’ll need to submit additional documentation for a complete application, including pay stubs, W-2 forms, income tax returns, bank statements, investment statements, and anything else required to substantiate your income, assets, and down payment.
Your lender may reach out with more questions and documentation requests. If that happens, try to respond quickly with complete and accurate details to help ensure a smooth mortgage approval process.