What is a Conventional Loan
What is a Conventional Loan

What is a Conventional Loan: Understanding the Basics of Traditional Mortgage Financing

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What is a Conventional Loan – A conventional loan is a type of mortgage that conforms to standards set by Fannie Mae and Freddie Mac, the two government-sponsored enterprises that purchase the bulk of conventional home loans from lenders.

Conventional loans make up most of the mortgage market and are considered the “standard” option for financing a home purchase. They offer competitive interest rates and flexible terms for borrowers with good credit and down payments of at least 3-20% of the purchase price.

With a conventional loan, paying private mortgage insurance (PMI) is required if your down payment is less than 20%. This protects the lender if you default. However, you can cancel PMI once you build 20% home equity.

Conventional loans have loan limits that adjust each year but are higher than government-backed FHA and VA loan limits. Approval is primarily based on your credit score, income, existing debts, and assets or reserves.

While they have stricter requirements than government loans, conventional mortgages provide home buyers with stable financing at affordable rates. They are a good option if you qualify based on credit, income, debts, and available down payment funds.CopyRetry

Table Of Contents

What is a Conventional Loan?

What is a Conventional Loan : A conventional loan is a type of mortgage that conforms to guidelines set by Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that securitize most conventional home loans. Conventional mortgages are what most people consider “standard” home loans and make up the majority of the mortgage market. What is a Conventional Loan

Key Features of Conventional Loans

Here are some of the main features that characterize conventional mortgages:

  • Loans limits that adjust yearly and run up to $647,200 in most areas
  • Minimum down payment of 3-20% typically required
  • Paying mortgage insurance if less than 20% down
  • Underwriting standards set by Fannie Mae and Freddie Mac
  • Rates driven by 10-year Treasury yields and bond market activity
  • Originated and securitized by private lenders rather than government agencies
  • Flexible qualifying guidelines based on credit, income, assets, and property

Conventional loans offer competitive interest rates and give borrowers many options. However, they come with stricter eligibility standards compared to government-backed loans.

Conventional Loan vs. Government Loans

The main alternatives to conventional loans are government-backed mortgages through FHA, VA, or USDA programs. Here’s a quick comparison:

Conventional Loans

  • Originated by private lenders
  • Larger down payments usually needed
  • Lower interest rates
  • Underwritten to GSE standards

Government Loans

  • Backed/insured by FHA, VA, USDA
  • Lower down payments or 100% financing options
  • Higher interest rates
  • Must meet agency eligibility rules

While conventional loans come with some advantages, government programs provide easier access to homeownership for certain borrowers.

Are Conventional Loans Right for You?

Conventional loans are a good option if you:

  • Have a substantial down payment and emergency savings
  • Have a good to excellent credit score
  • Want competitive interest rates
  • Qualify based on income, assets, and existing debts
  • Don’t meet specific government loan eligibility

If your finances aren’t as strong, an FHA, VA, or USDA loan may be a better alternative.

Requirements to Qualify for a Conventional Loan

To qualify for a conventional mortgage, you’ll need to meet certain requirements in these key areas:

Down Payment Amount

For a conventional loan, you’ll need a down payment of at least 3-20% of the purchase price:

  • Minimum is usually 3-5%
  • Avoid PMI with 20% down
  • 10% down offers a balance of equity and affordability for many

The more you can put down, the better the loan terms will generally be. But low down payment options exist too.

Credit Score

The minimum credit score for a conventional loan is around 620, but many lenders want:

  • 640+ for easier approval
  • 680+ for the best terms
  • 740+ for the lowest rates

The higher your score, the lower your interest rate will be. Having little credit history can also be a challenge.

Debt-to-Income Ratio

Your total monthly debt divided by gross monthly income is called the DTI ratio. Most lenders want your DTI to stay under 43% to qualify. The lower the better.

Income Verification

Lenders closely look at your income sources and stability. Expect to provide:

  • Tax returns and W-2s
  • Pay stubs covering 30+ days
  • Tax transcripts directly from the IRS
  • Proof of bonuses, commissions, and other income

Assets and Reserves

Lenders want to see you have enough assets for closing costs and reserves post-closing. Typical requirements are:

  • 3-6 months reserves of mortgage payments
  • 6-12 months reserves for better terms
  • 2-5% of purchase price for closing costs

Funds in your checking, savings, retirement, or investment accounts can count toward reserves.

Interest Rates on Conventional Loans

Interest rates have a huge impact on your monthly payment and long-term cost. Here’s an overview of how rates work on conventional mortgages.

How Conventional Rates Are Determined

Conventional mortgage rates are primarily influenced by:

10-Year Treasury Yields – The yields on 10-year Treasury notes are a key benchmark for conventional mortgage rates. When Treasury yields rise, mortgage rates tend to rise as well.

Your Credit Profile – Your individual credit score, income, assets, debts, and down payment amount determine the rate lenders offer you.

Loan Type – Fixed, adjustable, jumbo, and low down payment conventional loans can have varying rate ranges.

Market Forces – Competition among lenders and activity in global debt markets also shape pricing for conventional loans.

Comparing Conventional Loan Rates

Conventional vs. Government Rates – Conventional rates are usually lower than FHA and VA rates for borrowers with good credit.

Jumbo vs. Conforming Rates – Jumbo conventional loans above the conforming limit often have lower rates than conforming loans.

ARMs vs. Fixed Rates – Adjustable-rate mortgages often start with a lower teaser rate than fixed-rate conventional loans for the first few years.

Getting the Lowest Conventional Rate

To qualify for the lowest rates possible on a conventional loan:

  • Shop different lenders for rate quotes
  • Improve your credit score and payment history
  • Lower your debt-to-income ratio
  • Make a larger down payment
  • Opt for a shorter-term loan (15-year)
  • Get pre-approved to show you’re a serious buyer

Even small differences of an eighth to a quarter percentage point in your rate can save thousands over the loan’s term.

Fees Associated with Conventional Loans

Obtaining a conventional mortgage comes with various fees and closing costs you’ll need to budget for, including:

Origination Fee

This upfront fee paid to the lender covers processing your loan and ranges from 0-2% of the total amount borrowed. Discounts sometimes apply with larger down payments.

Appraisal Fee

An appraisal costs around $500 on average and is needed to confirm the property’s market value for lending purposes.

Credit Report Fee

Lenders will pull credit reports on each borrower for $50 or less to assess your credit risk.

Title Fees

Title insurance and title search fees can total $1,000-$2,000 altogether. These costs cover title-related work.

Recording Charges

A recording fee of around $200 is charged by the county clerk to file your mortgage documents publicly.

Prepaids

Upfront payment of property taxes, homeowner’s insurance premiums, and potentially mortgage insurance will be required at closing.

Miscellaneous Fees

Pest inspection, survey, home warranty fees, and other costs may also apply depending on your loan terms and property location.

Altogether, plan on conventional loan closing costs running 2-5% of your mortgage amount.

Mortgage Insurance on Conventional Loans

Private mortgage insurance or PMI applies to conventional loans with less than a 20% down payment. Here are some key details on PMI:

When PMI Is Required

If your down payment is less than 20% of the purchase price, PMI will be mandatory on a conventional loan to protect the lender from default risk.

How Much PMI Costs

PMI premiums typically range from 0.3-2% of the loan amount per year. On a $300,000 loan with 5% down, PMI may cost around $1,500 annually at a 0.5% rate.

Removing PMI

Once you reach at least 20% home equity through payments or appreciation, you can request PMI cancellation. This often takes 5-7 years of payments for most borrowers.

PMI Tax Deduction

The PMI premium can be tax deductible if your income falls under certain limits. This helps offset the cost somewhat.

PMI allows buyers to purchase with less cash upfront, but does add to the monthly payment. Be sure to get quotes on PMI rates from lenders.

Pros and Cons of Conventional Loans

There are a number of advantages to conventional loans, along with some potential drawbacks to factor in:

Pros of Conventional Mortgages

  • Competitive interest rates and potential discounts
  • Higher conforming loan limits than government loans
  • No recurring MIP required as with FHA loans
  • More flexible credit and income requirements than government programs
  • Ability to cancel PMI once 20% equity reached
  • Wider loan term options – 10, 15, 20, 30, 40 years
  • No prepayment penalties; pay off balance anytime

Potential Cons to Consider

  • Larger down payments usually needed vs. other loans
  • PMI required if less than 20% down payment
  • Stricter credit score requirements than government loans
  • Debt-to-income ratio capped at 43% of gross income
  • Closing costs and upfront fees can be high
  • Less payment stability than fixed government loans

Conventional loans provide competitive options for qualifying borrowers, but aren’t the right fit for everyone’s financial situation.

Alternatives to Conventional Loans

Beyond conventional mortgages, you may want to look at these other common home loan programs:

FHA Loans

FHA loans are popular for low down payments of just 3.5% and more flexible credit and debt requirements. But they require upfront and annual mortgage insurance premiums.

VA Loans

For military members and veterans, VA loans offer zero down payment options without PMI. But you need to qualify based on service status, and funding fees apply.

USDA Loans

In eligible rural areas and small towns, USDA loans can provide very low or no down payment options for moderate income borrowers. Credit score requirements are also lower.

Jumbo Loans

Jumbo loans exceed the conforming limits for conventional loans so are not securitized by Fannie Mae or Freddie Mac. But they offer higher loan amounts and often have lower rates.

Tips for Qualifying for a Conventional Loan

What can you do to increase your chances of successfully qualifying for a conventional mortgage loan? Here are some tips:

Save for a Down Payment of at Least 10-20%

The more you can put as a down payment, the easier qualifying becomes. Shoot for at least 10% down, or better yet 20% to avoid PMI. Budget, cut costs, invest early to build your down payment savings.

Keep Your Credit Score Above 700

Having a credit score of at least 700 will get you the best terms. Pay all bills on time, reduce card balances, and correct any errors to boost your score.

Lower Your Debt-to-Income Ratio

Lenders look closely at your DTI ratio. Pay off cards, cars, loans, and consolidate other debts to lower your ratio as much as possible.

Document All Sources of Income Thoroughly

Provide proper documentation of your wages, bonuses, commissions, investment returns, and any other income sources. Quantify expected overtime or future raises.

Build Up Your Post-Closing Reserves

Lenders want to see you have 6-12 months of mortgage payments and other living expenses in reserves after closing. Save diligently.

Include a Co-Borrower If Needed

Adding another borrower who qualifies well can significantly improve your chances. Their income, assets, and credit will be included.

Communicate Proactively with Your Lender

Ask questions, submit documents promptly, and keep your loan officer updated throughout the process to avoid delays or hiccups.

The Conventional Loan Process from Start to Finish

Here is an overview of the basic steps involved in getting approved, finding a home, and closing on a conventional mortgage loan:

Pre-Approval Stage

  • Check your credit reports and scores
  • Gather income, asset, debt documentation
  • Shop lenders and apply for pre-approval letters
  • Get rate quotes and determine budget/affordability

House Hunting Phase

  • Work with real estate agent to view potential homes
  • Make an offer once you find the right property
  • Negotiate deal terms and put down earnest money deposit
  • Complete inspections and sign purchase agreement

Loan Processing Period

  • Submit updated documents to underwriter
  • Get appraisal completed on the property
  • Receive finalized closing disclosure paperwork
  • Finalize homeowners insurance policies

Closing and Possession

  • Do final walkthrough inspection
  • Sign closing documents and transfer funds
  • Get keys and officially take ownership
  • Record deed and mortgage documents

Getting pre-approved early makes for a smoother home buying process. Then once under contract, act quickly to submit all documents needed to close on time.

Should You Refinance a Conventional Loan?

If you already have a conventional loan, refinancing to a new conventional mortgage could save you money if:

Your Credit Score has Improved – A higher score means qualifying for a lower rate on a new loan.

Interest Rates Have Dropped – Refinancing at lower rates can significantly reduce your monthly payments.

Your Finances Have Changed – Increased income or equity could help you qualify for better loan terms.

You Want to Adjust Your Loan Term – Switching from a 30-year to 20 or 15-year term builds equity faster.

You Need Cash Out – Cash-out refinancing converts equity into usable funds via a higher balance.

To see if refinancing makes sense, get quotes on new loan terms and plug them into a refinance calculator. There may be closing costs to consider as well.

Types of Conventional Loan Programs

Conventional mortgages come in a variety of forms beyond basic fixed and adjustable-rate loans. Some other types include:

Jumbo Loans

Jumbo loans exceed the conforming loan limits set by the GSEs. Popular for high-cost areas and luxury homes.

Conforming Loans

Conforming loans fall under the maximum limits for purchase by Fannie Mae and Freddie Mac. Most conventional loans conform.

Low Down Payment Loans

Many lenders offer conventional loan options with just 3-5% down for first-time and low-down buyers.

High Balance Loans

In pricier markets, high balance loans let you borrow above conforming limits up to a set ceiling like $726,525.

Doctor Loans

Specialized programs help physicians secure financing more easily, often with less cash needed upfront.

Energy Efficient Mortgages

Lets you roll financing for energy-saving upgrades into the mortgage by increasing the loan amount.

How Private Mortgage Insurance Works

Private mortgage insurance or PMI helps protect lenders and allows buyers to purchase with less than 20 percent down on a conventional loan. Here are some key details on how it works:

What PMI Covers

If you default, PMI pays the lender a portion of the unpaid mortgage balance, up to 25% of the original amount. This helps cover losses.

Who Pays the PMI Premium

You as the homebuyer are responsible for paying the monthly or annual PMI premium. It gets included with your regular mortgage payment.

Transferring PMI Obligation

When you sell the home, PMI does not automatically transfer. The new buyer must secure their own PMI if needed.

Shopping for Coverage

You can shop around with different insurers to compare PMI rates and find the most affordable option. Rates range from 0.3% – 2%.

Removing PMI

Reaching 20% home equity through payments or appreciation allows you to cancel PMI. This typically takes 5-7 years of mortgage payments for most borrowers.

PMI Tax Deduction

Depending on your income, the PMI premium may qualify as a tax deduction, helping offset the cost a little.

Calculating Your Private Mortgage Insurance Payment

Here is an example of how to estimate your monthly PMI payment:

Loan Amount: $200,000

Down Payment: 10% or $20,000

Loan-to-Value Ratio: 90%

PMI Rate: 0.5% annual

PMI Formula: Loan Amount x PMI Rate / 12

$200,000 x 0.005 / 12 = $83 per month

With higher PMI rates or on larger loan amounts, the monthly cost can exceed $100-150. Always ask lenders for sample PMI quotes before committing.

How to Eliminate Private Mortgage Insurance

Once you reach 20% equity in your home through amortization and appreciation, you become eligible to cancel PMI. Here are some tips for eliminating PMI sooner:

Make Extra Payments

Putting extra toward the principal monthly or annually will help you build equity faster to hit the 20% threshold. Even an extra $100/month can shave years off.

Pay Biweekly

Making half your normal payment every other week equates to an extra monthly payment per year, accelerating your amortization.

Refinance Your Loan

If home values have risen, you may be able to qualify for an 80% LTV refinance to drop PMI immediately.

Raise Your Credit Score

Some lenders will agree to cancel PMI if your score increases significantly, like from 680 to 740 or more.

Request an Appraisal

You can pay for an updated home appraisal to verify you have 20% equity based on appreciation if you’ve improved the home.

Wait It Out

Most homeowners reach 20% equity eventually through normal amortization after 5-7 years of payments. So patience pays off too.

What Impacts Interest Rates on Conventional Loans?

Many factors influence the mortgage rates lenders will offer you on a conventional home loan. Key factors include:

Your Credit Score and History

The higher your credit score, the lower the rate lenders will extend. Scores below 620 make financing difficult, while 740+ scores unlock the lowest rates.

The Loan Type

Fixed, ARM, jumbo, and low down payment conventional loans can have varied rate ranges. Government-backed loans typically have higher rates.

Loan Term Length

Shorter term loans of 15 or 20 years have lower rates than longer 30-year mortgages. You take on less interest rate risk over the shorter period.

Federal Reserve Rate Policy

When the Fed raises or lowers its benchmark interest rates, mortgage rates tend to follow over time. Lower federal funds rates allow lenders to set lower mortgage rates.

The Overall Economy

In slowing economies, rates fall as demand declines. When growth is strong, rates usually trend higher as borrowing and inflation increase.

Competition Among Lenders

When more lenders are competing for business, they may offer lower rates to win clients. Less competition can cause rates to be higher.

Shopping Multiple Lenders to Compare Quotes

Shopping mortgage lenders to compare interest rates and loan terms is crucial to getting the best conventional loan deal. Here are some tips:

Contact National Lenders

Large banks, credit unions, and mortgage lenders like Chase, Wells Fargo, and Rocket Mortgage let you easily compare quotes.

Check with Local Banks and Credit Unions

Community banks and credit unions may offer very competitive rates and personalized service.

Look at Online Lenders

Lenders like LoanDepot, LendingTree, and Better.com make shopping the market easy through their online rate comparison tools.

Compare All Costs and Fees

Look beyond just rates to factor in origination fees, discount points, and other costs that vary by lender.

Get Pre-Approved First

Having a pre-approval letter in hand shows sellers you can obtain financing and gets you accurate rate quotes.

Act Fast If You Find a Great Rate

Today’s quoted rate may change tomorrow. So lock in the rate once you find a competitive lender offer.

Casting a wide net and taking the time to shop ensures you get the best all-around conventional loan program.

Documentation Needed for a Conventional Mortgage

These key items will need to be provided to your lender to underwrite and approve a conventional loan:

Income Verification Documents

  • W-2s and tax returns for the last 2 years
  • At least 30 days of paycheck stubs
  • Two years of 1099s if self-employed
  • Proof of bonuses, overtime, and other income

Asset Statements

  • Two months of bank statements checking, savings, etc.
  • Retirement account balances (401k, IRA)
  • Documentation of gift funds being used
  • Two months of investment account statements

Liabilities and Credit History

  • Credit report and scores from all 3 bureaus
  • Written explanations for credit inquiries or issues
  • Statements showing monthly payments on credit cards, auto, student loans, etc

Property Documentation

  • Purchase contract and addendums
  • Home inspection report
  • Appraisal ordered by lender
  • Receipts for any renovations done

Identification Documents

  • Government-issued photo ID
  • Social Security card copy
  • Proof of legal residency if immigrant
  • Birth certificate or marriage license if name has changed

Providing complete documentation in a timely manner prevents delays so you can close as planned. Let your loan officer know if any required documents may be difficult to supply.

Conventional Loan Calculators

These handy calculators make it easy to estimate payments, costs, and scenarios when shopping for a conventional mortgage:

Loan Payment Calculator

Input your interest rate, loan amount, and term to estimate principal and interest. Helps gauge affordability.

PMI Calculator

Enter your loan amount, down payment percentage, and estimated PMI rate to see your monthly PMI costs.

Mortgage Affordability Calculator

Find the maximum loan amount you can afford based on income, debts, taxes, insurance, etc.

Mortgage Amortization Calculator

See how much equity you build each month and how loan balance declines over time as principal is paid down.

Closing Cost Calculator

Factor in all your estimated closing fees like origination, title, recording, etc. to budget for costs.

Refinance Calculator

Determine if refinancing will save money based on new rate, fees, loan amount, and time you plan to stay in home.

These tools help provide estimates as you evaluate different conventional loan options. Rely on your loan officer for final numbers tailored to your situation.

Frequently Asked Questions about Conventional Loans

What is the maximum loan amount for a conventional loan?

The current baseline conforming loan limit for a conventional loan is $647,200. Higher limits up to around $970,800 exist in more expensive metropolitan areas.

How much income do you need for a conventional loan?

There is no set minimum income, but your total monthly debts including the mortgage payment cannot exceed 43% of your gross monthly income. The more you earn, the easier qualifying becomes.

Can I get approved with a 600 credit score?

It will be very challenging with a score below 620. While possible with additional verified assets or a co-signer, you will pay higher rates and costs. Aim for at least a 640 FICO.

Do all conventional loans require PMI?

No, PMI is only mandatory if your down payment is less than 20% of the purchase price. With 20% or more down, no PMI is needed on a conventional loan.

Can I remove PMI early if home values rise?

Yes, if you can show through a new appraisal that your home value has increased enough so you now have 20% equity, lenders may agree to early PMI cancellation.

How long does underwriting take on a conventional loan?

For most borrowers with good credit submitting all documentation promptly, underwriting is usually complete within 2-3 weeks. It can drag on longer if information is missing or concerning issues arise.

Do conventional loans have prepayment penalties?

No, conventional loans do not impose any penalties or fees if you pay off your mortgage early through refinancing or paying additional principal.

What are points on a mortgage?

Points are upfront fees you pay to receive a lower interest rate when taking out a new loan. Each point equals 1% of the loan amount. Points help “buy down” the rate.

Can I use a conventional loan for a second home?

Yes, you can qualify for a conventional loan on a second home or vacation property. However, larger down payments around 10-20% are typically required, along with good credit and higher income ratios.

Are there conventional loans for investment properties?

Investment property mortgages are available through conventional lenders, often with at least 25% down, good credit, and solid cash flow from rent to cover the mortgage payments.

Conclusion – Key Takeaways on Conventional Loans

  • Conventional loans are the most common type of mortgage and meet the standards for purchase by Fannie Mae or Freddie Mac.
  • They offer competitive rates for buyers who qualify with good credit, income, and down payments of at least 3-20%.
  • Conventional mortgages provide more flexible qualifying than government-backed loans but come with stricter requirements.
  • Paying PMI is required with less than 20% down on a conventional loan until you build 20% equity.
  • Shopping lenders for the lowest rates and fees on a conventional loan is crucial to maximizing savings.
  • Conventional loans give borrowers many choices in terms of loan amounts, terms, types, and interest rate options.
  • With proper planning and preparation, a conventional loan can be an affordable financing option for purchasing or refinancing real estate.
  • Be sure to compare multiple lender quotes and get pre-approved to find the best conventional loan for your needs and budget.
  • Ask your loan officer plenty of questions and provide complete documentation for a smooth underwriting process.
  • Conventional mortgages offer home buyers flexible financing options with competitive interest rates assuming you meet the eligibility requirements.

So in summary, conventional loans are a stable choice for qualifying borrowers looking to finance home purchases or refinances with good rates and affordable payments. Just be sure to shop around and evaluate your options thoroughly before committing. With the right conventional mortgage, you can find an optimal balance of low rates, costs, and terms.

What is a Conventional Loan FAQ

Q : What credit score do you need for a conventional loan?

Ans : Most conventional loans require a minimum credit score of 620-700. However, to qualify for the best rates and terms, you typically need a score of at least 740 or higher.

Q : How long does it take to close on a conventional loan?

Ans : Closing often takes 30-60 days from the time you apply and get pre-approved. The exact timeline varies based on demand and how promptly you provide documentation.

Q : Do conventional loans have prepayment penalties?

Ans : No, conventional loans do not have any prepayment penalties if you pay off your mortgage early. You can pay down the principal or refinance whenever you want.

Q : Can you put less than 20% down on a conventional loan?

Ans : Yes, conventional loans allow down payments as low as 3-5% in most cases. But you’ll have to pay private mortgage insurance until you reach 20% home equity if less than 20% down.

Q : Is mortgage insurance required for all conventional loans?

Ans : No, PMI is only required on conventional loans with less than 20% down. If you put 20% or more as a down payment, no mortgage insurance is needed.

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