When you start exploring home loans, you’ll quickly encounter a variety of options, but none are more common than the conventional mortgage. Think of it as the standard, market-rate loan for homebuyers. Unlike loans backed by the government, a conventional loan is a direct agreement between you and a lender, making your financial health the most critical factor for approval.
How Conventional Mortgages Work
At its core, a conventional loan is a mortgage that meets the funding criteria of two government-sponsored enterprises: the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These organizations buy mortgages from lenders, which frees up cash for the lenders to issue more loans, keeping the housing market liquid.
Because of this system, conventional loans are often categorized in two ways:
- Conforming Loans: These loans “conform” to the size limits and standards set by the Federal Housing Finance Agency (FHFA). If your loan amount is at or below the conforming loan limit for your area, it can be purchased by Fannie Mae or Freddie Mac.
- Non-Conforming (Jumbo) Loans: If you need to borrow more than the conforming limit, you’ll need a non-conforming or “jumbo” loan. These loans cannot be sold to Fannie or Freddie, so lenders set their own stricter requirements.
What Are the Requirements to Qualify?
Because the government doesn’t insure these loans, lenders take on more risk. To qualify, you generally need to demonstrate strong financial stability.
- Credit Score: Most lenders look for a minimum credit score of 620. To secure the most competitive interest rates, a score of 740 or higher is recommended.
- Down Payment: While a 20% down payment helps you avoid extra costs, it’s not always required. Many conventional loan programs allow for down payments as low as 3-5%, especially for qualified first-time homebuyers.
- Debt-to-Income (DTI) Ratio: Your DTI ratio compares your total monthly debt payments to your gross monthly income. Lenders typically look for a DTI of 43% or less, though some programs may allow for a DTI up to 50%.
- Assets and Income: You must provide proof of a stable, verifiable income and show you have enough cash reserves to cover the down payment and closing costs.
Understanding Private Mortgage Insurance (PMI)
If you make a down payment of less than 20% on a conventional loan, your lender will require you to pay for Private Mortgage Insurance (PMI). PMI is an insurance policy that protects the lender—not you—in case you default on your payments.
The good news is that PMI on a conventional loan is temporary. You can request to have it canceled once you have built 20% equity in your home. By law, lenders must automatically terminate PMI once your loan balance drops to 78% of the original property value. For more details, you can review the guidelines from the Consumer Financial Protection Bureau.
Is a Conventional Loan Right for You? Pros and Cons
Pros:
- Lower Borrowing Costs: For borrowers with strong credit, conventional loans often have lower interest rates and fees compared to government-backed loans.
- Cancellable Mortgage Insurance: Unlike FHA loans, the PMI on conventional loans can be eliminated, which lowers your monthly payment over time.
- Loan Flexibility: Conventional loans can be used to finance a primary residence, a second home, or an investment property.
Cons:
- Stricter Qualification Standards: They typically require a higher credit score and a lower DTI ratio than government-backed alternatives like FHA loans.
- Larger Down Payment May Be Needed: While low down payment options exist, you often need a more substantial down payment to secure the best terms and avoid PMI.
Frequently Asked Questions (FAQs)
1. Do I absolutely need a 20% down payment for a conventional loan?
No, this is a common myth. Programs like Fannie Mae’s HomeReady and Freddie Mac’s Home Possible offer conventional loans with down payments as low as 3%. However, a down payment under 20% will require you to pay for PMI.
2. How is a conventional loan different from an FHA loan?
A conventional loan is funded without a government guarantee and requires stronger credit, while an FHA loan is insured by the government, allowing for lower credit scores and a smaller down payment. The downside to FHA loans is that their mortgage insurance premium often lasts for the entire loan term.
3. Can I get a conventional loan with bad credit?
It is very difficult. With a minimum credit score requirement of around 620, a conventional loan is not designed for borrowers with poor credit history. An FHA loan is often a more suitable starting point in this situation.