Conventional Loans: A Complete Guide
A conventional loan or conventional mortgage is a type of home loan offered by a private lender, as opposed to a government-funded organization. They are one of the better options available to home buyers, but they may be out of reach for many borrowers due to the strict criteria.
In this guide, we’ll discuss that criteria and tell you what you need for a conventional mortgage and what alternative options are available.
What is a Conventional Loan?
There are several types of mortgage and they all have different criteria regarding credit scores, credit histories, debt-to-income ratio, and down payments.
There is a lot of confusion regarding these mortgage types, as is often the case when multiple options present themselves. Conventional loans are often confused with FHA loans, which are a type of government-backed mortgage that we’ll discuss in more detail below. More frequently, they are confused with conforming loans.
A conforming loan is one that meets the terms and conditions set by Freddie Mac and Fannie Mae, conditions that include maximum loan limits. All conforming loans are conventional loans, but not all conventional loans are conforming loans, which is where the confusion lies.
As an example, jumbo loans are conventional loans, but because they allow for large loan limits, they do not “conform” to the terms set by the aforementioned agencies and are therefore classed as non-conforming loans.
Requirements for a Conventional Loan
Conventional loans account for roughly 70% of all mortgages in the United States. The borrower is tasked with meeting several demands and must have a relatively clean credit report, a respectable credit report, and a high down payment (although not always). The necessary documents and stages include:
Proof of Income
The lender needs confirmation that you can afford to meet the monthly payment and typically requests that your payments don’t exceed 28% of your gross income. They will ask for four weeks of pay stubs, two years of tax returns and W-2 statements, and a quarterly statement from bank accounts and savings accounts.
If you have any additional income that you want to be considered, including bonuses, investments or alimony, you must provide proof of this as well.
The next step is to prove that you have the necessary funds to make the down payment and cover the closing costs. If you were given money by a friend or relative, they need to provide gift letters which state that the money was a gift and you are under no obligation to pay it back.
The lender is simply seeking proof that you have the money and got it by saving or as a gift, as opposed to acquiring additional debts and responsibilities.
Proof of Employment
Your lender may dig deeper into your employment history to ensure you have a stable job and no history of employment issues. They may phone your current or previous employer or request additional proof.
The lender will ask for your Social Security number and identification. They will also pull your credit report and check your credit score. This needs to be above a certain amount before you can be considered for the mortgage.
Pros and Cons of a Conventional Home Loan
A borrower needs a good credit score and a sizeable down payment to make a conventional loan work for them. If so, it can be one of the best mortgage options and offer some fantastic mortgages rates. However, there are some downsides to consider, ones that may make an FHA, VA or USDA loan a better option.
Pro: Multiple Rate Options
With a conventional loan, you can opt for a fixed-rate loan, an adjustable-rate mortgage or a hybrid. There are many more options for your mortgage; you can discuss the most suitable one with your mortgage broker or lender.
Pro: Lower Closing Costs
Your down payment isn’t the only cost to consider—closing costs charged upon settling the loan can set you back several thousand dollars, depending on the lender and the money borrowed. However, a conventional mortgage has fewer closing costs, making that seemingly unscalable mountain much easier to climb.
Pro: Strong Position
If you have a 20% down payment, you’re in a very strong position as a borrower. Lenders will compete for your business and you can compare mortgage loans with low monthly payment obligations.
A 20% down payment takes a massive chunk out of the house price and means you need a much smaller mortgage loan. Combine this with a strong credit score and you can secure some very favorable rates.
Con: Down Payment Restrictions
It is possible to get a mortgage with a down payment of just 3%, but these come with strict criteria and higher interest rates. You’ll need a down payment of 20% to avoid this and while that can provide you with some very favorable interest rates, it’s also a lot of money to pay, especially for first-time homebuyers.
Con: Private Mortgage Insurance
Private mortgage insurance is added to conventional mortgages that don’t meet the 20% down payment requirement. This can be charged at between 0.55% and over 2% of the loan value every single year. The money is added to the mortgage payment every month and the held in Escrow by the lender, before being released at the end of the year.
Private mortgage insurance protects the lender against defaults and stops when you reach a 20% equity. By paying a 20% down payment, you’re essentially covering this cost straightaway and negating the need for the insurance.
Con: High Credit Score Requirements
You’ll need a high credit score and a good debt-to-income ratio to get a conventional mortgage. These requirements also exist for government-backed loans, but they are much more forgiving.
Types of Non-Conventional Loans
If your financial situation won’t allow for a conventional loan, there are a few other options to consider:
An FHA loan is backed by the Federal Housing Administration and has down payments of between 3.5% and 10%, with the higher offered to individuals with a credit score of between 500 and 580 and the lower offered to those with scores of 580 or more. As always, affordability will also be factored into the equation.
A VA mortgage is offered to veterans of the armed forces, as well as their families. A down payment is not required and they are guaranteed by the Department of Veteran Affairs. However, they have strict terms that the borrower needs to meet.
A Piggyback or Combo mortgage helps individuals to meet the 20% down payment by taking out an additional loan. This allows them to avoid paying private mortgage insurance, but it also creates an additional debt and is very rarely the best option.
Balloon Payment Mortgage
With a balloon mortgage, you make interest-only payments for a specific period of time and then cover the principal in its entirety. It’s a rare mortgage option and one that clearly won’t suit everyone.
Summary: Conventional Mortgage Loans or Not
Conventional loans are very common and for lenders with substantial down payments, they are a great way to purchase a home. A 20% down payment can help you to secure a low fixed-rate mortgage and keep your loan-to-value ratio high, thus increasing your chances of securing an equity option—like a cash-out refinance mortgage—in the future.
However, if you can’t cover that down payment and are struggling, a private lender might not be the way to go. Look into government-backed mortgage loans, assess your options, and do your sums.
You may find that it’s better to wait for a year or two, during which time you can build your credit score, save more money, and secure a favorable fixed-rate loan. Take a look at our guide on the best time to buy a home if you need a little incentive to wait and want to improve your chances of getting a great deal.