Buying a home is a huge milestone that many look forward to. This exciting time includes buyers who are looking for a larger home, their first home, a vacation home, or even a place to downsize once their children leave the nest. Among the various financial options, conventional loans stand out as one of the most popular and flexible choices for homebuyers. Homebuyers should consider that not all home loans are the same, and they often come in different types and with unique terms.
Generally, homebuyers seek a mortgage loan (also referred to as a home loan) that offers flexibility, competitive interest rates, reasonable terms, and manageable payments. Because of this, conventional loans are often their top choice when selecting a loan product.
What is a Conventional Loan?
While there are many different types of home loans available, the conventional loan is one of the most popular options on the market today. Homebuyers can be preapproved for a conventional loan through a private lender, such as a credit union, bank, mortgage broker, or similar institution.
Conventional loans are not government-backed, meaning they are not guaranteed by the federal government. Instead, they are secured by the real estate that will be used as collateral if the homeowner defaults on the loan.
With over 70% of new home loans being conventional loans, according to the US Census, this loan type has helped millions of homeowners leverage the financing needed to buy real estate. The conventional loan option provides more flexibility, so long as it adheres to the guidelines of Fannie Mae and Freddie Mac. However, unlike other major loan products, conventional loans are not backed by the US Federal Government, and because of this, lenders have more flexibility to set their own terms and options.
Qualifying for a conventional loan can be more challenging for some applicants than for other types of loans. Since the loan is technically riskier, conventional loans require applicants to have a higher credit score, typically no lower than 620.
Applicants with higher credit scores, particularly those above 780, will secure more favorable loan terms and interest rates. Applicants will also require a higher down payment, a lower debt-to-income ratio, and proof of savings compared to other loan options.
Types of Conventional Loans
There are two types of conventional loans in the market today. Homebuyers can choose from:
- Conforming Loans
- Non-Conforming Loans
Conforming Loans
Conforming loans are the most popular type and what we typically think of when looking for a conventional loan, with max loan amounts capping at $766,500 in most areas (excluding high-cost counties).
While it is recommended to save 20% for a down payment, that is not usually necessary. Depending on your state and lender, you might be able to secure a conventional loan with as little as a 5% down payment, so long as you pay an additional monthly fee called the Private Mortgage Insurance (PMI).
Conforming loans can be either fixed-rate or adjustable-rate mortgages. The Consumer Financial Protection Bureau explains that both describe how the interest rate will behave throughout the loan: one is fixed, while the other changes as the federal interest rate fluctuates.
Fixed-Rate Loans
Many homebuyers prefer fixed-rate loans because they maintain a steady interest rate throughout the payment schedule. This creates more consistency across monthly payments for homebuyers, allowing them to predict their monthly payments with little to no surprises.
Adjustable-Rate Mortgages (ARMs)
Loan interest rates move with the market in adjustable-rate mortgages, or ARMs. Typically, at the beginning, homebuyers experience lower interest rates; however, as the payment schedule progresses and the federal interest rate changes, homeowners may see their monthly payment change, sometimes even drastically.
Before taking out an ARM, homebuyers should ask their lender:
- How often will their rate change?
- What will their payments look like if there is a change? How much will that be?
- Is there a cap on how much the interest rate can go up or down?
Most importantly, homebuyers seeking this type of loan should ensure that they can still afford their mortgage if the interest rate ever reaches the highest possible cap.
Non-Conforming Loans
According to Investopedia, unlike conforming loans, non-conforming loans are available in only certain areas. These loans can exceed the maximum amount of conforming loans, but they are usually tough to sell because they do not adhere to the guidelines that allow them to be resold to Fannie Mae or Freddie Mac.
For this reason, this loan type is not popular with lenders; however, if they find themselves in a position to offer it to a homebuyer, they will generally offer the loan with a higher interest rate.
Despite this, non-conforming loans can be an excellent option for applicants who would not qualify for a conforming loan. Here are some examples of what would cause an applicant to seek preapproval through a non-conforming loan:
- A lower credit score
- An applicant has events in their credit history
- Does not have the right amount of down payment
- Has a high debt-to-income ratio
The Pros and Cons of Conventional Loans
Homebuyers should understand the benefits and potential disadvantages associated with a conventional loan.
Pros of Conventional Loans
- Conventional loans are one of the most popular loan products for a reason. They usually come with lower costs, competitive interest rates, flexible loan options, and the ability to be used with different property types. This type of loan can also close much faster than other types, as many sellers prefer it and it involves fewer steps to complete the closing process.
- Additionally, unlike government-backed loans such as FHA and USDA loans, conventional mortgages offer a cancellable PMI, which helps save thousands of dollars in the future, as there is no need for refinancing. Homeowners can hold onto the same loan for the full 30-year term, even if they start the payment schedule with a PMI attached.
Cons About Conventional Loans
- Just as conventional loans offer great benefits, they also have their downside. Unlike government-backed loan options, conventional loans require a higher credit score from applicants. For example, instead of a minimum credit score of 500, which is typically required to qualify for an FHA loan, applicants need a minimum credit score of 620. Applicants seeking better terms will need a credit score significantly higher than the minimum.
- In addition to a higher credit score, down payment requirements tend to be larger. The average person with a conventional loan typically puts down at least 5% to 10%, rather than the 3.5% or no down payment required by other mortgage programs.
- Homebuyers who put down less than 20% will be required to pay a monthly PMI that accounts for approximately 1% of the loan amount, which will continue to apply as long as they owe 80% or more of the original loan amount.
Consider Conventional Loans for Your Next Real Estate Purchase
Many homebuyers find that conventional mortgage loans are the most straightforward way to purchase real estate. It is popular, available, and can come with favorable terms if you meet the qualifications. Whether it is a conforming or non-conforming loan, with a fixed or adjustable interest rate, you can discuss with your lender to find the loan and terms that best fit your financial profile.
