What is a conventional loan?

A conventional loan is one that a government agency does not guarantee. Conventional loans are classified as “conforming” or “non-conforming. The Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association (Fannie Mae) set lending guidelines for conforming to conventional loans. Non-conforming conventional loans, on the other hand, may offer some flexibility from some lenders.

Conventional loan requirements

Private mortgage lenders such as credit unions, banks, and other financial institutions originate and service conventional loans, and many of them also sell government-insured mortgage loans. Conventional loans, on the whole, lack some of the benefits of government-backed loans, such as low credit score requirements and no down payment or mortgage insurance. Even if you qualify for a conventional loan, your interest rate will be determined in large part by your credit score and credit history. The better your credit, the less interest you’ll pay over the loan’s life. Here are some conventional loans requirements:

  • A down payment of a minimum of 3%
  • A minimum credit score of about 620
  • A debt-to-income ratio lower than 43%

The conventional loan amount must also fall within conforming loan limits, which are up to $548,250 in most areas but can be higher in some high-cost residential areas. If you apply for a conventional loan with good credentials, such as a credit score of 740 or higher and a 20% down payment, you’ll be able to get lower rates and a lower monthly payment.

If you’re on the verge of qualifying for a conventional loan, with a credit score of around 620 and a lot of debt, shop around even more. Mortgage lenders can set their own criteria and rates for conventional loans as long as they stay within Fannie Mae and Freddie Mac conforming loan limits. As a result, you’ll most likely be able to find one that’s more accommodating and offers better rates for your needs.

>>More: Conventional loan requirements

Minimum down payment for a conventional loan

It’s a common belief that you need a 20% down payment for a conventional loan. However, a conventional mortgage requires a minimum down payment of 3%, but borrowers with lower credit scores or higher debt-to-income ratios may be required to put down more. A jumbo loan, or a loan for a second home or investment property, will almost certainly require a larger down payment.

Some Low-down-payment conventional loan programs are designed to assist first-time homebuyers who have good credit but limited savings. You’ll almost certainly be required to pay private mortgage insurance or PMI if you put down less than 20% on a conventional loan. There are six major mortgage options for a conventional loan down payment requirements, ranging from 3% to 20%, and they include:

  • Piggyback loan (no PMI) — 10% down
  • Fannie Mae HomeReady loan — 3% down
  • Conventional loan without PMI — 20% down
  • Conventional 97 loan — 3% down
  • Conventional loan with PMI — 5% down
  • Freddie Mac Home Possible loan — 3% down

So, how do you get approved for a conventional loan? Simply by meeting Fannie Mae and Freddie Mac’s requirements. Once you’ve done that, you’ll be able to join the 69 % of homeowners who have a conventional loan.

The 20% down payment myth

When buying a home, the 20% down payment rule of thumb is a good way to keep your costs in check. Your lender will ask for private mortgage insurance if you put less than 20% down on a conventional loan (PMI). If you default on the loan, this coverage protects the lender.

PMI does raise mortgage payments on a monthly basis. But that’s fine if it means you can get a conventional loan with a manageable down payment. Also, keep in mind that traditional PMI can be canceled once your home has at least 20% equity. So you won’t be stuck with it indefinitely.

Conventional loan rates

Conventional loans have low-interest rates, making home ownership more affordable. For a 30-year, fixed-rate mortgage, which is the most common type, the current average rate is 3.125 % (3.125 % APR).

The average rate for a 15-year conventional loan is 2.625 % (2.625 % APR). Conventional loan rates are more heavily influenced by the applicant’s credit score than FHA loan rates. A home buyer with a 740 credit score and 20% down payment, for example, will be offered a 0.50 % lower rate than a buyer with a 640 credit score.

Rates can also be based on mortgage-backed securities (MBS) and can be traded like stocks. And just like stocks, conventional loan rates change daily and throughout the day. Here a few tips on how to get the cheapest rates:

Watch the markets to lock in the lowest rate.

Conventional loan rates can be affected by a lot of things, especially financial news, events, or even governmental policies. This can be exemplified by how the COVID-19 news made all loan rates drop last year due to the federal reserve decision to reduce the federal funds rate to increase spending.

So conventional rates can rise or fall. For a long time, 30-year fixed conventional loan rates have been below 3.5 percent, and they are unlikely to rise above that level in the near future.

Those who are ready to lock in when rates drop can still get the best deals. Any applicant who has been approved for a mortgage and has chosen a property to purchase can lock in a rate.

Shop around with at least three different lenders

Finally, it’s critical to obtain a customized rate quote.

The “ideal” applicant — one with excellent credit and a substantial down payment — is often used to calculate published rate averages. Your rate may be higher or lower.

No matter what loan duration or conventional loan type you want, it’s a good idea to get at least three written quotes from different lenders. According to one government survey, applicants who shop around earn up to 0.50 percent lower than those who do not shop around.

Get a traditional rate quote based on your details rather than that of a typical customer.]

Benefits of a conventional home loan

The most common type of mortgage is a conventional loan. Following that are government-backed loans, such as FHA, VA, and USDA loans. Small down payments and flexible credit guidelines are two advantages of government-backed mortgages. First-time homebuyers frequently require this kind of wiggle room.]

However, conventional loans can outperform government-backed mortgages in a number of ways. Conventional mortgages, for example, offer a variety of repayment options, don’t require borrowers to meet any “special” criteria (such as military status or geographic location), and don’t charge an upfront mortgage insurance fee.

Flexible repayment plans

Conventional loans, like most mortgages, have a variety of repayment options. Conventional loans are available in terms of 15, 20, 25, and 30 years. Some lenders even offer conventional 10-year loans. Your monthly payment will be higher if your loan term is shorter. Fortunately, the majority of home buyers and refinancers can still qualify for a 30-year fixed-rate conventional loan with low fixed-interest payments.

Adjustable rates available

Conventional loans are also a good option for those who know they won’t be staying in their home for long and want an adjustable-rate mortgage with a shorter term. A variable-rate loan has a lower interest rate than a fixed-rate loan.

Adjustable rates are fixed for a set period of time, usually three, five, or seven years. The homeowner pays ultra-low interest and can save thousands during the initial “teaser” period.

Today’s homebuyers frequently opt for a 5-year or 7-year ARM. These loans can save a home buyer thousands of dollars while giving them time to refinance into a fixed-rate loan, sell the house, or pay off the mortgage completely.

However, once the low introductory rate on a loan expires, the interest rate — and monthly mortgage payment — may decrease or increase each year, depending on market conditions. As a result, ARM loans are inherently risky for homeowners and should be approached with caution.

No special requirements to qualify

In some ways, conventional loans are the least restrictive of all loan types. Conventional loans, unlike government-backed mortgages, have no special requirements. Anyone with a good credit score, a steady income, and enough money for a moderate down payment can apply. Government-backed loans serve a specific purpose and are subject to a number of restrictions:

USDA loans are meant for those who want to buy properties in designated rural areas. This is excellent for homebuyers who live, work or want to buy houses in suburban and rural locations. But the USDA loans are not available for those who want houses in urban areas.

VA loans are available only to current spouses and veterans of military service members. They provide a lot of benefits, like no monthly mortgage insurance, zero down payment. But they are only designed for a particular part of the population.

FHA loans are a popular way to buy a home, but they come with high mortgage insurance fees that must be paid for the life of the loan, which can be up to 30 years. The only way to get rid of FHA mortgage insurance is to refinance out of the loan, which means you’ll have to pay closing costs all over again.

Furthermore, most federal government loan programs are not available for second homes or investment properties. They’re intended to assist Americans in purchasing single-family homes for a primary residence.

When choosing a conventional loan for a home purchase, first-time and repeat buyers can get a good deal. And, contrary to popular belief, more buyers qualify for this loan than you might think.

No upfront mortgage insurance fee

Even if the buyer puts less than 20% down, conventional loans do not require an upfront mortgage insurance fee. FHA, USDA, and even VA loans require an upfront insurance fee, typically between 1% and 4% of the loan amount.

Only when the homeowner puts down less than 20% does a conventional loan require a monthly mortgage insurance premium. Furthermore, if you have good credit and a sufficient down payment, conventional mortgage insurance may be less expensive than government loans.

How do you qualify for a conventional loan?

Many home buyers believe it is too difficult to qualify for a conventional loan, especially if their financial situations aren’t ideal. However, this is not the case. Qualifying for a conventional loan, just like qualifying for a government-backed loan, requires you to demonstrate:

  • You earn enough money to meet your monthly obligations.
  • It is expected that your earnings will continue.
  • You have the necessary funds to make the required down payment.
  • You have a decent credit score and a good credit history.

True, conventional loan requirements are slightly higher than those for FHA or VA loans. However, they are still sufficiently flexible to allow most homebuyers to qualify.

Credit score

Before you do anything else, it’s critical to understand your credit situation. You’ll have a better chance of getting approved for a conforming conventional loan if your credit score is 620 or higher. And if it’s in the mid-to-upper-700s, you’ll have a better chance of getting a new loan with favorable terms.

You should begin taking steps to improve your credit score if it isn’t where you want it to be. This includes paying bills on time (and catching up on late or collection accounts), paying off credit card debt, avoiding unnecessary borrowing, and more.

If you’re not sure where to begin, obtain a copy of your free credit report to assist you in determining which areas require attention. It takes time to improve your credit, but it can save you tens of thousands of dollars in interest over the course of a mortgage loan.

Employment and income

Lenders today want to make sure they’re only lending to people who have a stable job history. Not only will your lender want to see your pay stubs, but he or she may also call your employer to confirm that you are still employed and to inquire about your salary. If you’ve recently changed jobs, your previous employer may be contacted by a lender. Self-employed borrowers will have to provide a lot more paperwork about their business and income. These documents may include, but are not limited to, the following:

  • Pay stubs from the previous thirty days, as well as year-to-date earnings
  • Federal tax returns from the previous two years
  • Sixty days’ notice or a quarterly statement of all asset accounts, including your checking, savings, and investment accounts.
  • W-2 statements for the past two years
  • Borrowers must also have proof of any other sources of income, such as alimony or bonuses

Property value

A lender will not approve a mortgage for a sum greater than the home’s value. The lender will appraise the property before closing on the loan to determine its value.

Let’s say a buyer has agreed to pay $250,000 for a home, but the appraisal comes in at $200,000, as an example. In this case, the home buyer should use the appraisal as a bargaining chip to persuade the seller to reduce the price to a level that the lender will approve.

Alternatively, the buyer could pay the extra $50,000 out of pocket to make up for the lower loan limit. This $50,000 would be added to the deposit you’d already agreed to put down. For example, if you put down 20% on a $250,000 home, you would have $50,000. The appraised value, on the other hand, is $200,000. You’d have to put down 20% of the new value, or $40,000, plus the $50,000 difference in value, for a total of $90,000. On the other hand, conventional loans have fewer appraisal and property requirements than FHA, VA, or USDA loans. Another benefit of conventional financing is that you can qualify for a home in slightly poorer condition and plan to make repairs after your loan is approved and you move in.

Down payment

The amount of the down payment has an impact on the interest rate and total loan costs. Monthly mortgage costs will be lower if you put down a larger deposit.

Conventional mortgage insurance is also eliminated with a down payment of at least 20%. FHA and USDA loans, on the other hand, require mortgage insurance regardless of the amount of money you put down

Seven low-down-payment conventional loans

Conventional Loans with 3% down

Many conventional loans can be obtained with as little as a 3% down payment. One such option is the HomeReady mortgage program. It allows non-borrowing family members to assist the loan applicant in getting approved. Even if they are not officially on the loan file, lenders will consider the income of mothers, fathers, extended family, and non-married partners.

As the name implies, the Conventional 97 allows home buyers to borrow 97 percent of the purchase price. Unlike the HomeReady option, these loans are available to applicants of any income level who are purchasing a home in any location. The drawback to a 3% down loan? Compared to a conventional loan with a 5% or 10% down payment, the interest rate may be higher. Mortgage insurance may also be more expensive.

Avoid PMI with an 80/10/10 loan.

The piggyback 80/10/10 loan option allows the borrower to forego the full 20% down payment as well as mortgage insurance.

How do you do it? The buyer applies for a first mortgage worth 80% of the total purchase price. Simultaneously, he or she takes out a second mortgage for 10% of the purchase price, such as a home equity line of credit (HELOC).

Then, because the lender allows the borrowed 10% loan to count toward the applicant’s down payment, only a 10% down payment in cash is required. The second mortgage and cash put down a total of 20%, obviating the need for mortgage insurance premiums.

Sourcing your down payment

A borrower who takes out a conventional loan can put down anywhere from 3% to 20% or more.

Furthermore, in some cases, a down payment gift can cover the entire amount. Gift and donor documentation requirements should be discussed with your loan officer.

Unless the down payment is a gift, the applicant must show proof of a valid source of funds, such as a savings or checking account. Applicants can liquidate their investment accounts or take out a 401(k) loan to help with the down payment. In most cases, home buyers will be required to provide a 60-day history for any account used to make a down payment.

Private mortgage insurance (PMI)

Any conventional loan with a down payment of less than 20% requires private mortgage insurance or PMI. The cost of private mortgage insurance (PMI) varies a lot depending on your credit score and down payment. For example, as of this writing, one PMI company is offering the following rates for a $250,000 loan with a 5% down payment:

  • 740 credit score: $123 per month
  • 660 credit score: $295 per month
  • And these are quotes for a 10% down payment:
  • 740 credit score: $85 per month
  • 660 credit score: $208 per month

Many buyers opt for an FHA loan due to higher mortgage insurance premiums for borrowers with lower credit scores.]

FHA loans, unlike conventional loans, do not charge higher mortgage insurance rates, even if the applicant has a low credit score. The mortgage insurance company itself may have an impact on your PMI rate.

Your lender will typically select your PMI provider, and different providers may charge different rates. You do, however, have some input into the decision. Ask your lender if they work with a particular PMI company that offers the best deal.

If not, the lender might provide a similar offer from a different PMI provider, or you can choose a lender that works with your chosen mortgage insurance company.

Conventional loan limits

The national conventional loan limit is $548,250, but many areas have higher limits. For example, in certain high-priced ZIP codes, Fannie Mae and Freddie Mac allow a loan amount of up to $822,375. Homebuyers who require a loan amount greater than the standard limit should check their area’s specific limit. Non-conforming loans are those that exceed a region’s conventional loan limits. Instead of a conventional loan, these require a jumbo loan.

Debt-to-income ratio

The buyer’s debt-to-income ratio (DTI) is also taken into account when applying for a conventional loan. The debt-to-income ratio (DTI) compares your total monthly debts (including mortgage payments) to your gross monthly income. This figure is used to determine how much of a mortgage payment you can afford on a monthly basis.

Many lenders prefer a ratio of less than or equal to 36% of the borrower’s income. Conventional loans, on the other hand, may allow a DTI of up to 43 percent. To calculate your debt-to-income ratio, add all of your monthly loan payments together, including:

  • Credit card minimum payments
  • Your projected mortgage payment
  • Student loans
  • Car loans
  • Personal loans
  • You should also include your child support or alimony payments and then divide this total by your monthly gross (pre-tax) income.

Closing costs

Closing costs can include fees such as a lender’s origination fee as well as vendor fees such as appraisal, title insurance, and credit reporting fees. Depending on the strength of the market and the desire to close the transaction, a lender or seller may pay all or some of these costs. Check to see if your preferred lender offers lender credits, and double-check that any seller contributions meet Fannie Mae and Freddie Mac’s requirements. Based on the home price and down payment amount, sellers and other interested parties can typically contribute the following amounts:

  • Less than 10% down: 3% of the purchase price
  • More than 25%: 9% of the purchase price
  • 10 to 25% down: 6% of the purchase price
  • With a rental or investment property, the seller can contribute only 2% of the purchase price toward closing costs.

Conventional loan vs. government loans

Today’s homebuyers have a plethora of mortgage loan choices. Mortgages, on the other hand, may be classified into two types: government-backed loans and traditional loans.

A conventional loan is always the best option if you have good credit (680+) and a high down payment (5 percent or more). A government loan will help if you have bad credit or a small down payment. However, those aren’t universal guidelines. The best form of mortgage for you will be determined by your budget, credit score, and home-buying objectives. Here’s a quick rundown of the differences between traditional and government loans, as well as who they’re best for:

Conventional loans — People with credit scores over 680 and down payments of 5% or more are more likely to qualify for privately funded loans. On the other hand, conventional loans are available with credit scores as low as 620 and as little as a 3% down payment.

Jumbo loans — For those looking to purchase a high-priced house, jumbo loans are the best choice. In most cases, this covers any loan sum greater than $[conventional loan limits]. A credit score of 700 or higher is usually needed for a jumbo loan.

FHA loans — The Federal Housing Administration backs FHA loans. They’re typically better for people with credit scores of 580-680 and a 3.5 percent down payment.]

VA loans — For eligible veterans and service personnel, VA loans are almost always the best option. They allow you to purchase a home with no money down, very low-interest rates, and no monthly mortgage insurance.

USDA loans — In some rural and suburban areas, these zero-down loans are available. They’re designed for low- to moderate-income homebuyers, and interest rates are usually lower than the market. If you’re not sure which loan is right for you, do some research or talk to a loan officer about what you may be eligible for.

Bottom line

Finding a mortgage lender and filing an application for a traditional loan are both straightforward processes that can be completed online in most cases. Find the budget based on how much you can afford on a monthly basis before getting preapproved.

Then, once you have a preapproval letter in hand, you may begin looking for a home. Bear in mind that the mortgage lender who sent your pre approval letter isn’t your spouse. In reality, applying with several lenders to compare rates and terms is a good idea.

When you search for the best deals and apply for a mortgage with multiple lenders in a short period of time—usually 30 days—your FICO® Score will combine all of the inquiries on your credit report into one, minimizing the damage to your credit score. The mortgage process can take a long time from start to finish, but following each step highlighted can help you get the best deal for your situation.

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