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Conventional Loans: An In-Depth Guide

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In this article, you'll learn the ins and outs of conventional home loans, and how they differ from government-backed mortgages like the VA loan, USDA loan and FHA loan.

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Conventional loans are among the most popular home loan options because they work for a wide range of buyers and can be used for a wide range of residential properties. But what, exactly, is the definition of a conventional loan? How is it different from other loan types? And is a conventional loan the best mortgage option for you?

What Exactly is a Conventional Loan?

A conventional loan is a mortgage loan that is not insured by a federal agency. In other words, any loan that isn’t backed by a specific government entity (like the VA, FHA or USDA) qualifies as a conventional loan.

Conventional Loan Eligibility

Since conventional loans aren’t insured by the government, lenders generally have strict credit and income requirements for conventional loan borrowers. Lenders need to make sure you’re able to repay your loan since they won’t be able to recover their investment from a government entity if you default on the loan.

Specific eligibility requirements vary by lender, so it’s important to compare multiple lenders and find the right match for you. Generally speaking, you’re most likely to be eligible for a conventional loan if:

  • You have good credit. Lenders like to see at least a 620 credit score for a conventional loan.

  • You can put at least 3% down. If you can come up with a larger down payment, you can probably get a better interest rate. And if you can put 20% down, you can save yourself from the added monthly expense of Private Mortgage Insurance (PMI).

  • Your debt-to-income ratio (DTI) is around 36%. Your DTI ratio is the amount of your current debt payments as a percentage of your current income. Around 36% is generally acceptable, but the requirement can be more or less depending on your credit and down payment amount.

What’s the Difference Between Conventional and Government-Backed Loans?

The primary difference between conventional and government-backed loans is that the federal government does not insure conventional loans.

A few government-backed loans were created to serve different buyers or different residential property types.

Let’s look at some of the most common government-backed loan types.

VA Loans

Specifically designed for military service members and Veterans, VA loans are backed by the Department of Veteran Affairs.

FHA Loans

Insured by the U.S. Department of Housing and Urban Development (HUD), FHA loans are known for helping first-time homebuyers get on the property ladder. But even if you’ve owned a home before, you might qualify as a first-time homebuyer for FHA purposes (for example, if you owned a home with an ex-spouse or you haven’t owned a primary residence in the last three years).

The primary benefits of an FHA loan include:

  • Relaxed income and credit requirements (which makes this a good option for buyers with credit scores on the lower side),

  • Down payment options as low as 3.5% with acceptable credit, and

  • Down payment assistance programs for qualifying borrowers.

USDA Loans

USDA loans are backed by the United States Department of Agriculture with the goal of helping buyers with low-to-moderate income purchase homes in rural communities. If you’re planning to use a USDA loan, your home options are limited to those located in qualifying rural areas.

But if you find a qualifying home and meet the USDA’s income and credit requirements, you can take advantage of:

  • A $0 down payment,

  • Below-market interest rates, and

  • No loan limits.

Which Home Loan Type is Better?

One loan type isn’t inherently better than any other loan type. It’s more about which loan type works best for your unique needs and goals. If you’ve served in the military or are currently serving, a VA loan might work best for you. If you have some credit issues, an FHA loan might be your best option. And if you have good credit and at least 3% down, you might want to go with a conventional loan.

What Types of Conventional Loans Are There?

Conventional loans fall into one of two primary types: conforming loans and non-conforming loans. Conforming loans “conform” to the loan standards set by the Federal Housing Finance Agency (FHFA) for Fannie Mae and Freddie Mac. Without getting into too much detail, Fannie and Freddie are government-affiliated entities that purchase mortgages from lenders and then sell those mortgages to investors. This secondary mortgage market allows lenders to free up cash so they can get more buyers into more homes. And if a loan conforms to Fannie and Freddie’s standards, the lenders know they’ll be able to sell the loan to Fannie or Freddie.

Conventional conforming loan types are:

  • Fixed-rate: your interest rate will remain the same through the term of the loan.

  • Adjustable-rate (ARM): your interest rate will increase and decrease as market rates fluctuate.

Loans that don’t meet FHFA standards are called non-conforming loans. Non-conforming loans are riskier for lenders because they can’t sell these loans to Fannie Mae or Freddie Mac. So lenders usually charge higher interest rates on these loans to offset the extra risk.

Conventional non-conforming loan types include:

  • Jumbo loans: when a lender allows you to borrow more than the FHFA loan limits.

  • Portfolio loans: when a lender offers more flexible loan terms than the FHFA allows, knowing that they will keep the loan in their portfolio rather than selling to Fannie Mae or Freddie Mac.

  • Subprime loans: when a lender agrees to loan money to a borrower with an excessively high debt-to-income ratio or a particularly low credit score.

Is a Conventional Loan Good?

For the right homebuyer and the right property, conventional loans are an excellent option, especially for those with solid credit scores and minimal debt. Conventional loans offer:

  • The flexibility to choose your property type. Luxury estates, second homes and investment properties can all be purchased with a conventional loan.

  • The ability to cancel your PMI when you gain enough home equity.

  • $0 program fees (unlike government-backed loans which charge fees of 1-2%, depending on the program).

  • More flexible loan terms. Choose the length of your fixed-rate mortgage or opt for an ARM you’ll likely have more options with conventional loans.

Find Your Lender Today

Getting a preapproval letter from a lender is the first step toward buying your new home. Not only does your preapproval tell you how much you can afford to spend on a home, but when you’re ready to make an offer on a home, this letter will show the seller that you can qualify for a home loan, which makes your offer more attractive.

Whether you end up choosing a conventional loan or a government-backed loan, we can help you find a lender to make your homeownership dreams a reality.

Written by:
Kelly Ranft
Loan Officer Development NMLS #1728619

Kelly’s extensive background in the banking industry and bachelor’s degree in finance helps her serve as an FHA and Conventional home loan expert while co-leading Paddio’s production training team.

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