What is a conventional mortgage loan?
The mortgage industry is rife with jargon and acronyms, from LTV to DTI ratios. One term you’ll hear sooner or later is “conventional mortgage loan.”
It sounds boring, but it couldn’t be more important. Unless you’re a veteran, live in a rural area, or have poor credit, there’s a good chance you’ll need to apply for a conventional mortgage loan when buying your next house.
Which means you should know how conventional mortgages differ from other loan types.
What Is a Conventional Mortgage Loan?
Most conventional loans are backed by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac). These government-sponsored enterprises guarantee the loans against default, which lowers the cost for borrowers by lowering the risk for lenders.
As a general rule, stronger borrowers tend to use these private conventional loans rather than FHA loans. The exception concerns well-qualified borrowers who qualify for subsidized VA or USDA loans due to prior military service or rural location.
How a Conventional Mortgage Loan Works
In a typical conventional loan scenario, you call up your local bank or credit union to take out a mortgage. After asking you some basic questions, the loan officer proposes a few different loan programs that fit your credit history, income, loan amount, and other borrowing needs.
These loan programs come from Fannie Mae or Freddie Mac. Each has specific underwriting requirements.
After choosing a loan option, you provide the lender with a filing cabinet’s worth of documents. Your file gets passed from the loan officer to a loan processor and then on to an underwriter who reviews the file.
After many additional requests for information and documents, the underwriter signs off on the file and clears it to close. You then spend hours signing a mountain of paperwork at closing. When you’re finished, you own a new home and a massive hand cramp.
But just because the quasi-governmental entities Fannie Mae and Freddie Mac back the loans doesn’t mean they issue them. Private lenders issue conventional loans, and usually sell them on the secondary market right after the loan closes. So even though you borrowed your loan from Friendly Neighborhood Bank, it immediately transfers to a giant corporation like Wells Fargo or Chase. You pay them for the next 15 to 30 years, not your neighborhood bank.
Most banks aren’t in the business of holding loans long-term because they don’t have the money to do so. They just want to earn the points and fees they charge for originating loans — then sell them off, rinse, and repeat.
That’s why lenders all follow the same loan programs from Fannie and Freddie: so they can sell predictable, guaranteed loans on the secondary market.
Conventional Loan Requirements
Conventional loans come in many loan programs, and each has its own specific requirements.
Still, all loan programs measure those requirements with a handful of the same criteria. You should understand these concepts before shopping around for a mortgage loan.
Each loan program comes with a minimum credit score. Generally speaking, you need a credit score of at least 620 to qualify for a conventional loan. But even if your score exceeds the loan program minimum, weaker credit scores mean more scrutiny from underwriters and greater odds that they decline your loan.
Mortgage lenders use the middle of the scores from the three main credit bureaus. The higher your credit score, the more — and better — loan programs you qualify for. That means lower interest rates, fees, down payments, and loan requirements.
If you have excellent credit, you can qualify for a conventional loan with a down payment as low as 3% of the purchase price. If you have weaker credit, or you’re buying a second home or investment property, plan on putting down 20% or more when buying a home.
In lender lingo, bankers talk about loan-to-value ratios (LTV) when describing loans and down payments. That’s the percentage of the property’s value that the lender approves you to borrow.
Each loan program comes with its own maximum LTV. For example, Fannie Mae’s HomeReady program offers up to 97% LTV for qualified borrowers. The remaining 3% comes from your down payment.
Debt-to-Income Ratio (DTI)
Your income also determines how much you can borrow.
Lenders allow you to borrow up to a maximum debt-to-income ratio: the percentage of your income that goes toward your mortgage payment and other debts. Specifically, they calculate two different DTI ratios: a front-end ratio and a back-end ratio.
The front-end ratio only features your housing-related costs. These include the principal and interest payment for your mortgage, property taxes, homeowners insurance, and condo- or homeowners association fees if applicable. To calculate the ratio, you take the sum of those housing expenses and divide them over your gross income. Conventional loans typically allow a maximum front-end ratio of 28%.
Your back-end ratio includes not just your housing costs, but also all your other debt obligations. That includes car payments, student loans, credit card minimum payments, and any other debts you owe each month. Conventional loans typically allow a back-end ratio up to 36%.
For example, if you earn $5,000 per month before taxes, expect your lender to cap your monthly payment at $1,400, including all housing expenses. Your monthly payment plus all your other debt payments couldn’t exceed $1,800.
The lender then works backward from that value to determine the maximum loan amount you can borrow, based on the interest rate you qualify for.
In 2022, “conforming” loans allow up to $647,200 for single-family homes in most of the U.S. However, Fannie Mae and Freddie Mac allow up to $970,800 in areas with a high cost of living.
Properties with two to four units come with higher conforming loan limits:
|Units||Standard Limit||Limit in High CoL Areas|
You can still borrow conventional mortgages above those amounts, but they count as “jumbo” loans — more on the distinction between conforming and non-conforming loans shortly.
Private Mortgage Insurance (PMI)
If you borrow more than 80% LTV, you have to pay extra each month for private mortgage insurance (PMI).
Private mortgage insurance covers the lender, not you. It protects them against losses due to you defaulting on your loan. For example, if you default on your payments and the lender forecloses, leaving them with a loss of $50,000, they file a PMI claim and the insurance company pays them to cover most or all of that loss.
The good news is that you can apply to remove PMI from your monthly payment when you pay down your loan balance below 80% of the value of your home.
Types of Conventional Loans
While there are many conventional loan programs, there are several broad categories that conventional loans fall into.
Conforming loans fit into Fannie Mae or Freddie Mac loan programs, and also fall within their loan limits outlined above.
All conforming loans are conventional loans. But conventional loans also include jumbo loans, which exceed the conforming loan size limits.
Not all conventional loans “conform” to Fannie or Freddie loan programs. The most common type of non-conforming — but still conventional — loan is jumbo loans.
Jumbo loans typically come with stricter requirements, especially for credit scores. They sometimes also charge higher interest rates. But lenders still buy and sell them on the secondary market.
Some banks do issue other types of conventional loans that don’t conform to Fannie or Freddie programs. In most cases, they keep these loans on their own books as portfolio loans, rather than selling them.
That makes these loans unique to each bank, rather than conforming to a nationwide loan program. For example, the bank might offer its own “renovation-perm” loan for fixer-uppers. This type of loan allows for a draw schedule during an initial renovation period, then switches over to a longer-term “permanent” mortgage.
The name speaks for itself: loans with fixed interest rates are called fixed-rate mortgages.
Rather than fluctuating over time, the interest rate remains constant for the entire life of the loan. That leaves your monthly payments consistent for the whole loan term, not including any changes in property taxes or insurance premiums.
Adjustable-Rate Mortgages (ARMs)
As an alternative to fixed-interest loans, you can instead take out an adjustable-rate mortgage. After a tempting introductory period with a fixed low interest rate, the interest rate adjusts periodically based on some benchmark rate, such as the Fed funds rate.
When your adjustable rate goes up, you become an easy target for lenders to approach you later with offers to refinance your mortgage. When you refinance, you pay a second round of closing fees. Plus, because of the way mortgage loans are structured, you’ll pay a disproportionate amount of your loan’s total interest during the first few years after refinancing.
Pros & Cons of Conventional Home Loans
Like everything else in life, conventional loans have advantages and disadvantages. They offer lots of choice and relatively low interest, among other upsides, but can be less flexible in some important ways.
Pros of Conventional Home Loans
As you explore your options for taking out a mortgage loan, consider the following benefits to conventional loans.
- Low Interest. Borrowers with strong credit can usually find the best deal among conventional loans.
- Removable PMI. You can apply to remove PMI from your monthly mortgage payments as soon as you pay down your principal balance below 80% of your home’s value. In fact, it disappears automatically when you reach 78% of your original home valuation.
- No Loan Limits. Higher-income borrowers can borrow money to buy expensive homes that exceed the limits on government-backed mortgages.
- Second Homes & Investment Properties Allowed. You can borrow a conventional loan to buy a second home or an investment property. Those types of properties aren’t eligible for the FHA, VA, or USDA loan programs.
- No Program-Specific Fees. Some government-backed loan programs charge fees, such as FHA’s up-front mortgage insurance premium fee.
- More Loan Choices. Government-backed loan programs tend to be more restrictive. Conventional loans allow plenty of options among loan programs, at least for qualified borrowers with high credit scores.
Cons of Conventional Home Loans
Make sure you also understand the downsides of conventional loans however, before committing to one for the next few decades.
- Less Flexibility on Credit. Conventional mortgages represent private markets at work, with no direct government subsidies. That makes them a great choice for people who qualify for loans on their own merits but infeasible for borrowers with bad credit.
- Less Flexibility on DTI. Likewise, conventional loans come with lower DTI limits than government loan programs.
- Less Flexibility on Bankruptcies & Foreclosures. Conventional lenders prohibit bankruptcies and foreclosures within a certain number of years. Government loan programs may allow them sooner.
Conventional Mortgage vs. Government Loans
Government agency loans include FHA loans, VA loans, and USDA loans. All of these loans are taxpayer-subsidized and serve specific groups of people.
If you fall into one of those groups, you should consider government-backed loans instead of conventional mortgages.
Conventional Loan vs. VA Loan
One of the perks of serving in the armed forces is that you qualify for a subsidized VA loan. If you qualify for a VA loan, it usually makes sense to take it.
In particular, VA loans offer a famous 0% down payment option. They also come with no PMI, no prepayment penalty, and relatively lenient underwriting. Read more about the pros and cons of VA loans if you qualify for one.
Conventional Loan vs. FHA Loan
The Federal Housing Administration created FHA loans to help lower-income, lower-credit Americans achieve homeownership.
Most notably, FHA loans come with a generous 96.5% LTV for borrowers with credit scores as low as 580. That’s a 3.5% down payment. Even borrowers with credit scores between 500 to 579 qualify for just 10% down.
However, even with taxpayer subsidies, FHA loans come with some downsides. The underwriting is stringent, and you can’t remove the mortgage insurance premium from your monthly payments, even after paying your loan balance below 80% of your home value.
Consider the pros and cons of FHA loans carefully before proceeding, but know that if you don’t qualify for conventional loans, you might not have any other borrowing options.
Conventional Loan vs. USDA Loan
As you might have guessed, USDA loans are designed for rural communities.
Like VA loans, USDA loans have a famous 0% down payment option. They also allow plenty of wiggle room for imperfect credit scores, and even borrowers with scores under 580 sometimes qualify.
But they also come with geographical restrictions. You can only take out USDA loans in specific areas, generally far from big cities. Read up on USDA loans for more details.
Conventional Mortgage Loan FAQs
Mortgage loans are complex, and carry the weight of hundreds of thousands of dollars in getting your decision right. The most common questions about conventional loans include the following topics.
What Are the Interest Rates for Conventional Loan?
Interest rates change day to day based on both benchmark interest rates like the LIBOR and Fed funds rate. They can also change based on market conditions.
Market fluctuations aside, your own qualifications also impact your quoted interest rate. If your credit score is 800, you pay far less in interest than an otherwise similar borrower with a credit score of 650. Your job stability and assets also impact your quoted rate.
Finally, you can often secure a lower interest rate by negotiating. Shop around, find the best offers, and play lenders against one another to lock in the best rate.
What Documents Do You Need for a Conventional Loan?
At a minimum, you’ll need the following documents for a conventional loan:
- Identification. This includes government-issued photo ID and possibly your Social Security card.
- Proof of Income. For W2 employees, this typically means two months’ pay stubs and two years’ tax returns. Self-employed borrowers must submit detailed documentation from their business to prove their income.
- Proof of Assets. This includes your bank statements, brokerage account statements, retirement account statements, real estate ownership documents, and other documentation supporting your net worth.
- Proof of Debt Balances. You may also need to provide statements from other creditors, such as credit cards or student loans.
This is just the start. Expect your underwriter to ask you for additional documentation before you close.
What Credit Score Do You Need for a Conventional Loan?
Improve your credit score as much as possible before applying for a mortgage loan.
How Much Is a Conventional Loan Down Payment?
Your down payment depends on the loan program. In turn, your options for loan programs depend on your credit history, income, and other factors such as the desired loan balance.
Expect to put down a minimum of 3%. More likely, you’ll need to put down 10 to 20%, and perhaps more still.
What Types of Property Can You Buy With a Conventional Loan?
You can use conventional loans to finance properties with up to four units. That includes not just primary residences but also second homes and investment properties.
Do You Need an Appraisal for a Conventional Loan?
Yes, all conventional loans require an appraisal. The lender will order the appraisal report from an appraiser they know and trust, and the appraisal usually requires payment up front from you.
The higher your credit score, the more options you’ll have when you shop around for mortgages.
If you qualify for a VA loan or USDA loan, they may offer a lower interest rate or fees. But when the choice comes down to FHA loans or conventional loans, you’ll likely find a better deal among the latter — if you qualify for them.
Finally, price out both interest rates and closing costs when shopping around for the best mortgage. Don’t be afraid to negotiate on both.