What is a conventional loan?
When you’re hunting for a mortgage, you’re bound to come across one of the most popular options: a conventional home loan. For most home buyers with healthy credit, this is the most cost-efficient route. So, what exactly is it? The rules are simple. A conventional loan is a mortgage loan that’s not directly backed by the government. Instead, these loans are supported by government-sponsored entities (GSEs) such as Fannie Mae or Freddie Mac. These organizations help keep the mortgage market stable by buying loans that meet certain maximum loan amount limits set annually by the Federal Housing Financial Association (FHFA), which makes it easier for banks to offer more loans to more people.
You might wonder why that matters. Well, when a lender offers a loan directly, they take on all the risk. There’s no one to swoop in with financial padding if things go south for the borrower. That’s why conventional loan lenders look for borrowers with secure financial footing, as opposed to government-backed programs, which are more lenient.
How do conventional loans work?
When you think of a standard mortgage, you’re probably thinking about a conventional loan. But did you know they come in all shapes and sizes? Most lenders offer a range of conventional loans with different structures, loan terms and borrower requirements.
Let’s take a peek at some of the most common variations and how they work:
- Conforming loans: These mortgages follow criteria set at the government level by Fannie Mae, Freddie Mac and the Federal Housing Finance Agency. If a loan meets the down payment, income and price limits, it’s considered a conforming loan and often comes with the perks of lower interest rates.
- Nonconforming loans aka portfolio loans: These loans don't meet Fannie Mae and Freddie Mac guidelines and are held by the lender. They offer flexibility for unique financial situations but may have higher interest rates and down payments.
- Jumbo loans: As the name conveys, this nonconforming loan is reserved for big-ticket homes. Jumbo loans go over conforming loan limits, so they can finance those pricier properties if the borrower has good credit and solid savings.
- Fixed-rate loans: A tried-and-true option, fixed-rate loans promise stability over the life of the loan. You’ll pay one interest rate throughout the whole term, no matter how long it is (typically 15 or 30 years).
- Adjustable-rate mortgages (ARMs): These loans start out with a low, fixed rate during the introductory period, but then the rate, and your monthly payment, fluctuate with market conditions later in the term. ARMs are good for buyers who plan on either paying off the loan or selling the property in a few years.
- Low- and zero-down payment conventional loans: If you’re a first-time home buyer or have modest savings, you may be able to bag a generous loan with little to no down payment.
- Nonqualified mortgages: These loans have different eligibility criteria and can help borrowers with nontraditional income or a tricky financial background.
Conventional loan requirements
You already know that conventional loans come in many forms, so there’s no single set of requirements. Instead, every lender makes its own rules for what they want to see from a potential borrower. Let’s go over the general targets you’ll want to hit if you’re considering a conventional mortgage.
Conventional loan limits
Conforming or nonconforming—that is the question. Conforming loan limits are set by the Federal Housing Finance Agency (FHFA) and can vary depending on where you live.
If you want a conforming loan, your house-hunting budget sits below that set dollar amount. If your sights are set higher, welcome to nonconforming territory. You’ll have to go for a jumbo loan that requires a bigger down payment, stellar credit and a good chunk of savings.
Conventional loan interest rates
The interest rate is established based upon market conditions and the risk assessment your lender established about you. For example, your credit score, down payment and debt-to-income ratio will be used to determine your eligibility which influences the interest rate you can obtain.
Conventional loan down payments
Although it may be common to see many conventional loans set a minimum down payment of 20%, some conventional loan programs, like HomeReady and Home Possible, offer first-time and low-income home buyers down payments as low as 3%.
Pro Tip
The state of the housing market also influences the size of the down payment you'll need. In a seller's market, where demand exceeds supply, securing a loan or making a successful offer on a home with a small down payment may be more difficult. On the other hand, in a buyer's market, where there are many homes available, a smaller down payment may suffice.
Conventional mortgage insurance
Private mortgage insurance (PMI) is generally required with less than a 20% down payment. This type of mortgage insurance protects the lender against default, which is when the loan cannot be repaid. The PMI premium is established in part by your credit score and other factors. PMI is added each month to your monthly payment until you reach 20% equity in the home, at which point you can request that private mortgage insurance be cancelled.
Conventional loan credit score
Your credit score is a component lenders use to establish your eligibility for a mortgage loan. Typically, when it comes to conventional home loans, lenders like to see a credit score of 620 or more. If you’re not at 620 now, you can work to improve your score by making payments on time and paying off some of your larger debts. Excellent scores of 740 and above may help get the best interest rates.
Conventional loan DTI
For conventional loans, lenders may prefer a debt-to-income (DTI) ratio of 36% or lower.
So, what is DTI and what does it have to do with loans? DTI is your debt-to-income ratio, a measure that compares your total monthly debt payments to the amount you earn each month. For conventional loans, lenders may prefer a debt-to-income (DTI) ratio of 36% or lower. These elements can help offset the higher DTI, making you a more appealing candidate for a loan. A low ratio shows lenders that you’re good at managing debt, which may help you get a great rate and lower monthly payments. If your DTI needs a little work, you can move the needle by paying down your high-interest debts.
Conventional loan income requirements
Lenders require proof of a stable and consistent income. They typically require at least two years of employment history and will want to see some financial paperwork, including W2s, pay stubs and bank statements.
How is a conventional mortgage different from other loan types?
Here’s how conventional loans stack up against popular government-backed options.
Conventional loans vs. VA loans
While conventional loans are open to anyone, VA loans help veterans, service members and surviving spouses. VA loans are packed with perks, including lower rates, zero down payment and no mortgage insurance.
| Feature | Conventional Loans | VA Loans |
|---|---|---|
| Down payment | Minimum 3%, but often higher | Zero down payment with 100% VA Loan Guaranty Benefit |
| Mortgage insurance | PMI required if down payment is less than 20% | No PMI required, but includes funding fee |
| Interest rates | Usually higher, influenced by credit score | Lowest average rates on the market, not as credit-dependent |
| Credit score requirements | Typically, 620+ required | Typically, 620, but lower scores are accepted |
| Purpose | Generally for consumers with better credit/finances | Flexible and forgiving for veterans/service members |
Conventional loans vs. FHA loans
If you have a lower credit score or a smaller down payment, an FHA loan may give you the wiggle room you need.
| Feature | Conventional Loans | FHA Loans |
|---|---|---|
| Down payment | Minimum 3%, but often higher | Minimum of 3.5% required |
| Mortgage insurance | PMI required if down payment is less than 20% | Upfront and annual premiums required |
| Interest rates | Usually higher, influenced by credit score | Generally lower than conventional loans if credit is good |
| Credit score requirements | Typically, 620+ required | Minimum 580 in most circumstances |
| Purpose | Generally for consumers with better credit/finances | To help lower- or moderate-income folks become homeowners |
Conventional loans vs. USDA loans
If you have a lower income and your heart is set on the countryside, a USDA loan can help you settle in a designated rural region with no down payment and a lower rate than conventional loans.
| Feature | Conventional Loans | USDA |
|---|---|---|
| Down payment | Minimum 3%, but often higher | Zero down payment |
| Mortgage insurance | PMI required if down payment is less than 20% | No PMI, but an upfront and annual fee |
| Interest rates | Usually higher, influenced by credit score | Generally lower than conventional loans |
| Credit score requirements | Typically, 620+ required | Typically, 640+, but could be lower based on lender |
| Purpose | Generally for consumers with better credit/finances | To help lower-income folks settle down in designated rural areas |
How do I apply for a conventional loan?
Applying for a conventional loan is a straightforward process that consists of several key steps. Here’s how you can get started:
- Check your credit score
Before applying, it's important to check your credit report as it can affect your loan terms. - Gather necessary documents
You will need to provide documents such as proof of income, tax returns, employment verification and a list of assets and liabilities. - Get pre-approved
If you are buying a home consider getting pre-approved. This shows sellers that you are a serious buyer with financing already lined up. - Submit your application
Once you’ve found a home you love and have your pre-approval letter, submit your application along with all required documentation. - Undergo loan processing
The lender will review your application, perform a credit check and appraise the property to ensure everything is in order. - Close the loan
If approved, you'll close the loan by signing all necessary paperwork, paying closing costs and finalizing the mortgage terms.
Need expert advice before you apply?