Conventional loans are one of the most common types of mortgage financing, offering flexibility and a range of options to suit different needs. Unlike government-backed loans such as FHA, VA, or USDA loans, conventional loans are not insured or guaranteed by any federal agency.
This independence from government programs means they can be tailored to a wider variety of borrower profiles, provided that certain criteria are met. In this guide, we’ll explore what conventional loans are, the different types available, how they compare to FHA loans, and the requirements to qualify. We’ll also discuss what credit score you need, specific characteristics of a 30-year conventional loan, and the pros and cons of choosing this type of loan.
What is a Conventional Loan?
A conventional loan is a mortgage that is not insured or guaranteed by the federal government. These loans adhere to the guidelines set by Fannie Mae and Freddie Mac, the two largest investors in the secondary mortgage market. They can be conforming, meeting the criteria set by Fannie Mae and Freddie Mac, or non-conforming, such as jumbo loans that exceed these limits.
Types of Conventional Loans
Conventional loans come in several forms to cater to different financial needs and goals:
Fixed-Rate Conventional Loans
Fixed-rate mortgages have an interest rate that remains constant for the entire term of the loan, typically 15, 20, or 30 years. This stability makes budgeting easier for homeowners since their monthly payments do not change over time. For example, a 30-year fixed-rate mortgage offers predictable payments, making it a popular choice for long-term homeowners.
Adjustable-Rate Mortgages (ARMs)
ARMs start with a fixed interest rate for an initial period — commonly 3, 5, 7, or 10 years — after which the rate adjusts periodically based on a specific index. For instance, a 5/1 ARM has a fixed rate for the first five years, then adjusts annually. ARMs can offer lower initial rates, which can be beneficial if you plan to sell or refinance before the adjustment period begins.
Jumbo Loans
These are non-conforming loans that exceed the maximum loan limits set by Fannie Mae and Freddie Mac. Jumbo loans are used to finance luxury properties or homes in high-cost areas. They typically require a higher credit score and larger down payment.
Conventional Mortgage vs. FHA Mortgage
When choosing between a conventional loan and an FHA loan, it’s important to understand their key differences:
Conventional Mortgage:
Down Payment: Usually requires 5-20% of the home’s purchase price.
Credit Requirements: A minimum credit score of 620, with better rates available for higher scores.
Mortgage Insurance: Private mortgage insurance (PMI) is required if the down payment is less than 20%.
Loan Limits: Conforming loan limits apply, which are higher in high-cost areas.
FHA Mortgage:
Down Payment: Can be as low as 3.5%.
Credit Requirements: More lenient, often requiring a score of at least 580.
Mortgage Insurance: Includes both an upfront premium and annual premiums regardless of the down payment amount.
Loan Limits: Generally lower than conventional loans, varying by location.
More on FHA Mortgages:
Who Qualifies for an FHA Loan? Eligibility Explained
Requirements for a Conventional Loan
To qualify for a conventional loan, borrowers must meet several key criteria that demonstrate their financial stability and ability to repay the loan:
Credit Score:
Minimum: Typically 620, though higher scores are preferred.
Ideal: Scores of 740 or higher can secure better interest rates and terms.
Down Payment:
Standard: Generally between 5% and 20% of the home's purchase price.
20% Advantage: Avoids private mortgage insurance (PMI), lowering overall costs.
Debt-to-Income Ratio (DTI):
Ideal: Below 43%, indicating better financial management.
Higher Ratios: Accepted with compensating factors like high credit scores or substantial savings.
Employment History:
Stability: Typically requires at least two years of consistent employment in the same field.
Documentation: Includes pay stubs, W-2 forms, tax returns, and employment verification letters.
Assets and Reserves:
Proof of Funds: For down payment and closing costs, verified through bank and investment statements.
Reserves: Additional funds to cover several months of mortgage payments, serving as a financial cushion.
Additional Considerations:
Property Appraisal: Ensures the property's market value matches the loan amount.
Title Search and Insurance: Verifies the property’s legal status and protects against future claims.
Applying for a Conventional Loan
If you’re considering a conventional loan, here is a quick breakdown of the steps to apply for a conventional loan:
Check Your Credit Report: Ensure there are no errors and your credit score meets the minimum requirements.
Determine Your Budget: Use a mortgage calculator to understand how much you can afford.
Gather Documentation: Prepare necessary documents such as tax returns, pay stubs, bank statements, and employment verification.
Get Pre-Approved: Obtain a pre-approval letter from a lender to strengthen your offer when shopping for a home.
Shop for a Home: Work with a real estate agent to find a property within your budget.
Submit an Offer: Once you find a home, make an offer and negotiate the terms.
Complete the Loan Application: Submit the full application to your lender, including all required documentation.
Close the Loan: Review and sign the final loan documents at closing.
Pros and Cons of Conventional Loans
Conventional loans have their advantages and disadvantages. Understanding these can help you decide if this type of mortgage is right for you.
Pros:
Flexibility: They can be used for primary residences, second homes, and investment properties.
No Upfront Mortgage Insurance: Unlike FHA loans, there is no upfront mortgage insurance premium.
Higher Loan Limits: In high-cost areas, conforming loan limits are higher than FHA limits.
Lower Overall Cost: For borrowers with strong credit, conventional loans often have lower overall costs compared to FHA loans.
Cons:
Stricter Requirements: Higher credit score and lower DTI ratios are needed compared to government-backed loans.
PMI for Low Down Payments: If you put down less than 20%, you will need to pay for private mortgage insurance.
Higher Down Payment Requirements: Conventional loans typically require a higher down payment than FHA loans.
Not Ideal for Low Credit Scores: Borrowers with lower credit scores might not qualify for the best rates and terms.
What Credit Score Do I Need for a Conventional Loan?
To qualify for a conventional loan, lenders typically require a minimum credit score of 620. However, borrowers with higher credit scores can benefit from lower interest rates and better loan terms. Maintaining a strong credit profile is crucial, as lenders also evaluate your debt-to-income (DTI) ratio, employment history, and overall financial health.
Summary
Conventional loans offer flexibility and potential savings for borrowers with strong credit profiles and stable financial histories. Understanding the different types of conventional loans, the requirements to qualify, and how they compare to other mortgage options like FHA loans can help you make an informed decision. Whether you're a first-time homebuyer or looking to refinance, a conventional loan could be the right choice for your financial needs. By weighing the pros and cons, you can determine if a conventional loan aligns with your financial goals and homeownership plans.
