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Conventional Loans: How They Work And How They Compare To Other Loans

Molly Grace7 Minute Read
July 10, 2021

Shopping for a mortgage? You might hear the term “conventional loan” thrown around quite a bit. But what exactly does it mean?

Conventional loans are to the mortgage world what four-door sedans are to the car world: a classic option that suits the needs of millions of consumers each year.

If you’re looking to buy a home or refinance your current loan, a conventional loan could be a great option for you. Let’s take a look at how these loans work, who they’re best for and what some alternatives are.

What Is A Conventional Home Loan?

Conventional loans are home loans that aren’t insured by a government agency. They’re offered through private lenders for the purpose of purchasing a home or refinancing an existing loan.

While mortgages such as FHA loans and VA loans are insured or guaranteed by the Federal Housing Administration and Department of Veterans Affairs, respectively, conventional loans have no such government backing.

Because of this, conventional mortgages often have more stringent requirements for borrowers, such as higher credit scores and low debt-to-income ratios (DTI).

How Does A Conventional Mortgage Work?

Most conventional loans are conforming loans, meaning they’re eligible for sale to the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

To be considered conforming, a loan must conform to the loan limits set by the Federal Housing Finance Agency (FHFA) as well as meet Fannie Mae and Freddie Mac’s own guidelines, which include things like minimum credit scores and maximum DTIs.

Fannie Mae and Freddie Mac provide liquidity to the mortgage market. Conventional lenders that originate conforming loans can sell their loans to these entities once they’ve closed, giving them the cash flow they need to continue lending new mortgages.

Conventional loans can also be nonconforming, which means they don’t meet these standards and can’t be sold to the GSEs.

Jumbo loans are a common type of nonconforming loan. Jumbo loans exceed the conforming loan limit. Typically, these loan amounts can go up to $2 – $3 million.

Regardless of the type you’re getting, the mortgage process for conventional loans is essentially the same as it is for other mortgage types.

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Requirements For A Conventional Loan

What do you need to qualify for a conventional loan? Let’s go over some of the typical requirements specific to these loan types.

Credit Score

Typically, you’ll need a credit score of at least 620 to get a conventional loan.

However, you may need a higher score than this depending on your lender and the details of loan you’re getting. For example, if you’re buying an investment property, your lender might have higher minimum score requirements.

Additionally, individuals with higher scores tend to have access to better interest rates. A lower interest rate can save you a lot of money in the long run. So, even if you meet a lender’s minimum credit score requirements, it might make more sense for you to wait to get a mortgage until you’ve improved your score a bit.

Debt-To-Income Ratio (DTI)

DTI is the percent of your monthly gross income that is spent on debt.

Lenders will look at all of your required monthly payments – including things like student loans, auto loans, minimum credit card payments or child support payments – and compare the total amount to how much income you earn each month. They’ll also include your projected monthly mortgage payment in this calculation.

To qualify for a conventional loan, you’ll need a DTI of 50% or less.

Down Payment

To get a conventional loan, you’ll have to put some money down.

The absolute minimum down payment you can make on a conventional loan is 3%.

However, the actual amount you’ll be required to put down will depend on your lender and your financial situation. Riskier borrowers – such as those who have lower credit scores or high DTIs – or borrowers who aren’t purchasing a single-family, primary residence may be asked to put down more.

First-time home buyers. If you’re a first-time home buyer – which, for the purposes of getting a mortgage, typically includes those who haven’t owned a house in the past 3 years – you may be eligible for a 3% down conventional loan.

Low-income home buyers. If you make less than or equal to 80% of your area’s median income, you may only need to put 3% down.

Repeat home buyers or middle- to upper-income buyers. If you aren’t a first-time home buyer or you make more than 80% of your area’s median income and don’t qualify for a 3% down option, you’ll likely need to put down at least 5%.

Multifamily property. If you’re purchasing a multifamily property to live in as your primary residence and rent out the other units, you’ll typically have to put down at least 15%.

Buying a second home or investment property. If you’re buying a vacation home, you’ll need to put down at least 10%. For investment properties, you’ll need at least 15% for a single unit.

Adjustable-rate mortgages. If you’re getting an adjustable-rate loan, you’ll need to put down at least 5%.

Jumbo loans. If you’re getting a jumbo loan, meaning your loan amount exceeds the conforming loan limit for your area, you may need to put down between 10% – 20%, but it can vary.

Keep in mind that your down payment isn’t the only cash you’ll need to bring to closing – you’ll also need to pay your closing costs, which can equal 3% – 6% of the loan amount.

Private Mortgage Insurance (PMI)

If you make a down payment that’s less than 20%, you’ll have to pay for private mortgage insurance (PMI). This insurance protects the lender in case you default.

Your annual PMI premium may cost between 0.58% – 1.86% of the loan amount, according to the Urban Institute. You’ll pay this in equal amounts each month as part of your monthly mortgage payment.

Once you reach 20% equity in your home, you can have PMI removed.

Loan Limits

To get a conforming conventional loan, you’ll need to remain within the conforming loan limit for your area.

The baseline conforming loan limit is $548,250 in 2021. If you live in a high-cost area, you may be able to get a conforming loan up to $822,375.

To view current and past conforming loan limits, head to the FHFA website.

If you’re getting a nonconforming conventional loan, such as a jumbo loan, you’ll only be limited by what a lender is willing to lend you.

Property Type

Conventional loans are the most flexible in terms of how they can be used. Government-backed loans can’t be used to purchase vacation homes or investment property. If you’re looking to finance either of these property types, you’ll need a conventional loan to do so.

Comparing A Conventional Mortgage To Other Loan Types

Conventional loans can be a great mortgage option, but they aren’t the best choice for everybody.

How do conventional loans compare to your other loan options?

Conventional Loan Vs. FHA Loan

FHA loans are geared towards those who might have trouble qualifying for a conventional loan, often because they’re a first-time home buyer, a low-income borrower or because they have a lower credit score.

FHA loans allow down payments as low as 3.5%. You’ll need a minimum credit score of 580, though you can potentially go lower if you make a higher down payment.

FHA loans come with both upfront and annual mortgage insurance. If you make a down payment of 10% or more, you’ll pay mortgage insurance for 11 years.

If your down payment is less than this, you’ll pay mortgage insurance for the life of the loan. However, once you reach 20% equity in your home, you can refinance into a conventional loan without PMI.

Your upfront mortgage insurance costs can either be paid at closing or financed into the loan amount.

Conventional Loan Vs. VA Loan

VA loans are available to qualifying veterans, active-duty service members, National Guard and Reserve members and eligible surviving spouses.

If you meet the service requirements for a VA loan and are able to qualify through a lender, you’ll be able to get into a home with 0% down and no mortgage insurance.

VA loans do, however, have an upfront funding fee. For first-time VA borrowers who put 0% down, this is equal to 2.3% of the loan amount. The funding fee can be added onto the loan amount, meaning you won’t have to pay it in a lump sum at closing.

Keep in mind, though, that even with 0% down and a fully-financed funding fee, you’ll still likely have to bring some cash to closing for your other closing costs.

The minimum credit score for these loans varies by lender. Usually, you’ll need a credit score of at least 620 to qualify for a VA loan.

Conventional Loan Vs. USDA Loan

USDA loans are intended for lower-income borrowers in eligible rural or suburban areas.

To be eligible for a USDA loan, you’ll need to meet the program’s income limits and be purchasing a property in an area that meets the USDA’s definition of a “rural area.”

You can check out whether a given property meets this requirement by using the USDA’s property eligibility tool. They have a tool to determine income eligibility as well. Generally, your household’s total income can’t exceed 115% of your area’s median income.

Like VA loans, USDA mortgages don’t require a down payment.

In lieu of mortgage insurance, USDA borrowers must pay a guarantee fee. You’ll pay both an upfront fee and an annual fee. The upfront fee can be financed into your loan.

Typically, you’ll need a credit score of at least 640 to qualify.

Average Rates For Conventional Loans

Mortgage interest rates are always changing. Looking at the current average rates can give you a general idea of what type of rate you might get, but the actual rate you end up getting will depend on many different factors, including your individual financial situation.

The less risky you are as a borrower, the more likely you are to get a better rate. Borrowers with high credit scores tend to get better rates, for example.

If you don’t have the best credit history, you might find that you can get a better rate with a government-backed mortgage, such as an FHA loan, than you would with a conventional loan. Borrowers with great credit scores, on the other hand, would likely save more money with a conventional loan.

The Bottom Line

It’s all about getting the best loan for you.

Conventional loans offer flexibility, low down payment options and affordable financing for borrowers with good credit. However, if you think you’ll have a hard time qualifying for a conventional loan, or you’re looking for a 0% down option, a government-backed loan might make more sense for you.

Want more home buying tips? Check out our Home Buyer’s Guide.

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Molly Grace

Molly Grace is a staff writer focusing on mortgages, personal finance and homeownership. She has a B.A. in journalism from Indiana University. You can follow her on Twitter @themollygrace.