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Conventional Loan: Definition And How They Work

Erin Gobler7-Minute Read
July 29, 2022

When you’re shopping for a new home, one of the biggest decisions you’ll have to make is the type of mortgage you want. There are plenty of options to choose from, but conventional loans are the most popular.

Conventional loans come with plenty of benefits, including their low down payment requirements and their accessibility. However, there are also plenty of alternatives to consider.

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What Is A Conventional Loan?

A conventional loan is a mortgage offered through a private lender without backing from a government agency. Conventional loans can be used to finance the purchase of a new home or to refinance an existing mortgage.

Non-conventional mortgages, like FHA loans, and VA loans, are insured or guaranteed by the Federal Housing Administration (FHA) and Department of Veterans Affairs (VA). Without this type of government backing, conventional loans may have stricter eligibility requirements.

When you apply for a conventional loan, you’ll have to meet certain requirements as it relates to your down payment, credit score and debt-to-income ratio (DTI). While the requirements may be different for other types of loans and with different lenders, the process for applying and being approved for these loans is similar.

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.

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.

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

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 that exceeds the conforming loan limit.

Conventional Loan Requirements

Like other types of mortgages, conventional loans come with certain requirements that borrowers must meet. Some of these requirements are set by the individual lender, while others are set by the FHFA and GSEs.

Credit Score

One of the most important requirements you’ll have to meet to borrow a conventional loan is a minimum credit score. Typically, you’ll need a credit score of at least 620 to qualify for a conventional loan.

While 620 is the minimum credit score required for a conventional loan, you may want an even higher score. First, lenders will consider your credit score in combination with other factors. Based on the rest of your financial picture, a lender may want you to have a higher credit score.

Additionally, your credit score will affect the interest rate you can get. Generally speaking, the higher your credit score, the lower your interest rate. So even if your credit score is high enough to qualify for a conventional loan, it may not be high enough to get the best rates.

Down Payment

Another requirement of a conventional mortgage is the down payment, which is the percentage of the home’s purchase price that you pay upfront.

In many cases, you’ll need a minimum down payment of 3% to qualify for a conventional loan. That means if, for example, you by a $200,000 you’ll need to put down at least $6,000.

Your lender may require a larger down payment under certain circumstances. If you’re getting a jumbo loan, have a lower credit score or high DTI or are purchasing a multi-family home, a lender is likely to require more money down. To avoid paying mortgage insurance, you’ll need to put down 20%.

Loan Limits

As we’ve mentioned, to get a conforming conventional loan, you’ll have to meet the conforming loan limit set by the FHFA.

In 2022, the baseline conforming loan limit is $647,200 for most of the U.S. For high cost of living areas, like Alaska and Hawaii, the limit is $970,800.

Noncomforming loans such as jumbo loans aren’t subject to these limits. As a result, your lender may allow you to borrow over a million dollars for your home. However, jumbo loans often have stricter borrowing requirements since lenders must take on more risk.

It’s also worth noting that just because a home is within the conforming loan limits doesn’t necessarily mean you’ll be qualified. Your DTI, as we’ll discuss below, will be the most important factor in determining how large of a loan you’ll qualify for.

Debt-To-Income Ratio (DTI)

Your DTI is the percentage of your income that goes toward debt, including housing, student loans and credit card payments.

There are two types of DTI: a front-end DTI and a back-end DTI. The front-end DTI is the percentage of your income that goes toward housing, while your back-end DTI is the percentage of your income that goes toward all debt, including housing.

Generally speaking, you’ll need a back-end DTI of 50% or less to qualify for a conventional loan. However, like other requirements we’ve discussed, a lender might require a lower DTI based on your financial situation.

Private Mortgage Insurance (PMI)

If you buy a home with a down payment of less than 20%, you may be required to pay private mortgage insurance (PMI). This insurance helps protect the lender in case you default. After all, the lower your down payment, the more risk the lender takes on.

According to Freddie Mac, PMI generally ranges from $30 to $70 per month per $100,000 borrowed.

You’re only required to pay PMI until you reach 20% equity in your home. PMI will eventually fall off on its own, but if you’ve made enough payments to reach 20% equity or your home has increased in value, you can request to have PMI removed (though it may require an appraisal).

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Conventional Home Loan Vs. Other Loan Types

A conventional loan may be the most popular type of mortgage, but it’s not your only option. Compare these other types of home loans to see if there’s one that might be a better fit.

FHA Loan Vs. Conventional Loan

An FHA loan is one that’s backed by the FHA. These loans are geared toward those borrowers who might have trouble qualifying for a conventional loan, often because of a low down payment, credit score or annual income.

To qualify for an FHA loan, you’ll need a down payment of at least 3.5% as long as you have a credit score of 580. If your credit score is lower than 580, you may need a higher down payment. You can’t qualify for an FHA loan with a credit score of less than 500. Keep in mind that, while the minimum is score is 500, lenders will set their own credit score requirements at or above that number. For example, Rocket Mortgage® requires a minimum credit score of 580 for FHA loans.

Like a conventional loan, an FHA loan may require you to pay mortgage insurance with a down payment of less than 20%. You’ll have to pay an upfront mortgage insurance premium (MIP), as well an annual one. The upfront premium can either be paid at closing or financed into the loan amount.

If your down payment is more than 10%, the mortgage insurance can come off the loan after 11 years. Otherwise, it stays on for the life of the loan. To remove mortgage insurance with an FHA loan, you’ll need to refinance into a conventional loan once you have 20% equity.

VA Loan Vs. Conventional Loan

A VA loan is a type of mortgage that’s backed by the VA and is 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 can qualify through a lender, you’ll be able to get into a home with 0% down and no mortgage insurance.

If you're looking at VA loans versus conventional loans, know that VA loans have an upfront funding fee. For first-time VA borrowers who put less than 5% down, the VA funding fee will be equal to 2.3% of the loan amount. This fee can either be added to the loan amount or paid at closing.

First-time borrowers who put more than 5% down will pay a lower funding fee. And in some cases, borrowers can have this fee waived if they have a service-connected disability or meet other requirements. On the other hand, repeat VA borrowers may be subject to a larger funding fee.

USDA Loan Vs. Conventional Loan

A USDA loan is a mortgage that’s backed by the U.S. Department of Agriculture (USDA) and is 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 these requirements by using the USDA’s property eligibility tool. They have a tool to determine income eligibility as well.

Like VA loans, USDA mortgages don’t require a down payment. And while USDA loans don’t require mortgage insurance, they do require a guarantee fee, which is paid both upfront and annually. Like FHA loans, a USDA loan can be either financed into your loan or paid upfront.

USDA loans generally have the highest credit score requirement of any of the mortgage types we've discussed. You’ll usually need a credit score of at least 640 to qualify.

Conventional Loan Rates

Mortgage interest rates are always changing based on the current economic and interest rate environment. 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 with will depend on many different factors, including your financial situation. For example, your DTI, down payment and credit score impact your interest rate. Generally speaking, the less risky you are as a borrower, the more likely you are to get a better rate.

Your interest rate will also depend on the type of mortgage you have. If your credit score prevents you from getting the best interest rate with a conventional loan, you might consider a government-backed loan, which can give you access to a better interest rate. On the other hand, borrowers with good or excellent credit can usually save the most money with a conventional loan.

The Bottom Line

A conventional loan is one of the most popular types of mortgages on the market, thanks to its flexibility, low down payment options and affordable financing. But conventional loans aren’t right for everyone, and borrowers who have a difficult time qualifying or want to access special perks like 0% down payment loans might want to consider a government-backed loan, if they qualify. It’s best to speak with a loan expert, who can recommend the best loan option based on your financial situation and goals.

Once you’re ready, apply to get approved for a mortgage or refinance.

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Erin Gobler

Erin Gobler is a freelance personal finance expert and writer who has been publishing content online for nearly a decade. She specializes in financial topics like mortgages, investing, and credit cards. Erin's work has appeared in publications like Fox Business, NextAdvisor, Credit Karma, and more.