What is a Conventional Loan

What is a Conventional Loan?

Homebuyers are faced with many tough decisions when purchasing a home. One of the most important decisions is whether or not you should pull out a conventional loan, and if so, what are the options, limitations, and qualifications?

A conventional loan is currently the most popular choice among homebuyers. What makes conventional loans so appealing? What the alternatives to conventional loans are? What exactly is a conventional loan? Receive answers to all these questions in the post below.

What is a conventional loan?

A conventional loan is a mortgage loan from a private lender that will go towards the purchase of a home. The lender will essentially pay the purchase price of the house while the buyer makes monthly payments to the lender over several years. Conventional loans are intended for low-risk homebuyers, meaning that they have a stable income, good credit history, and can provide a substantial down payment upon approval.

Private conventional loan lenders are different than government-backed lenders. Examples of government-backed loans are the Federal Housing Administration (FHA) loan and the Veterans Affairs (VA) loan. These types of loans were initially intended to attract lower-income people into the housing market. However, they remain good options for homebuyers from all walks of life due to their low down payment requirements.

Despite the attractiveness of government loans that don’t require large down payments, conventional loans still comprise around two-thirds of the mortgage loans borrowed from lenders. For many reasons, conventional loans remain preferable to experienced homebuyers, and even some first-time homebuyers.

One such reason is that they don’t limit homebuyers in the way that government-backed loans do. With a conventional loan, buyers can purchase just about any home for any number of reasons. Whether you’re looking to invest in real estate or buy a vacation home, a conventional loan will be the best option.

Term durations for conventional loans are available for between 10-30 years. Interest is fixed-rate for the duration of the loan.

How to qualify for a conventional loan?

To be eligible for a conventional loan, you will need to prove that you are a low-risk borrower. Since conventional loans are not government-backed, they cannot protect lenders from borrowers that default on their loans. Below are the main requirements for a conventional loan.

Credit score. Your credit score can be as low as 620 but should be between 680 – 740 for the best interest rates. A higher credit score allows leniency in other qualification areas too. Aside from the score, you will also need to have minimal derogatory marks on your credit history, such as past defaults, foreclosures, or bankruptcy. 

Debt-to-income ratio (DTI). The minimum DTI ratio for conventional loans is 36%, but this ratio can be as high as 43% if your credit score is high enough.

Down payment. A down payment of 20% is the typical requirement for conventional loans. Recently, competition between lenders and the popularity of the FHA loan have driven that requirement down a bit. Some private lenders will require as low as 3-5% down payment with excellent credit.

Stable job. Applying for a conventional loan will involve proving that you can keep up with your monthly payments. Showing that you can pay your mortgage will require a couple of years’ worth of W-2’s and tax returns. Self-employed homebuyers will need to provide even more paperwork.

Conforming vs. Nonconforming Conventional Loans

Beyond just conventional and government-backed loans are two different types of conventional loans known as “conforming” and “nonconforming.” Conforming conventional loans are ones that abide by federally-imposed limits. Conversely, nonconforming loans (also known as “jumbo loans”) impose no limit on the amount a homebuyer can borrow.

For conforming loans, the price ceiling of the loan is between $480,000-$727,000, depending on the location. There is no limit for nonconforming loans, but the qualifications and requirements are much more strict.

Conventional vs. FHA Loans

As mentioned above, conventional loans are from private lenders, while FHA loans are examples of government-backed lenders. FHA loans are the next most popular loan next to conventional loans, but how do they compare?

For starters, the most glaring difference between conventional and FHA loans is the down payment requirement. While conventional loans typically require at least 20% down, FHA loans only require as low as 3%. However, conventional loans are slowly starting to crack under competition, with some lenders offering down payments as little as 3% as well.

If you decide to pay at least 20% down payment on a conventional loan, this waives you from needing to pay mortgage insurance, which is an additional monthly payment placed on high-risk loans. On the other hand, FHA loans require mortgage insurance no matter what.

Furthermore, interest rates for conventional loans tend to be slightly higher than with FHA loans. Interest rates can be reduced for conventional loans depending on how high the down payment is, and how good your credit history is. All things considered, conventional and FHA loans often end up costing around the same in the long run, but it’s always possible for the conventional loan to be cheaper.

Even though there tend to be even trade-offs in the overall costs of conventional and FHA loans, the former still allows for more freedom as well. Buying a house in a particular state or county will limit the amount an FHA loan will allow you to borrow. The ceiling for FHA loans is about $315,000 but can be more in high-cost areas. Additionally, since FHA loans are meant to protect borrowers and lenders, they usually restrict certain types of homes. Fixer-uppers and vacation homes, for example, are typically not allowed with FHA loans. 

Conventional vs FHA Loan

Is Conventional Loan right for you?

Not all conventional loans are the same. Make sure to shop around for different lenders that offer the best deals. Private lenders today are competing against each other and will sometimes lower the barrier to entry. In the end, as long as you have established or excellent credit, a conventional loan is arguably the best choice for homebuyers. If you can maximize your down payment and show good credit history, you will pay the lowest possible interest rate. It will save the most money in the long run. Like with all important financial decisions, make sure you know why you are making the purchase and what your budget is.

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