What Is A Conventional Mortgage?
Often mistaken for a conforming mortgage or loan, a conventional loan is a home buyer’s loan not provided by a government institution. These organizations are typically the Federal Housing Association (FHA), the USDA Rural Housing Service or the U.S. Department of Veterans Affairs (VA).
Related: Buying a house? Make sure you’re prepared by reading our complete guide on how to buy a home.
But instead of using them, your conventional loan is given by a private lender such as a bank, or government sponsored ventures like the Federal Home Loan Mortgage Corporation or Freddie Mac.
Roughly two-thirds of confirmed homeowner loans in the U.S. today are conventional mortgages. Most are traded on the TBA (to be announced) market once packaged into pass-through mortgage-backed securities. Of those securities, a large segment is securitized even more into CMO’s (Collateralized Mortgage Obligations.)
The most popular of these loans are the 10, 15 and 30 year fixed rate mortgages.
What Kind Of Properties Are They Used For?
These loans can be utilized to cover the financing of primary residences, vacation homes, rental properties and a second home purchase, providing a much wider variety than government-based loans, which can only back primary residence purchases.
Government funded loans are supplied by private lenders and guaranteed by Federal Government entities like the FHA or VA. In contrast, conventional loans are insured by private insurance companies.
Types of government loans:
- FHA Loans: This is a popular loan since the credit score requirement is just 580, accompanied by a miniscule down payment of 3.5%
- USDA Loans: Created by the Department of U.S. Agriculture, this program is targeted toward low-medium salary buyers who reside in rural areas.
- VA Loans: Designed for war veterans, these loans come without mortgage insurance or downpayment. However, they’re not available to the general public. Click to read our complete guide to VA home loans.
Conventional Loan Pros And Cons
- Availability of both adjustable and fixed rate loans
- Higher mortgage limits than FHA and a lower PMI
- These loans are available for investment properties and second homes
- PMI cancels when a 78% LTV (loan to value) is achieved.
- Conventional 97 with 3% down
- No PMI with (LTV) loan to value ratio of 80%
- Requires a higher credit score than FHA
- You are asked for a higher down payment
- Stricter qualification guidelines
- These guidelines make it harder for prospective buyers with low income.
How Conventional Loans Function
Mortgages have undergone a makeover since the subprime mortgage collapse that happened over a decade ago. Although the basics remain the same, the “No down payment” and “zero verification” mortgage options have been removed, and rightly so. Now buyers need to fulfill an application for a mortgage, then provide the required documents for the lender to complete a background check. This check can extend to the applicant’s current credit score, their credit history and background.
What Documents Are Needed?
By law a downpayment is required, so no property is ever 100% financed as a safety measure. For further checks, the lender shall look into your assets and liabilities to see if you can keep up with monthly payments. By rule, mortgage payments should be no higher than 28% of your gross income, but also they need to see if you can cover the down payment and other expenses, such as closing costs and broker fees. To help calculate this, your lender needs the following documents:
Verification of income
- Two years of federal tax returns
- Two years of W-2 statements
- Year to date income as well as 30 days of pay stubs
- Quarterly statement of all asset accounts such as checking, savings and investment accounts.
- An offer letter, if you haven’t started work
- If recently graduated, then proof of education such as your degree.
Proof of employment
For financial security, lenders loan only to buyers with a long, stable work history. Their search into the topic may not only be restricted to the pay stubs you provide, but also direct contact with your employer for confirmation. If you’ve changed jobs, your lender will potentially call your previous employer as well. For the self-employed, it’s possible to obtain a loan but you will need to provide significantly more paperwork proving that you can sustain yourself
These include bank and investment statements demonstrating you have sufficient finances for the downpayment and closing costs. If you, the buyer, are being financially assisted by friends or family for the down payment, gift letters on their behalf will be needed as proof to the lender to demonstrate they’re not loans and don’t need to be repaid.
Drivers License or State ID
Social security number and signature.
Conventional Loan Interest Rates
Typically higher than a government based mortgage, a private rate can be affected by multiple things. These include the size of the loan, the terms that have been agreed to, the loan’s length and whether the rate is fixed or adjustable.
The overall outlook of the market plays a significant factor as well, since rates are often influenced by current market conditions. The Federal Reserve (or central bank) reacts to these changes by altering the funds rate, which in turn is passed on to the loan via the banks you approach.
The length of a loan also helps in establishing your mortgage., as the shorter the term the higher the payment
An adjustable rate mortgage is actually more steady than it sounds, at least for preset periods of time. Agreed to be either 3, 5 or 7 year time frames these “teaser” periods that start off the loan give the buyer the chance to pay extremely low interest, potentially saving them thousands of dollars that can be used later in the process.
A points system is usually incorporated with conventional mortgages, since they represent the amount of fees that have been paid to the lender, going by the rule of the more you pay, the lower your rate. For buyers planning to reside in the property for more than a decade, a points system would be helpful in reducing the interest rates of their loan.
Who Qualifies For A Conventional Loan?
Buyers with respectable and steady credit are the ones most likely to qualify for a conventional mortgage. If you’re looking for an idea of a specific requirement, read the list below:
Have a minimum 20% down payment of the home’s purchase price easily accessible. They can accept less, but if you don’t want to get private mortgage insurance and cover the difference with monthly payments, you should wait until you have enough cash reserves to fulfill 20% down payment directly.
A high credit score, ideally over 700, as a higher score means a lower interest rate. The best rates are often given to buyers with a score of 740 or higher.
Debt to income ratio is the total of your obligatory monthly expenses in relation to your monthly income. You’re looking for a number about 36%; if you’re in the 40 percentile range then it’s riskier territory.
If you make these requirements, you’ll be offered a rate roughly 0.5% lower than a buyer who accumulated a credit score of 640.
Who Doesn’t Qualify?
Loans often aren’t provided to people just starting their job career, with debt higher than average or an unexceptional credit rating. Obtaining a mortgage would be extremely difficult for you, if you have any of the following:
- Credit score of 650 or lower.
- You’ve experienced a foreclosure or bankruptcy
- Less than 20% of the down payment is ready
- A DTI of 43% or higher.
As you can see from the list above, private lenders have requirements in place to minimize their risks of having an exceedingly high ratio of buyers defaulting on their loans.
This is a type of loan that doesn’t quite stand up to bank funding requirements. This can be because the loan amount exceeds the conforming loan limit, or they don’t have enough credit.
Your average conforming loans are underwritten by government-backed organizations like Freddie Mac and Fannie Mae. In total, they make up for more than half of all mortgages.
Loans that don’t fall under this are called non-conforming loans. Non-conforming loans include investor, jumbo and portfolio loans. So be sure to remember the difference.
Since conventional loans can last anywhere between 10 and 30 years, it would be advisable to thoroughly go over every aspect of this article again prior to buying a home. There are enough hints to see if you’re qualified and if not, gather an idea of what you need to do in order to be.
From there I would suggest meeting with various lenders to see which rates and what sort of plans they offer. After doing so, it will be easier to choose the one you want to move forward with.
Lastly, you should save more than 20% down payment of the purchase price prior to doing any of this, otherwise you’ll just be putting yourself at risk and wasting time. Aim to have a savings even higher than 20% so you have cash to fall back on should something go wrong.
You should always have a safety net to fall back on.