If you’re trying to decide how you’ll finance your mortgage, you’ve probably come across conventional loans. A conventional mortgage isn’t backed by any government agency and often comes with stricter credit requirements.
It’s a good idea to understand how conventional loans work and how they stack up to other types of mortgages. This information will help you find the loan that’s right for your situation.
- How does a conventional loan work?
- Types of conventional loans
- How to qualify
- Pros and cons
- The cost of a conventional loan
- FAQ
How does a conventional loan work?
A conventional loan isn’t backed by any government program. You can find loans with low interest rates and flexible down payment requirements, but they’re usually harder to qualify for than government-backed loans.
There are two main types of conventional loans — conforming and non-conforming loans. The government sets maximum loan amounts for conforming loans, and they must meet the standards set by Fannie Mae and Freddie Mac.
Non-conforming loans either have loan amounts exceeding the conforming loan limits or don’t fit into any other loan categories. For example, jumbo loans are a type of non-conforming loan since they come with loan amounts of up to $2 million.
Types of conventional loans
Here are five different types of conventional loans first-time homebuyers can choose from:
- Conforming loans: Conforming loans meet the standards set by Fannie Mae or Freddie Mac and come with maximum loan amounts. These maximum loan amounts range from $726,200 to $1,396,800 depending on the number of units. These amounts will differ if your property is located in Alaska, Guam, Hawaii, or the U.S. Virgin Islands.
- Non-conforming loans: Non-conforming loans don’t have maximum loan amounts and are less standardized than conforming loans. The eligibility requirements will vary depending on your lender.
- Fixed-rate loans: Fixed-rate loans come with a set interest rate that won’t change over the life of the loan. This makes it easier to budget for your monthly payments.
- Adjustable-rate loans (ARMs): When you take out an ARM, your interest rate will go up and down depending on market conditions.
- Jumbo loans: Jumbo loans exceed the maximum loan limits set by Fannie Mae and Freddie Mac. The loan limits can go as high as $1 to $2 million, depending on where you’re located.
Conventional loans vs. FHA loans
The following table outlines how conventional loans stack up to FHA loans:
| Conventional loans | FHA loans |
|---|---|
| Not backed by a government agency | Backed by the Federal Housing Administration (FHA) |
| Down payment as low as 3% | Down payment as low as 3.5% |
| Private mortgage insurance (PMI) is required when the down payment is below 20% | Upfront and monthly mortgage insurance required |
| Better for borrowers with good credit | Better for borrowers with poor credit |
Comparisons with other loans
Here’s how conventional loans compare to other popular loan types:
Conventional loans | VA loans | USDA loans | Jumbo loans | |
|---|---|---|---|---|
| Backing | Not backed by a government agency | Backed by the Department of Veterans Affairs | Backed by the U.S. Department of Agriculture | Not backed by a government agency |
| Down payment amount | Down payment as low as 3% | No down payment requirements | No down payment requirements | Typically 10% but varies by lender |
| PMI | PMI required when down payment is below 20% | No PMI required | No PMI required | PMI required when down payment is below 20% |
| Best for | Better for borrowers with good credit | Best for veterans, active-duty service members, and eligible spouses | Best for low-income borrowers who live in rural areas | Best for borrowers needing a loan that exceeds $726,200 (note that the conforming loan limit changes annually) |
How to qualify for a conventional loan
Conventional loans tend to be harder to qualify for than government-backed loans. Since a government agency isn’t backing the loan, the lender bears the full burden if you default. Here are the minimum eligibility requirements you’ll need to meet to qualify for a conventional loan.
Proof of income
You’ll need to provide proof of income to show your mortgage lender that you can afford the monthly mortgage payments. You can do this by providing pay stubs, your W-2, and tax returns. You should also show any additional assets or streams of income, like alimony payments or income from a second job.
Credit score
You’ll need a minimum credit score of 620 to qualify for a conventional loan. But if your credit score is higher, you’ll qualify for a better interest rate and terms on your loan. If your credit score is too low, you may have better luck applying for an FHA loan.
Debt-to-income ratio
Your debt-to-income ratio (DTI) is your total monthly debt payments divided by your gross monthly income. Most lenders will look for a DTI ratio below 45%, though some lenders will require a lower DTI if you have poor credit.
Down payment
You may be able to qualify for a conventional loan with a down payment as low as 3%, but that means you’ll have to pay for PMI. If you make a down payment of 20%, you can avoid this.
Pros and cons of conventional loans
Applying for a conventional loan may be a good choice, depending on your financial situation. Here are some pros and cons to consider:
Pros
- More options: When you apply for a conventional loan, you have more loan options to choose from. You’ll also have more options when it comes to the type of interest rates and terms you want.
- Higher loan limits: Conventional loans are a better option for borrowers who want higher loan limits. When you take out a jumbo loan, you can access borrowing limits that are higher than those set by Fannie Mae and Freddie Mac.
- No PMI: If you take out an FHA loan, you have to pay for mortgage insurance regardless of the size of your down payment. But if you put down a 20% down payment on a conventional loan, you can avoid it altogether.
Cons
- Higher credit score required: You’ll need a minimum 620 credit score to qualify for a conventional loan. But if you want to qualify for the lowest interest rates, you’ll need excellent credit. For that reason, government-backed loans may be the better option for borrowers with bad credit.
- Higher closing costs: Many government-backed loans allow you to roll your closing costs into the mortgage, but this isn’t usually an option with conventional loans.
The cost of a conventional loan
Let’s say you’re planning to take out a 30-year loan on a $300,000 mortgage with a 6.5% interest rate, and you’ve saved up for a 20% down payment. Your credit score is 620, so it’s OK, but not great. You’re eligible to take out a conventional loan and an FHA loan, and you’re wondering which you should choose.
The following table outlines what you can expect to pay for both loans:
| Conventional loan | FHA loan | |
|---|---|---|
| Monthly payment | $1,517 | $1,676 |
| Upfront costs | $7,200 | $4,200 |
| Monthly mortgage insurance | $0 | $159 |
| Total 30-year cost | $613,307 | $631,359 |
The upfront costs will be significantly higher with a conventional mortgage. But it’s interesting to note that a conventional mortgage comes out on top when you look at the total 30-year cost — it is $18,052 cheaper than an FHA loan.
FAQ
What is the interest rate for a conventional loan?
The interest rate you receive on a conventional loan will vary depending on your credit score, financial history, and lender. It’ll also depend on what the current market conditions are like.
Is a conventional loan good or bad?
A conventional loan is a good option for some borrowers and a less ideal option for others. If you have a strong credit score and history, a conventional loan may be a good choice for you.
Is a conventional loan better than an FHA loan?
A conventional loan is a better choice for borrowers with good to excellent credit. If you’re a low-income borrower and have poor credit, you may want to consider an FHA loan.