If you’re just starting your financial journey, you’ve probably heard the term “conventional loan” thrown around, especially when it comes to buying a house.
But what exactly is a conventional loan? And why is it important to understand it as you embark on making big financial decisions?
What is a Conventional Loan?
A conventional loan is a type of mortgage that is not backed by a government agency. Unlike FHA loans, VA loans, or USDA loans that are guaranteed or insured by the government, conventional loans are provided by private lenders, such as banks, credit unions, or mortgage companies.
These loans follow guidelines set by Fannie Mae and Freddie Mac, the two major entities that buy and sell mortgages in the U.S.
Key Features of a Conventional Loan
Understanding the characteristics of conventional loans can help you make an informed decision when you’re ready to purchase a home.
Here are some key features:
- Credit Requirements: Conventional loans typically require a higher credit score than government-backed loans. A credit score of 620 is usually the minimum, but higher scores (700 and above) can help you secure better interest rates.
- Down Payment: One of the biggest benefits of a conventional loan is flexibility in down payments. While many people think they need to put down 20%, some lenders allow as little as 3-5% down.
- Loan Limits: Conventional loans come with borrowing limits set by Fannie Mae and Freddie Mac. As of 2024, the conforming loan limit for most areas is $726,200, but it can be higher in some high-cost areas.
- Interest Rates: The interest rates on conventional loans are typically fixed, meaning you pay the same rate for the life of the loan. However, you can also find adjustable-rate mortgages (ARMs), where the interest rate changes after an initial fixed period.
- Mortgage Terms: Conventional loans generally come in 15-year or 30-year terms.
Why Choose a Conventional Loan?
There are many reasons why a conventional loan might be a great fit for your financial journey:
- More Flexibility in Property Type: Conventional loans can be used to buy many different types of properties, including second homes, vacation homes, and investment properties, whereas some government-backed loans have restrictions.
- Lower Overall Costs: While the down payment can be higher, the costs associated with a conventional loan can be lower over time, particularly if you can avoid PMI by putting down 20% or more.
- Avoiding Mortgage Insurance Costs: Unlike FHA loans, which require mortgage insurance premiums (MIP) for the life of the loan, conventional loans allow you to cancel PMI once you reach 20% equity in your home.
- Better Rates for Good Credit: If you have a strong credit score and stable income, a conventional loan can offer lower interest rates compared to government-backed loans.
Pros and Cons of Conventional Loans
Understanding the pros and cons of conventional loans will help you weigh your options and decide what fits best with your financial goals.
Prós:
- Lower Interest Rates for Good Credit: Borrowers with good credit scores can enjoy lower interest rates and better loan terms.
- More Flexibility in Terms and Loan Amounts: You can choose different loan terms (15, 20, or 30 years) based on your budget and preferences.
- No Upfront Mortgage Insurance Fees: Unlike FHA loans that require upfront MIP payments, conventional loans only require PMI if you put down less than 20%.
Cons:
- Higher Credit Score Requirements: You generally need a credit score of at least 620, but a higher score is recommended to get the best rates.
- Potential PMI Costs: If you can’t put down 20%, you’ll need to pay for PMI, which adds to your monthly payment.
- Strict Debt-to-Income (DTI) Ratios: Lenders usually prefer a DTI ratio (the percentage of your income that goes toward debt payments) of around 43% or lower, which can be a challenge for some borrowers.
How to Qualify for a Conventional Loan
If a conventional loan seems like the right choice for you, here’s what you need to do to qualify:
- Build and Maintain a Good Credit Score: Since conventional loans rely heavily on credit scores, it’s important to work on building your credit. This means paying your bills on time, keeping credit card balances low, and avoiding opening too many new accounts.
- Save for a Down Payment: While the minimum down payment can be as low as 3%, saving more can help you avoid PMI and reduce your monthly payments.
- Manage Your Debt-to-Income Ratio: Lenders look at your DTI to ensure you can afford the mortgage payments. Reducing your debt or increasing your income can help you meet the required DTI ratio.
- Steady Employment and Income: Lenders prefer borrowers with a stable job history, so consistent employment and a steady income can help strengthen your application.
When is a Conventional Loan the Right Choice?
A conventional loan is a great option if you:
- Have a good to excellent credit score and can secure a low interest rate.
- Have enough savings for a down payment (ideally 20% to avoid PMI).
- Are looking to purchase a property that doesn’t meet government loan standards (like an investment property or second home).
- Want more options in terms of loan amount, property type, and mortgage length.
- However, if you have a lower credit score or struggle with a high DTI ratio, you might want to explore other options like FHA, VA, or USDA loans.
Summary: Key Takeaways
- A conventional loan is a mortgage not backed by the government, typically provided by private lenders.
- It requires a higher credit score, usually at least 620, and may need a down payment of 3-20%.
- You may have to pay for private mortgage insurance (PMI) if you put down less than 20%.
- Conventional loans are flexible in terms of property types, and borrowers with good credit can benefit from lower interest rates.
- They are a solid choice for those with good credit and enough savings for a down payment.
Conclusion
Choosing the right type of mortgage is a big step in your financial journey, and understanding what a conventional loan is can help you make an informed decision.
Conventional loans offer flexibility, competitive interest rates for those with good credit, and potential savings if you’re able to put down a larger down payment.