A home is the most expensive purchase most people ever make, which is the main reason consumers take out home loans that take up to 30 years to pay back. Without the ability to finance the purchase with a mortgage, it would be nearly impossible for most people to afford a home.
If you’re in the market for a home, you’re probably excited about the possibility of becoming a homeowner — even with the prospect of a long-term loan on the horizon. Still, it’s important to learn as much as you can before you dive in, and one piece of the puzzle is differentiating between a conventional loan and other types of mortgages. Keep reading to learn more about conventional loans, how they work, and what makes them different.
What Is a Conventional Loan?
Conventional loans are, well, pretty conventional: They make up the majority of mortgages issued in the United States. Three out of every four new homes were purchased with a conventional mortgage last year.
The main detail to note is this: Some mortgages are guaranteed by the government, like FHA loans, while others are not. And a conventional loan, specifically, is not guaranteed by the government — which can be either a positive or a negative for consumers.
While conventional mortgages typically meet basic lending standards determined by Fannie Mae and Freddie Mac, you can shop around for the best conventional loan at a private bank, credit union, mortgage broker, non-bank lender, or any other savings institution. The lack of government red tape can help make the process quicker, and conventional mortgages may offer lower interest rates, too.
On the other hand, because it’s not government-backed, a conventional loan puts more risk on the lender’s shoulders and may require a larger down payment or better credit to qualify. If you want to qualify for the best conventional loan with the lowest rate, you’ll need a very good credit score. Most applicants should strive for a score over 650 before they apply for a conventional mortgage, but the best loan terms will go to those whose FICO scores are above 740.
How Conventional Mortgages Work
Conventional mortgages can be packaged in a number of ways, but they usually come with a 15- or 30-year term. Most lenders who offer conventional mortgages require clients to put down at least 3% of the purchase price, although a 20% down payment is considered standard.
If your down payment is less than 20% of the purchase price, you’ll need to pay PMI, or private mortgage insurance, each month. This insurance, which can cost up to 1% of your home’s purchase price each year, protects the lender if you default.
If you can manage a down payment of 20% or more, you can avoid PMI and the associated costs altogether. With a larger down payment at closing, you’ll also borrow less money and enjoy a lower monthly payment as a result.
In addition to coming up with a down payment, there are other fees associated with getting a conventional loan, just like any other mortgage. Those fees can include origination fees, appraisal fees, and closing costs. You may be able to negotiate with the seller of your home and get them to pay some of these costs for you.
Types of Conventional Loans
The amount of money you can borrow with a conventional mortgage will depend on how much you earn, how large your down payment is, and the type of conventional mortgage you choose. For the most part, there are two types of conventional mortgages you can qualify for — fixed-rate mortgages and adjustable-rate mortgages.
Fixed-rate mortgages come with a fixed interest rate and a fixed repayment timeline, usually for 10 to 30 years. With a fixed-rate mortgage, your monthly payment will stay the same for the duration of the loan (with the exception of any changes in property taxes or homeowners insurance). The most popular fixed-rate mortgage is the 30-year, fixed-rate mortgage. This type of mortgage allows consumers to lock in their interest rate for 30 years and score a low monthly payment due to the extended timeline.
With an adjustable-rate mortgage, or ARM, on the other hand, the interest rate is only fixed for a certain amount of time. After that, the rate adjusts up or down based on an index. With a 7/1 ARM, for example, you’d get a fixed introductory rate for seven years, followed by a rate that can change with market conditions every year thereafter.
Keep in mind there are many loans within the worlds of fixed-rate mortgages and ARMs. Some last longer than others and there are additional differences, but they mostly fall into these two categories.
Conforming vs. Noncomforming Home Loans
Another difference among conventional mortgages is whether they are conforming loans or noncomforming loans.
Conforming loans must meet certain guidelines set by Fannie Mae and Freddie Mac, and fall under a specific threshold. In 2019, conforming loans for single-family homes in most areas were limited to $484,350. In certain regions of the country with a higher cost of living, conforming loans for single-family homes could be as high as $726,525 this year.
Nonconforming loans are those that are out of the ordinary – either because they’re for a large amount or have been extended to nontraditional borrowers.
One type of nonconforming loan, called a jumbo loan, is for individuals and families who borrow more money than the conforming loan threshold. Since these loans tend to be riskier, they may come with higher interest rates and less comfortable terms.
Other types of nonconforming loans include loans made to people with bad credit, a large debt load, or a recent bankruptcy. These loans are considered nonconforming because they don’t meet standards set by Freddie Mac and Fannie Mae. Nonconforming loans tend to come with higher interest rates, additional fees, and heftier insurance requirements to offset the increased risk.
When a Conventional Loan Makes Sense
Because conventional mortgages aren’t guaranteed by the federal government, they’re mostly geared toward borrowers who pose less risk to the lender. If you have good or excellent credit and a down payment of at least 5% (but ideally 20%), you’re a good candidate for a conventional mortgage.
If you have a low income, have veteran status, or live in a rural area, on the other hand, you might want to consider a home loan backed by the federal government. FHA loans were created to make home ownership more attainable for low and middle-income buyers, while VA loans offer special benefits for both active duty military members and veterans. USDA loans, on the other hand, were created to make home ownership in rural areas more attractive and feasible.
The Bottom Line
If you’re ready to buy a home and don’t know where to start, you should research home loans and learn as much you can. Compare the different types of mortgages and ask yourself whether a loan backed by the federal government — such as the low-down payment mortgages found in first-time home buyer programs — might leave you better off or not.
Once you figure out which type of loan would work best for your needs, you can shop around among banks and other lenders. By shopping around for a loan with the best interest rate and terms, you can save big on the long-term costs of home ownership.