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What is a conventional loan?

What is a conventional loan?

06.30.2023

Purchasing a home or other property can be an exciting yet complicated process. One of the first decisions you’ll need to make is to choose your home mortgage. The most popular type of mortgage1 option today is a conventional loan.

What is a conventional loan? In basic terms, it’s any type of mortgage that is not insured by the federal government. Instead, private lenders, such as banks and credit unions, issue conventional loans to homebuyers.

Before determining which loan is best for your specific situation, it’s important to understand all your options. Below, we’ll take a closer look at conventional loans, the advantages and disadvantages these loans offer, as well as additional details on how to qualify for this type of loan.

What are the differences between conventional loans and government loans?

The main difference between conventional loans and government loans is that government loans are insured by the federal government. This insurance makes it possible for homebuyers who may not qualify for a conventional loan to purchase a home.

Government loans also come with various benefits that aren’t available through a conventional loan. These benefits vary based on the type of government loan. Below is a closer look at how various government loans differ from conventional loans.

FHA vs. conventional loans

FHA loans are insured by the Federal Housing Administration. Homebuyers with credit scores as low as 500 may be able to qualify for an FHA loan, but they could be required to have a 10% down payment. Those with credit scores higher than 580 may be able to secure an FHA loan with as little as a 3.5% down payment.

It’s important to note that with an FHA loan, homebuyers must pay a mortgage insurance premium (MIP), which is usually added to the loan and included in the monthly payment. With a conventional loan, homebuyers can stop paying private mortgage insurance (PMI) once they have 20% equity in their property. For FHA loans, the length of required MIP payments depends on the size of the loan and down payment along with other factors. Down payments of less than 10% on FHA loans typically require MIP payments for the life of the loan, or at least until  the loan is refinanced.

VA vs. conventional loans

VA loans from the Department of Veterans Affairs also come with a variety of special features that conventional loans don’t offer, such as no down payment or PMI requirements. Unless exempt, homebuyers obtaining a VA loan do have to pay a funding fee that ranges from 1.25% to 3.3% of the full loan amount.

However, these loans are backed by the Department of Veterans Affairs and are therefore only available to qualifying current and veteran members of the U.S. Armed Forces, their spouses and certain members of the National Guard.

USDA vs. conventional loans

Rural homebuyers can obtain a USDA loan with no down payment and no PMI. Although, they do incur a guarantee fee, which if paid upfront, is about 1% of the full loan amount. Unlike conventional loans, USDA loans do have income eligibility guidelines, so not all homebuyers qualify. Additionally, with a USDA loan, you can only purchase a property in specific rural areas, which could be quite limited depending on where you live.

Types of conventional loans

If you’re considering using a conventional loan to purchase your next home, you’ll have several types of these loans to choose from.

Conforming loans

Conforming loans are the most popular type of conventional loan. These loans adhere to the various guidelines set by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), such as maximum loan amounts. The maximum loan amounts for 2023 are $726,000 and $1,089,300 in designated high-cost areas. In most cases, homebuyers with less than a 20% down payment must purchase PMI.

Jumbo loans

Jumbo loans are for homebuyers purchasing a property that goes over the Fannie Mae and Freddie Mac spending limits. To obtain a jumbo loan, homebuyers typically have to have a higher down payment, better credit score and lower debt-to-income ratio than those obtaining a conforming conventional loan.

Portfolio loans

A portfolio loan is one where the lender decides to keep the loan in-house as part of its portfolio rather than sell it to a secondary lender. This lending method offers more flexibility than conforming loans. For example, lenders offering portfolio loans can be more flexible with down payments and credit score requirements.

Subprime loans

Homebuyers who cannot meet the standard requirements for obtaining a conventional loan, such as a 620 credit score or debt-to-income ratio under 50%, may qualify for a subprime loan. Typically, subprime loans have higher-than-average interest rates.

How to qualify for a conventional loan

To qualify for this type of loan, you must first meet a set of conventional loan requirements.

Credit score

Most conventional loan lenders require homebuyers to have a minimum credit score of 620 to qualify. Keep in mind that the better your credit score, the more favorable loan terms you may obtain. For example, those with credit scores in the mid to high 700s are likely to receive better interest rates on their mortgage. If your credit score is lower than 620, you may want to look for a government-back loan, such as an FHA loan.

Down payment

Nearly all conventional loan lenders require some type of down payment. If you qualify as a first-time homebuyer, you may be able to secure a conventional loan with as little as 3% down. However, most lenders require at least a 5% down payment. If the property being purchased is a secondary or multi-unit home, you could be required to have a 10% or 15% down payment.

You may be required to purchase PMI if you don’t have at least a 20% down payment. There are a variety of down payment assistance programs that may be able to help cover all or a portion of your down payment and closing costs. These programs vary by state and location.

Debt-to-income ratio

Fannie Mae and Freddie Mac guidelines require homebuyers to have a debt-to-income (DTI) ratio of 50% or less. However, many conventional loan lenders prefer homebuyers to have a DTI under 35%. You can easily calculate your personal DTI ratio by dividing the sum of all your debt payments, including auto loans, personal loans, credit cards and student loans, by your total gross monthly income.

Loan size

Fannie Mae and Freddie Mac regulations also set limits to the size of a conventional loan you can obtain. The 2023 limit for purchasing a single-family home is $726,200.2 If you live in a recognized high-cost area, this limit increases to $1,089,300. If the value of the home you want to purchase exceeds these limits, you can apply for a jumbo loan, but keep in mind that these loans have higher qualification requirements.

These requirements determine your eligibility for a home loan and help determine your mortgage interest rates. For example, the higher your credit score, the better interest rate you’re likely to receive.

What are the advantages of a conventional loan?

There are several advantages of using a conventional loan vs. a government-insured loan, including:

  • Lower interest rates. Exact interest rates are based on your personal information, such as your credit score, amount of down payment and DTI ratio. On average, interest rates on conventional loans tend to be slightly lower than interest rates for FHA loans. Depending on your specific situation, you may be able to save money through the duration of your loan by choosing a conventional loan.
  • Higher loan limits. If you want to take out a home mortgage with a value higher than the Fannie Mae/Freddie Mac guidelines of $726,200 ($1,089,300 in high-cost areas), a conventional jumbo loan may be one of your only options. The jumbo loans have more flexibility, but you may need to pay a higher down payment depending on your credit, DTI ratio and the value of the home.
  • Flexibility. While conforming conventional loans still abide by all Fannie Mae and Freddie Mac guidelines, non-conforming conventional loans may not. For instance, homebuyers with credit scores lower than 620 may qualify for a subprime loan, or homebuyers looking for more flexibility in qualifications may qualify for a portfolio loan.  

What is the downside of a conventional loan?

While there are plenty of benefits that come with conventional loans, there are also a few disadvantages. It’s important to understand these downsides before applying for a conventional loan.

  • High credit score requirements: Unless you're seeking a subprime conventional loan, it’s likely that you’ll need a credit score of at least 620. This requirement could be even higher for jumbo loans. If your credit score prevents you from securing a conventional loan, you may want to consider applying for an FHA loan. In some cases, homebuyers can obtain an FHA home mortgage with a credit score as low as 500.
  • Higher down payment: If you’re a first-time homebuyer, you may be able to get a conventional loan with as little as 3% down, but in most cases, a minimum 5% conventional loan down payment is required. On the other hand, you’re only required to put down a 3.5% down payment for an FHA loan, and VA and USDA loans often have no down payment requirements.
  • Stricter guidelines: Most lenders consider government loans less risky because they are insured by the federal government. Because conventional loans don’t have this government insurance, lenders often have stricter conventional loan requirements. This means that lenders will thoroughly scrutinize your finances, including your credit score and debt-to-income ratio, prior to loan approval. This factor can make it more difficult for some potential homebuyers to obtain a conventional loan.  

The bottom line

Before applying for a home loan, it’s important to get a solid grasp on your financial situation:

  • Check your credit score
  • Calculate your debt-to-income ratio
  • Determine how much you can afford to spending on your down payment and closing costs
  • Know what monthly mortgage payments, including PMI, insurance and property taxes, that you can afford

This information can help you compare your loan options and determine whether a conventional loan or government loan is best for you.

As you prepare for home buying, you may want to consider signing up for free financial tools to help you manage your money and save for the big purchase. The Empower Personal Dashboard™ can help you analyze your financial health, plan for expenses like a home down payment, and see how this purchase may impact your retirement plans.

1 ICE Mortgage Technology, “Origination Insight Report,” August 2021.

2 Federal House Finance Agency, "FHA Announces Conforming Loan Limit Values for 2023," November 2022.

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JJ Lester, CFP®

Contributor

JJ Lester is an Options and Real Estate Specialist at Empower. A CERTIFIED FINANCIAL PLANNER™ professional, he provides clients with robust planning advice on employer equity compensation and real estate investing.

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