What is a Conventional Mortgage Loan?
A conventional mortgage loan is any type of home buyer’s loan that is not offered or secured by a government entity. (such as the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the Department of Agriculture (USDA) loan mortgage programs). Instead, conventional mortgages are available through private mortgage lenders, such as banks, credit unions and mortgage companies. However, some conventional mortgages can be guaranteed by two government-sponsored enterprises like the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Conventional loans can be conforming or non-conforming mortgage loans.
KEY POINTS:
- A conventional mortgage loan is a home buyer’s loan that is not offered or secured by a government entity (FHA, VA, USDA)
- These mortgage loans are available through or guaranteed by a private lenders or the two government-sponsored enterprises—Fannie Mae and Freddie Mac.
- Borrowers need to complete an official mortgage application (URLA / Form 1003), provide required documents, credit history, and a current credit score.
- Conventional mortgage loan interest rates tend to be a bit higher than those of government-backed mortgages, like FHA mortgage loans.
Understanding Conventional Mortgages
Conventional mortgage loans have usually a fixed interest rate, which means that the interest rate does not change over the life of the mortgage loan. Conventional mortgages are not guaranteed by the federal government and as a result have stricter lending requirements by banks and creditors.
Government agencies that secure mortgages for banks include, the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs(VA), and the USDA Rural Housing Service. There are requirements that borrowers must meet to qualify for these mortgage loan programs.
Conventional vs. Conforming
Conventional mortgage loans are often referred to as conforming mortgages, which is not true. There is overlap in the two distinct categories. A conforming mortgage loan is one where the terms and conditions meet the funding criteria of Fannie Mae and Freddie Mac. The dollar limit of the mortgage loan amount, set annually by the Federal Housing Finance Agency (FHFA) is the main difference. In almost every state, a loan must not exceed $548,250 for 2021.
While all conforming loans are conventional, not all conventional mortgage loans qualify as conforming. A jumbo mortgage loan of $800,000 dollars, is a conventional mortgage but not a conforming mortgage for example — just because it surpasses the dollar limit amount allowed and backed by Fannie Mae or Freddie Mac.
There were 8.3 million homeowners with FHA insured mortgage loans in the year 2020. The secondary market for conventional mortgage loans is extremely large and liquid. Most conventional mortgages are packaged into mortgage-backed securities to be passed thru, which trade as the mortgage to be announced (TBA) market. These conventional pass-thru securities are securitized into collateralized mortgage obligations (CMOs).
How a Conventional Mortgage Loan Works
Since the subprime mortgage meltdown in 2007, mortgage lenders have tightened the qualifications for mortgage loans like “no verification” and “no down payment” mortgages have been eliminated, for example — but most of the basic requirements have not changed. Borrowers need to complete an official mortgage application (pay an application fee), supply the mortgage lender with the necessary documents to perform an extensive background check, credit history and their current credit score.
Required Documentation
There is no property that is 100% financed. The Ability to Repay Rule (ATR) is required for checking your assets and liabilities. The lender is looking to see not only if you can afford your monthly mortgage payments, which should not exceed 28% of your gross income and if you can handle a down payment on the property, other up-front costs, such as loan origination or underwriting fees, broker fees, and settlement or closing costs, all of which can substantially increase the cost of a mortgage loan. Items required are:
1. Proof of Income
These documents will include but may not be limited to:
- Full Thirty days of pay stubs that show income as well as year-to-date income
- Two years of federal tax returns (signed)
- Sixty days or a quarterly statement of all asset accounts, including your checking, savings, and any investment accounts
- Two years of W-2 statements
Borrowers also need to be prepared to proof of any additional income, such as alimony or bonuses.
2. Assets
You have to present bank statements and any investment account statements to prove that you have the funds for the down payment and closing costs on the property and any cash reserves. Money you receive money from a friend or relative to assist with the down payment need a gift letter, which show that the money is not a loan and there is no obligation of repayment. The gift letter will have to be notarized.
3. Employment Verification
Today, Lenders want to make sure they loan to only borrowers with a stable work history. The lender will want to see your pay stubs and may also call your employer to verify your employment and to check your salary. If you have recently changed jobs, the lender may want to contact your previous employer. Self-employed borrowers will have to provide additional paperwork about their business and income.
4. Other Documentation
The lender will want to copy your driver’s license or state ID card and will need your Social Security number and your signature, giving permission to the lender to pull your credit report.
Interest Rates for Conventional Mortgages
Conventional mortgage loan interest rates lean to be higher than those of government-backed mortgages, such as FHA loans (these mortgage loans, which mandate that borrowers pay mortgage-insurance premiums, work out to be as costly over time).
The interest rate for a conventional mortgage loan depends on several factors, including the terms of the loan — its length, its size and whether the interest rate is a fixed interest or an adjustable rate— as well as current economic and/or financial market conditions. Mortgage lenders set interest rates based on their expectations for future inflation, the supply and demand for mortgage-backed securities also influences these rates.
When the Federal Reserve increases their rates for banks to borrow, the banks in turn pass on the higher costs to their customers and consumer loan interest rates, including mortgage interest loan rates go up.
These interest rate are points, fees paid to the lender (or broker), the more points you pay, the lower your interest rate will be. One point costs equals 1% of the loan amount and reduces your interest rate by about a quarter of a percent. (%).
Finally in determining the interest rate is the individual borrower’s financial profile, personal assets, creditworthiness and the size of the down payment they can make on the property to be financed.
A buyer, who plans on living in a home for 7 or more years should consider paying for points to keep interest rates lower for the life of the mortgage loan.
Special Considerations for a Conventional Mortgage Loan
These loans are not for everyone. Who is likely to qualify for a conventional mortgage loan and who is not.
Who May Qualify
People with established credit and excellent credit reports who are in a solid financial situation usually qualify for conventional mortgages. The ideal candidate should have:
Credit Score
A credit score is a reflection of a borrower’s ability to repay a loan. Credit scores include a borrower’s credit history and the number of late payments. A credit score of at least 680 and well over 700 can be required for approval. The higher the score the lower the interest rate on the loan with the best terms for those over 740.
Debt-to-Income
An acceptable debt-to-income ratio (DTI) is the sum of your monthly debt payments, like credit cards and loan payments are compared to your monthly income. The debt-to-income ratio should be around 36% and no more than 43%. You should spend less than 36% of your monthly income on debt payments.
Down Payment
The down payment of at least 20% of the home’s purchase price available? Lenders can and do accept less and if they do, they often require that borrowers take out private mortgage insurance (PMI) and pay its premiums monthly until they achieve at least 20% equity in the property.
Additionally, conventional mortgages are often the best or only option for homebuyers who want the residence for investment purposes, for a second home and/or who want to purchase a property priced over $500,000.
Who May or Will Not Qualify
Those who are starting out in life, those with more debt than normal and those with a lower credit scores often have trouble qualifying for conventional loans. Specifically, these mortgages would be tough to those who have:
- Had a bankruptcy or a foreclosure within the past seven years
- Credit scores below 650
- Debt-to-Income Ratio (DTI) above 43%
- Down Payment of less than 20% or even 10% of the home’s purchase price
If you are turned down for the mortgage loan, make sure to ask for the bank’s reasons in writing. You may qualify for other programs that could help you get approved for a mortgage loan.
For example, you have no credit history and you are a first-time homebuyer, you may qualify for an FHA loan. FHA loans are loans that are created for first-time home buyers. As a result, FHA loans have different qualifications and credit requirements for the borrower, including a lower downpayment.