Owning real estate is expensive. Even for those with a solid savings account and a comfortable salary, it’s unlikely that you’ll be able to simply buy a home outright. That’s why most people, when they decide to invest in property and purchase a home, decide to take out a mortgage loan.
You’ve probably heard of mortgages at various points throughout your life, but you may not have ever arrived at answers to the questions, “what is a conventional loan?” or “how do mortgages work?” Don’t worry: we’re here to make it clear. Let’s start with a simple definition.
What is a conventional loan?
A conventional home loan is a large sum of money lent to a borrower by a bank, credit union, or lending agency—often referred to as a conventional mortgage when the loan is used to purchase property. The term conventional distinguishes this kind of financial product from other types of loan, like a jumbo loan, a VA loan, or an FHA loan.
In this article, we’ll walk you through the conventional loan basics you need to know to start your search with confidence. We’ve also included information on how to qualify for a mortgage and where to start looking for one when the time is right.
How do conventional loans work?
Conventional loans work like this: the bank (or credit union or lending agency) purchases property on your behalf and turns the title over to you—however, you promise to pay back the lender with interest.
Interest is the percentage rate you pay the bank for the trouble of lending you money, and it’s how the bank makes money from having lent you such a large sum. Interest rates are either fixed or adjustable; in the latter case, they typically change once per year depending on the state of the economy. The interest rate you receive on a conventional loan will also vary based on your own personal financial profile (more on that in a bit).
Interest rates and qualifications for a mortgage can vary significantly across the wide range of home loan products available to consumers, but conventional home loan terms tend to fall into a narrower set of categories. One distinction you’ll find between two types of mortgage products is conforming vs nonconforming loans.
Conventional mortgages are typically lent out with 15 or 30 year repayment periods; the one that’s right for you depends on your personal finances, your income, and the interest rate you can secure.
Conforming vs nonconforming
In the US, there are two federally run institutions that oversee a large portion of mortgage lending: Fannie Mae and Freddie Mac. The important takeaway is that conforming loans abide by lending standards put in place by Fannie Mae and Freddie Mac. Most importantly, these limits determine the possible size of the loan; In 2020, the conforming loan limit for a single-family home is $510,400. (Limites are higher in Hawaii, Alaska, Guam, and the US Virgin Islands.)
Nonconforming loans, sometimes called jumbo loans exceed these borrowing amounts. Nonconforming loans can vary more in their limits, rules, and conditions. Because they present a larger risk to lenders, they tend to come with higher interest rates. Non-conforming loans are not necessarily risky by default—though the Consumer Financial Protection Bureau warns they sometimes can be—but it’s still wise to read the fine print when shopping, and be sure to shop around before committing to any lender.
If you’re curious whether the homes you are interested in can be financed with a conforming loan, you can read more about the 2020 Federal Housing Finance Agency guidelines on FHFA.gov.
Who qualifies for a conventional loan?
Conventional home loans are more accessible to those with middle- to high-income, as they often necessitate a down payment and favorable financial profiles in order to secure a reasonable rate. This distinguishes them from government-backed loans, such as FHA loans, VA loans, and other products that are aimed at people with lower incomes, and make purchasing homes accessible to them.
In general, there are three areas that lenders care most about when assessing an applicant for a conventional loan: credit score, debt-to-income ratio, and down payment. Let’s take a look at each one of those qualifying criteria and what a lender might look for in a loan applicant.
You may have often heard about people who want to improve their credit, or who want to gain access to certain financial benefits due to having good credit. Your credit score is essentially a measure of your trustworthiness as a borrower. It’s based on your past abilities to consistently pay off debts in a timely manner, as well as other factors like the number of accounts you have open. This includes debts like:
In fact, one reason many people work to improve their credit scores is to gain more favorable terms on a home loan they hope to apply for in the future. Credit scores are measured using a few different metrics. Two of the most common credit reports pulled by lenders are FICO and VantageScore. Both of these are measured from 300 to 850, with a score of 300 representing a very dubious borrowing history (likely with many late payments and defaults), and a score of 850 representing a strong and trustworthy history of borrowing.
Having high credit can mean the difference between a massive interest rate and one that’s much easier to manage. If you can, it’s smart to work on improving your credit before you seriously consider applying for a mortgage.
The next mortgage lender consideration is your debt-to-income (DTI) ratio. This ratio is pretty much exactly what it sounds like: the total amount of money you spend on debt in a month divided by the amount of money that you bring in. Lenders consider this metric important because it indicates how well you may be able to keep up with payments. If your ratio is too high, it may suggest that there will be strain on your finances when adding a mortgage payment to the mix.
Check out the graphic below for instructions on how to calculate your own debt-to-income ratio.
If your DTI is too high, it may be worth taking steps to lower it before you apply for a conventional loan. This can be done by asking for a raise at work, following a debt repayment strategy, or consolidating outstanding debts to lower monthly payments. Waiting might feel frustrating, but facing a high interest rate for years or decades down the road will be more of a hassle in the long term.
Your down payment is another significant factor that lenders closely consider when determining your eligibility for a conventional loan and the interest rate attached to it. A down payment is just a large lump-sum of money that you pay up front; it’s a percentage of the total cost of the home. For example, a 20% down payment on a home worth $500,000 would be $100,000; the remainder of the price could be financed through a conventional mortgage loan.
Many lenders may be more willing to approve you for a loan with a favorable interest rate if you’re able to put down a larger down payment.
You may have heard that you need a 20% down payment in order to afford a home. The average house costs around $250,000 according to Zillow, so it’s understandable if you don’t have $50,000 on hand. While that 20% number is definitely still a great option if you can comfortably afford it, you don’t need to panic if you don’t have that kind of cash laying around. Some lenders may allow you to make a down payment as low as 3%.
However, it’s important to note that if you do make such a low down payment, you may have to purchase private mortgage insurance, or PMI. The cost of PMI is added to your monthly mortgage payments, usually until you’ve paid 20% or more of the balance on the loan. For this reason, it’s generally a good idea to put 20% down if you can; this way, you wave PMI fees, lowering your monthly payments.
How to apply for a conventional loan
Applying for a conventional loan can be a nerve-racking process, but by making the right preparations and taking the right steps, it’s totally doable. If you’re considering applying for a conventional loan in the near future, here are some steps that you may want to take.
Consider your financial profile
Before you start seriously inquiring about a mortgage, it’s smart to get your personal finances in the best shape you can. That means repairing bad credit if your score is less than ideal, paying down existing debts and working on increasing your monthly income, and saving for a down payment as large as you can comfortably make.
From local credit unions, to large multinational banks, and consumer-friendly lending agencies to less-than-reputable ones, there are tons of places where you might apply for a mortgage. Some offer more preferable terms than others, and some make it easier to apply—but might come with greater risk.
These are all factors you should consider as you seek out the right lender for your mortgage. It’s smart to compare several lenders before you settle on the right fit for your needs.
Apply for your mortgage
Once you’ve decided on which lender best suits your needs, you can apply for your mortgage. At this point, your house hunt can begin! The application process can take some time—sometimes more than a month—and involves heavy documentation so it’s smart to start this early, preferably before you’ve started house hunting in earnest.
Conventional home loans can feel confusing and stressful, especially because there is so much money at stake. However, by learning the ins and outs of mortgages prior to applying, you can give yourself a leg up in the game, and the resources you need to find the financial product that’s right for you.