So, you want to know more about conventional loans.
Let's start things off with a disclaimer: Beyond the usual "consult with your CPA before taking this as gospel" bit, conventional loans are just your basic loans. While it should come as no surprise that this isn't going to read like the next Stephen King novel, being prepared for it upfront should help you when we get to the bit about conforming loans and adjustable rate mortgage.
What is a conventional loan?
Lenders have gotten creative with their products. Nowadays, you can get a variety of loans. FHA loans, for instance, service first-time home buyers. And VA loans support those who serve our country. There are many ways to get financing for your next real estate venture. To get to know what a conventional loan is, let's take a look at what it is NOT:
Conventional loans are not FHA loans. FHA loans service first-time homebuyers by providing them with a low downpayment rate (3.5%), except those with lower credit, and buyers have the option to get part of their down payment gifted, among other things.
FHA loans require you to have mortgage insurance as it is a higher-risk loan. There are certain qualifications that both you and the house you buy must fulfill to go with FHA. The government does back FHA loans, which means the lenders that are approved FHA lenders are covered if the buyer defaults on their loan.
Conventional loans are not VA loans. The Department of Veterans Affairs funds the VA loan program. The Department of Veterans Affairs is a government entity, which means that the government backs the VA loan program. The VA loan program approves low credit scores and provides great loan benefits to those who have served or continue to serve our country.
Conventional loans are also not USDA loans. USDA loans (yet another category of loan that the government backs) approve loans with no down payments for people looking to live in rural or suburban homes. USDA loans have great rates but are not for everyone as your house must meet specific criteria.
Conventional loans are:
- Higher risk. The government does not back them, which means the buck defaults to the mortgage lenders if the homeowner forecloses.
- For people who have good credit (620 or higher, but 740 or higher for those looking to get a good interest rate).
- For people who are in good financial standing. Their debt to income ratio must be less than or equal to 36%, but some lenders will lend up to 43%, which is the ratio set by recent federal legislation.
Benefits of Conventional Loans
There are many benefits of conventional mortgages.
One of the benefits of conventional mortgages is that you do not need private mortgage insurance if you put down a 20% or higher down payment. This is great news for those who can afford to put down more money and want to cut down on their monthly mortgage payment, as the mortgage insurance premiums decline as you put down a larger down payment.
Another benefit is the variety. Because they are not backed by the government, there is some wiggle room for lending qualifications. For example, you can get a jumbo conventional loan (a non-conforming loan), which allows you to take out a loan amount for a higher than conforming loans, which hit their limit at $453,100 in the continental U.S., and $679,650 in Alaska and Hawaii.
If you need to borrow more money (think 90% loan-to-value ratio), then conventional loans have your back. They often approve higher risk loans—at a cost, of course.
Lower mortgage rates (think below 5%) are yet another benefit to conventional loans. Your rate depends on your down payment, but the rates are one reason conventional loans are up 71% in the last seven quarters, according to the Census Bureau.
Types of Conventional Loans
There are several different types of conventional loans. Five different types, to be exact.
Sub-Prime Conventional Loans
Like other lenders, Fannie Mae and Freddie Mac (two of the most prominent agencies that standardize mortgage lending in the US) advertise to those with less-than-stellar credit or those needing to put down lower payments. We call these type of loans sub-prime conventional loans. Sub-prime conventional loans typically come with higher fees and interest rates.
Amortized Conventional Loans
These are the loans that many of us know and use the most. Amortized conventional loans are based on the loan-to-value (LTV) ratio. The loan is amortized over a period of 30, 20, 15, or 10 years. The LTV is essentially the amount you are borrowing vs. the value of the home. So a 95% LTV ration means you are borrowing 95% of the home's value
The interest rates and down payments are based around the credit history and financial standing of the borrower, as well as the length of their mortgage.
Conventional "Portfolio" Loans
Conventional (or portfolio) loans are conventional loans that lenders hold onto. This means the lenders do not sell them to investors like they might for other loans. This allows them more leeway when it comes to setting their loan standards, which is great news for buyers as it can mean they have an easier time borrowing.
Adjustable Conventional Loans
Adjustable conventional loans are also known as adjustable rate mortgages (ARM) because the interest rate fluctuates depending on how the economy is doing.
Some adjustable conventional loans are fixed (or set) for a period of time before they start fluctuating. For example, a 5/1 ARM starts out at a lower interest rate for 5 years before it changes for the remaining 25 years (in a typical 30-year mortgage).
Most people tend to stay away from ARMs because they prefer to know what their monthly payments will be for the life of the loan. An adjustable conventional loan could be ideal for someone who plans on making more money in the future and presently wants to benefit from lower interest rates.
ARM Interest Rates
To figure out the interest for ARM rates, you need to add the margin rate to the index rate.
ARM rates adjust to the market and can change monthly, quarterly, biannually, or annually. So, if you started out with a fixed mortgage rate for three years, and it became adjustable for the rest of the term, it could change bi-annually for the remainder of the term of the loan.
Starting out, the initial interest rate is typically lower than a fixed-mortgage rate and has a cap rate when it does begin to fluctuate. The cap rate prevents it from going over a set price.
How to Qualify for a Conventional Loan
Qualifying for a conventional loan is much like qualifying for any other loan, except the stakes are higher.
Fannie Mae and Freddie Mac have worked to lower their down payment rate to compete with the FHA loan in recent years. Although that is a step toward allowing more people to qualify for conventional loans, there are still barriers in place that make it difficult for those who have poor credit from credit cards or other forms of debt, or who are unable to make up the difference for putting down a low down payment.
Many who go the conventional loan route have great credit of 740 or higher, which allows them to get an interest rate that competes well with other loans. They also are in good financial standing, which means they have little debt and make a good paycheck consistently. There is no set amount of money that a borrower must make to qualify for a conventional loan, but their debt-to-income ratio is usually below 43% with strong credit.
To see if you qualify for a conventional loan, talk to your mortgage broker. They'll be able to help you determine which loan is right for you.
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