An Overview of Conventional Loans

Conventional loans represent about two-thirds of all loans issued in the United States.  Here’s some of the basic information you need to know about this popular financing vehicle.

What is a conventional loan and how does it work?

A conventional loan is a home buyer’s loan that is available through a private lender such as a bank, credit union, mortgage company or two government sponsored programs, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

These loans are not offered or secured by federal government agencies such as the FHA, VA or the USDA Rural Housing Service.

Lenders have tightened the qualification for conventional loans in recent years, so there are no longer “no verification” or “no down payment” loans available, but otherwise the requirements to qualify have been basically the same for many years. 

Borrowers will be required to complete a mortgage application and supply necessary documents so that a lender will be able to perform an extensive check on their finances and credit history.  Typically, this will involve supplying proof of income, assets and bank account information, employment verification, and several pieces of related documentation.

The interest rate on a conventional mortgage will depend on several things, such as the length, size, amount of down payment, and whether or not the loan is a fixed or variable rate loan as well as current economic or financial market conditions.

Mortgage lenders set interest rates based on their expectations for future inflation; the supply of and demand for mortgage-backed securities also influences the rates

2019 conventional loan limits

The conventional loan limit for 2019 is $484,350 for a single family home. Increased loan amounts are also available for 2-, 3-, and 4-unit homes. 

In some high-cost areas, the limits are higher.  For example, a home in Los Angeles can be eligible for a loan of up to $636,150.  The same holds true for multi-unit homes as well.  In Hawaii, a 4-unit home can be financed for up to $1.2 million.

Currently, standard conventional loan limits are as follows:

  • 1 unit home: $484,350
  • 2 unit home: $620,200
  • 3 unit home: $749,650
  • 4 unit home: $931,600
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Who qualifies for a conventional loan?

There are certain qualifications that must generally be met to qualify for a conventional loan

People most likely to qualify for have a solid financial foundation that will include:

  • A credit score of at least 680.  Lenders prefer that scores be well over 700.  The higher the credit score, the better the terms of the loan.  The best terms are made available for those with a credit score of over 740.
  • An acceptable debt-to-income ratio of no more than 45%, with a preference of around 36% or lower.
  • A down payment of at least 20%.  Lenders will obviously accept less but this will mean there will be an additional cost to put PMI in place.

Conversely, people with credit scores below 650, a DTI above 43% or who have gone through a bankruptcy or foreclosure in the past seven years will have trouble qualifying for a conventional loan. 

Types of properties that are eligible for conventional loan financing

  • Single-family homes (detached homes)
  • Planned Unit Developments (PUDs), which typically consist of detached homes within a homeowner’s association
  • Condominiums
  • 2-, 3-, and 4-unit properties
  • Some co-op properties
  • Manufactured homes (although few lenders offer this program)

Conventional loans can also be used to buy a second home or a rental property. Interest rates and down payment requirements are higher when financing a rental home, but a conventional loan is one of the few loan programs you can use to purchase rental properties.

Conventional loans and credit scores

Although you may still qualify with a lower score, conventional loans are the most well suited for applicants who have a credit score of 680 or higher.

The catch is that with a lower credit score, your costs and fees may be higher. Other loan programs such as Fannie Mae and Freddie Mac may actually give you a better deal on costs and fees because they impose Loan Level Price Adjustments on lenders.  Those costs are then passed on to consumers. 

Conventional loan down payments

You can put as little as 3% down when applying for a conventional loan.  Keep in mind that down payment of less than 20% will require private mortgage insurance (PMI) until you reach a 20% equity position in your home.

What is private mortgage insurance?

If you take out a conventional loan, you will be required to pay for private mortgage insurance (PMI) if you make a down payment of less than 20% on the value of your home.  It is also usually required if you refinance your home and you equity is less than 20% of the value of your home.

PMI protects the lender in the event you stop making payments on your loan.  Once you reach 20% equity in your home, you can have PMI removed. 

PMI is risk-based insurance.  This means that the better your credit score and credit history, the better rate you will be entitled to.  Each private mortgage insurance company offers varying rates depending on various credit scenarios and it pays to have your lender shop around to try and get you the best terms for your situation.

PMI is usually paid for through a monthly premium that is added to your mortgage payment.  At other times, it may be a one-time up front payment that is paid at closing.  Keep in mind that if you refinance your loan, you may not be entitled to any kind of a refund of the unused premium if paid up front.

Lenders may offer you a conventional loan with smaller down payments that do not require PMI. But the trade off is that you will pay a higher interest rate for these loans. You will need to calculate if paying a higher interest rate can be more or less expensive than PMI. 

If you want to avoid paying PMI, then if you can swing it, consider making a 20% down payment.  You may also get the added benefit of a lower interest rate with a 20% down payment as well.  You also want to consider a piggyback mortgage.  Ask your lender for details on this option.

Debt-to-income (DTI) ratio requirements for conventional loans

Your DTI ratio is a measure of your monthly debts compared to your monthly income.  Lenders consider all of your financial obligations plus what your new mortgage payment will be and divide it by the sum of your gross monthly income.  This produces a percentage that lenders use to assign a level of risk to your loan.

The maximum debt to income ratio for a conventional loan is usually 45%. 

In some cases, a DTI may be as high as 50% is there are certain strong compensating factors such as a lot of cash reserves or a very high credit score. 

If you don’t have much in the way of cash reserves or have blemishes on your credit history, your maximum acceptable DTI may be less than 45%.