What is a Conventional Loan and How Does It Work?
When it comes to purchasing a home, one of the first things a buyer needs to consider is how to finance it. Many people turn to traditional home loans, such as conventional loans, to help them pay for their dream home.
What is a Conventional Loan?
A conventional loan is a type of mortgage that is not guaranteed or insured by a government agency, such as the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the US Department of Agriculture (USDA). This means that conventional loans are offered by private lenders such as banks, credit unions, and mortgage companies, and they are subject to the lender’s underwriting guidelines.
How Does a Conventional Loan Work?
Conventional loans typically require a down payment of at least 3% to 20% of the home’s purchase price. The higher the down payment, the less risky the loan is to the lender. If a borrower puts down less than 20%, they may be required to pay private mortgage insurance (PMI) until they reach 20% equity in their home.
Conventional loans also come with a fixed interest rate or an adjustable rate, with fixed rates being the most popular. The interest rate on a conventional loan can vary depending on a borrower’s credit score, income, debt-to-income ratio, and other factors.
Conventional loans have several advantages over other mortgage options. They typically have a lower interest rate than FHA or VA loans, which can save a borrower thousands of dollars over the life of the loan. Additionally, conventional loans tend to have fewer fees associated with them.
However, conventional loans can be more difficult to qualify for than other loan types, as lenders have stricter underwriting guidelines. Borrowers must have a good credit score, a low debt-to-income ratio, and a good employment history to be considered for a conventional loan.
Conventional loans can also be used to finance investment properties or second homes, as well as primary residences.
Types of Conventional Loans
There are two types of conventional loans: conforming and non-conforming.
Conforming loans adhere to the guidelines set by Fannie Mae and Freddie Mac, which are two government-sponsored entities that buy and sell mortgages on the secondary market. These guidelines include limits on the amount of the loan, the borrower’s debt-to-income ratio, and the borrower’s credit score. In most parts of the US, the maximum conforming loan limit is $548,250.
Non-conforming loans, also known as jumbo loans, are not eligible to be sold to Fannie Mae or Freddie Mac because they exceed the conforming loan limit. These loans are typically for borrowers wanting to purchase high-end homes or those with a lot of debt.
Benefits of a Conventional Loan
Conventional loans have several benefits that make them a popular choice for homebuyers. These benefits include:
1. Lower interest rates: Conventional loans typically have lower interest rates than other types of loans, which can save borrowers thousands of dollars over the life of the loan.
2. Fewer fees: Conventional loans often have fewer fees attached to them than FHA or VA loans, making them a more affordable option.
3. Flexibility: Conventional loans can be used to finance primary residences, investment properties, and second homes.
4. No mortgage insurance once the loan-to-value ratio reaches 78%: Borrowers are typically required to pay PMI until they reach 20% equity in their home. However, once their loan-to-value ratio reaches 78%, they are no longer required to pay PMI.
Disadvantages of a Conventional Loan
While conventional loans have many advantages, they also have some drawbacks. These include:
1. Stricter underwriting guidelines: Conventional loans are generally more difficult to qualify for than other loan types, as lenders have stricter underwriting guidelines.
2. Higher down payment requirements: Conventional loans typically require a higher down payment than FHA or VA loans.
3. PMI: Borrowers who put down less than 20% of the purchase price of their home will be required to pay PMI until they reach 20% equity in their home.
Conclusion
When it comes to purchasing a home, a conventional loan is a popular choice for many homebuyers. While they may have stricter guidelines and higher down payment requirements, they also offer lower interest rates and fewer fees. It’s important to carefully consider all options and work with a lender to determine which loan type is best for you.