Are you in the market for a new home? With so many mortgage options to choose from, how do you know which one is best? Among the list of top loan products is conventional mortgages. Wondering how they work or what makes them different from government-backed loans? Keep reading to learn the answer to this question and much more.
How Does a Conventional Mortgage Work?
Unlike FHA, USDA, and USDA loans that are backed by the federal government, conventional loans follow criteria established by Fannie Mae and Freddie Mac. In turn, they have more stringent qualification criteria as they are more risky to the lender. Consequently, you may have a tougher time qualifying if your credit score isn’t up to par or you have very little saved for a down payment.
Minimum Credit Score
To qualify for a conventional loan, you’ll need a minimum credit score of 620. However, you probably won’t receive a competitive interest rate as they are generally reserved for borrowers with a credit score of 740 or higher.
Down Payment Requirement
Long gone are the days of having to put 20 percent down for a conventional mortgage product. While doing eradicates the need for mortgage insurance, most conventional mortgages can be approved with a down payment of 5 percent. And in some instances, you may qualify with as little as 3 percent down, which is 0.5 percent lower than what FHA loans require. But with a lower down payment, you’ll have to pay private mortgage insurance (PMI) until the balance is below 78 percent of your home’s value.
Loan Terms
Most borrowers go for a 30-year fixed-rate conventional loan. But it’s possible to secure a loan for 20 or even 15 years if you want to save a bundle in interest by paying your home off faster.
Closing Costs and Prepaids
These include loan appraisal fees, origination fees, mortgage insurance other prepaid expenses. On average, they’re 2 to 5 percent of the loan purchase price, according to Zillow, and are a bit steeper for conventional loans than you’d find with other mortgage products.
Conventional Loan Options
Fixed-Rate vs. Adjustable-Rate Mortgages
The key difference between fixed-rate and adjustable-rate mortgages lies in how interest is assessed. With a fixed-rate mortgage, you’ll pay a set monthly payment over the life of the loan because the interest rate will not change. So, if you secure an interest rate of 3.5 percent, it won’t change for the duration of the loan unless you refinance for a lower rate.
But with an adjustable-rate mortgage (ARM), the monthly payment will change over time as the interest rate adjusts with the federal index. This means your payment could increase by hundreds of dollars out of nowhere. To illustrate, an 8/1 ARM means that your rate will remain the same for eight years, but will adjust with the market index after this point until the loan is paid in full.
Consumers that decide to go with ARMs usually do so because they only intend to own the property for a short period and believe they can get out before the rate skyrockets And others are willing to take on the risk if an ARM is the only type of loan they’ll qualify for, and have their hopes set on refinancing into a conventional loan product.
Conforming vs. Nonconforming Loans
If your mortgage is $484,350 or lower, it will be classified as a conforming loan. (The exceptions to the rule are single-family homes in more expensive areas, which have loan limits of up to $726,525). You can use this tool to find out what the conforming loan limit is in your area.
But if the loan amount comes in higher (also known as a jumbo loan), the lender qualifies you even if you are carrying a massive amount of debt, or your credit is poor, your loan would be nonconforming.
Have you recently filed for bankruptcy? If approved, your loan would also be classified as nonconforming since it doesn’t meet Fannie Mae or Freddie Mac’s standards.
Keep in mind that nonconforming loans are harder to qualify for, have higher down payment requirements, and come with higher interest and fees. And you may be forced to pay exorbitant mortgage insurance premiums to minimize the risk posed to the lender.
Should You Apply for a Conventional Mortgage?
If you have good or excellent credit and at least 5 percent saved for a downpayment on a new home, a conventional mortgage may be right for you. While you’ll have to pay private mortgage insurance (PMI) until you build up enough equity in the loan, you won’t be stuck paying PMI over the life of the loan like you would with an FHA loan.
But if your credit is a bit shaky and saving up 5 percent poses a major challenge, a government-backed FHA loan product may be more suitable. Or you can explore USDA loans if you’re moving to a rural area as they may be a better fit if you have low to moderate-income and are looking for 100 percent financing. And VA loans are also an option if you’re a member of the armed forces as they have lax qualification criteria and allow you to purchase a new home with no money down.
The Bottom Line
Conventional loans may seem like a good fit for your financial situation. But before making a financial decision, do your homework and consult with a few lenders or reputable mortgage brokers to determine which mortgage product will give you the best bang for your buck.
