Conventional Loans Explained

Conventional Loans

Conventional Loans are mortgage loans that are not insured by the government (like FHA, VA, USDA Loans).  Lending rules and restrictions known as "underwriting guidelines" are determined by Fannie Mae and Freddie Mac, the two government sponsored entities tasked with maintaining liquidity in the U.S. mortgage markets.  Conventional loans can be used for primary residences, second homes and investment properties.

Conventional loans come in two varieties, fixed rate mortgages and Adjustable Rate Mortgages (ARM's).  Popular fixed rate terms for conventional mortgages are 30, 20,15 & 10 year mortgages. Popular Adjustable rate terms are 10/1, 7/1, 5/1, 3/1 mortgage with the first number being the period of time that the interest rate is fixed (cannot change) and the second number being how frequently the rate can adjust in a 12 month period from anniversary date to anniversary date. 

Fox example: a 7/1 ARM is a loan where the interest rate is fixed for the first 7 years and then will adjust upwards or downwards 1 time each year based upon the current financial markets at the anniversary date.

Conventional mortgages are also broken up into two additional categories; conforming and non-conforming.  A "conforming" loan is a loan that is not backed by a government agency insuring the lending bank against default (conventional) and the terms of the loan conform to the underwriting guidelines set by Fannie Mae and Freddie Mac.  Therefor, it is possible to have a conventional loan that is not a conforming loan.  Non-conforming loans are loans that are not backed by the any government agency but do not meet Fannie Mae or Freddie Mac's guidelines and therefor those loans can never be sold to Fannie Mae or Freddie Mac.  If a bank then chooses to make non-conforming loans, they ensure that they will be servicing that loan (collecting the payments, paying the property taxes and insurance, etc.) themselves or selling it to another bank or investor who purchases non-conforming loans.  For the most part, whenever someone refers to a loan as a conventional loan, what they mean is a "conforming loan" since few investors are in the business of making loans that they intend to service themselves. 

Maximum conventional loan limits vary by county.  To search the maximum conventional loan limit by county, click here


Advantages of Conventional Loans

Mortgage Insurance.  Conventional loans with a loan-to-value of 80% or less do not require mortgage insurance.  Loans with mortgage insurance will see their mortgage insurance automatically discontinue when the loan-to-value reaches 78%.

Down Payment.  Conventional loans can be obtained with as little as 3% down.

Loan Limits.  Conventional loans have higher loan limits the most common alternative, the FHA loan.


Disadvantages of Conventional Loans

Interest Rate.  The interest rate on conventional loans is higher than government backed loans.  Since conventional bonds are not guaranteed by the federal government, they are a riskier investment.  More risk demands a higher return and that requires bond sellers to pay investors a higher yield on conventional bonds.  Higher yield on conventional mortgage bonds = higher interest rates on mortgages. 

Minimum Qualifying Credit Score.  The minimum credit score a consumer can have and still successfully apply and receive a conventional mortgage is 620.  For comparison purposes, FHA loans will accept consumers with credit scores down to 500 and consumers who have no credit score at all.

Credit Score Adjustments.  Every loan has pricing adjustments.  These adjustments effect the interest rate each borrower will receive.  Some adjustments improve mortgage pricing and some increase the cost of a mortgage.

For example: If two consumers apply for the same size mortgage on identical houses but one consumer intends to make the subject property their primary residence while the other consumer intends the subject property to be a rental property used for investment purposes, the consumer purchasing the house as an investment property will either pay a higher interest rate or greater fees at the close of escrow due to the pricing adjustment required on investment properties.  These pricing adjustments are set by Fannie Mae and Freddie Mac and apply to all conforming loans at every bank, mortgage company and credit union who wants to be able to sell that mortgage to Fannie Mae or Freddie Mac at a later date to recoup the capital that was loaned out so they may loan it again and earn the loan origination fees on another originated mortgage.

The largest pricing adjustment on a conventional loan is the credit score adjustment.  The adjustment for a consumer with a low credit score 620-639 will pay as much as 3.5% of the loan amount as a pricing adjustment for a conventional loan.

For example: If a consumer with a 635 credit score applies for a conventional / conforming loan on a property that is selling for $300,000.00 and that consumer is making a 3% down payment, thus financing $291,000, then that consumer will pay a pricing adjustment of 3.5% of the loan amount or $10,185.00 as a pricing adjustment at the close of escrow or they may accept a higher interest rate from the bank to entice the bank to cover that cost for them.  In order to absorb a 3.5% pricing adjustment, the consumer would have to increase their interest by a full percent where as another consumer with an 740 credit score would only have to deal with a $2,182.50 adjustment and raise their rate only 0.25% to absorb the credit score pricing adjustment.

Keep in mind that pricing adjustments are cumulative so on a conventional loan it could be possible to a consumer to pay a negative pricing adjustment for a low credit score + an extra hit for pulling cash-out on a refinance + an investment property adjustment (if the property was an investment property) + a loan amount pricing adjustment if the loan amount is low + another pricing adjustment if say the property was a duplex.

So, while the credit score is the highest pricing adjustment, it is by no means the only pricing adjustment a conventional loan might have.  By way of comparison, the FHA loan pricing adjustment on an FHA loan is only 1.25% (vs. 3.5%) and FHA does not have a secondary pricing adjustment for pulling cash-out of your mortgage (conventional loan adjustments can be as high as an additional 3.50%) in addition to the 3.5% for having the low credit score to begin with.

Other Notable Conventional Guidelines

Seller Credit.  A seller can credit a borrower up to 3% of the purchase price on conventional loans.

Maximum DTI.  The maximum debt-to-income ratio (DTI) is 50% on conventional loans.

Gift Funds.  Gift funds can be used on conventional loans for down payment, closing costs, etc.


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