What Is A Conventional Loan? A Complete Guide

When shopping for a home loan, you’ll quickly discover there are many choices to explore. A conventional loan is a straightforward option that will fit the bill for many prospective homeowners.

Let’s explore the details of a conventional loan to help you determine if it's a good fit for your situation.

What Is A Conventional Loan?

A conventional loan is a mortgage that isn’t backed by the government. There are two types of conventional mortgages: conforming and nonconforming loans. Conforming loans follow the guidelines from Fannie Mae and Freddie Mac. There are limits as to how much you can borrow – for 2023 it’s up to $726,200 for most parts of the U.S. Areas that have higher costs can be up to $1,089,300.

Also referred to as jumbo loans, nonconforming loans are for those who need an amount that’s higher than the limits for a conforming loan in their location. These types of loans tend to be riskier to lenders, which means rates can be higher. It might be harder to find a lender who’s willing to grant a jumbo loan.

How Does A Conventional Loan Work?

When you’re buying a home, you can apply for a conventional loan from a lender. If you qualify and the loan closes, you’re promising to pay the lender back for the borrowed funds plus interest. Interest rates can either be fixed or adjustable.

In general, terms for conventional loans typically span 15, 20 or 30 years. You’ll continue to make payments for the duration of the loan term. With each payment, your equity in the home increases. Equity is the portion of your home that you own. At the end of the loan term, you’ll own your home outright.

Conventional Loan Requirements

If you want to take out a conventional loan, you’ll need to meet basic eligibility requirements. Here’s a look at conventional loan requirements:

• Down payment: The down payment requirements can be as low as 3%. However, many lenders require a down payment between 5% and 20%.
• Credit score: In most cases, you’ll need to have a credit score of at least 620. If you have a higher credit score, you might have access to lower interest rates.
• Debt-to-income ratio (DTI): Many lenders require that your debt-to-income ratio be less than 50%. You can calculate your DTI by dividing the sum of your minimum monthly debt payments by your gross monthly income.
• Private mortgage insurance (PMI): If you are putting down less than 20% on your home purchase, you’ll be required to pay PMI. The extra cost serves to protect your lender in case you don’t keep up with your payments.
• Sufficient income: Lenders will take a close look at your financial situation to ensure your income can support the mortgage payments.
• Closing costs: In addition to a down payment, you’ll need to have enough on hand to cover closing costs. The exact cost will vary, but closing costs often amount to 3% – 6% of your loan amount.

As you read through the requirements, you might decide that this loan type won’t work for you. Just because a conventional loan is a popular choice and can get you a lower interest rate doesn’t mean it’s the best choice for you. In fact, if you have a low credit score, you may not even qualify for one.

But you still have options: an FHA loan, which is backed by the Federal Housing Agency and requires a minimum 580 credit score; or a VA loan, which technically doesn’t have minimum score requirements.

Neither of these options require a high down payment, either – the FHA loan only requires 3.5%, whereas a VA loan doesn’t require a down payment at all. It can pay off to explore all of your options before settling on a particular loan type.

Types Of Conventional Home Loans

Conventional home loans come in different flavors. Here’s a look at the different loan types:

• Conforming loans: Conforming loans stay below specific limits set by Fannie Mae and Freddie Mac. In most parts of the country, the loan limit is $726,200 for 2023.
• Jumbo loans: Jumbo loans, or nonconforming loans, allow you to borrow more than the conforming loan limit.
• Fixed-rate loans: A fixed-rate loan comes with an interest rate that doesn’t change over the course of the loan. With that, you can lock in a rate for the duration of your home loan.
• Adjustable-rate loans: Adjustable-rate mortgages (ARMs) come with an interest rate that can change over the course of the loan. With that, you might pay more or less in interest payments along the way based on market conditions.

Selecting the right type of conventional home loan will depend on your situation as a home buyer. For example, you might opt for a fixed-rate loan if you want to maintain stable housing costs for the long term.

Pros And Cons Of Conventional Mortgages

Every home loan comes with advantages and disadvantages. Here’s what to keep in mind about conventional mortgages.

Pros

• Low interest rate if your credit score is reasonably high
• Flexible repayment options
• Low down payment options available
• Ability to cancel PMI after increasing home equity
• Ability to choose between fixed or adjustable interest rates

Cons

• Possible PMI
• Stricter credit requirements than government-insured loans
• Stricter DTI requirements than government-backed loans

The Bottom Line

Conventional home loans are a popular option for many prospective homeowners. If you have a solid financial history and a good credit score, a conventional loan might be the right fit for you. Speak with a lender to learn more about your home buying options.

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