What is a conventional mortgage?
One of the first decisions you’ll make when shopping for a home loan is whether you want a government-backed loan or a conventional loan.
A government-backed loan is secured by a federal agency. You may qualify for a mortgage backed by the Federal Housing Administration, United States Department of Agriculture, or Veterans Affairs. If you default on a mortgage that’s backed by the government, then the agency pays the lender on your behalf. When a lender gives you a government-guaranteed mortgage, it’s like the lender is getting insurance on your loan.
A conventional loan is not guaranteed by the government. A private lender, such as a bank or credit union, gives you the loan without insurance from the government. But you may choose a conventional mortgage backed by government-sponsored mortgage companies Fannie Mae or Freddie Mac.
You typically have to meet stricter requirements to qualify for a conventional loan than for a government-backed loan. You’ll need a higher credit score, lower debt-to-income ratio, and more money for a down payment.
Government-backed loans do have their own eligibility requirements, though. For example, a VA loan is only for people who have served in the armed forces.
Types of conventional mortgages
Conventional mortgages can be broken down into two categories: conforming and nonconforming loans. The main difference between these two types is the amount of money you need to borrow.
A conforming mortgage meets the standards set by the Federal Housing Finance Agency (FHFA). The FHFA sets the limit for conforming loans every year, and in 2020, the limit is $510,400 in most parts of the US. In areas with a higher cost of living, such as Alaska, Hawaii, Guam, and the US Virgin Islands, the limit has been increased to $765,600.
A nonconforming mortgage is for an amount that exceeds the FHFA limit. You also might hear it referred to as a jumbo loan.
To qualify for a nonconforming mortgage, you’ll likely need a higher credit score, bigger down payment, and lower debt-to-income ratio than you would for a conforming loan.
If you a) need more money than allowed by the FHFA, and b) can qualify for the loan, then a nonconforming mortgage may be for you. If not, then you’ll want to go with a conforming mortgage.
Who qualifies for a conventional mortgage
For the most part, the eligibility requirements for a conventional mortgage break down into three categories: credit score, debt-to-income ratio, and down payment.
If you can’t meet all three qualifications, then you may want to check whether you qualify for a government-backed mortgage. Or consider waiting to buy a home so you can improve your credit score, pay off some debt, or save more for a down payment.
Credit score
You’ll need a credit score of at least 620 to qualify for a conforming loan. Some lenders have increased their minimum scores during the coronavirus pandemic, though, so ask a lender about its requirement.
For a nonconforming loan, you’ll probably need a score of 700 or higher.
Debt-to-income ratio
Your debt-to-income ratio is the monthly amount you pay toward debts divided by your gross monthly income. For example, if you spend $2,000 per month on your mortgage and student loan payments, and you earn $3,000 per month, your debt-to-income ratio is $2,000 divided by $3,000, or 66%.
You might qualify for a mortgage with a DTI as high as 43%, depending on the lender. Most lenders like to see a DTI of 36% or less, though.
Many lenders require lower DTIs for nonconforming mortgages than for conforming mortgages. A lower ratio means you owe significantly less than you earn, leading lenders to believe you can afford the high payments that accompany a jumbo loan.
Down payment
As a general rule of thumb, many lenders accept down payments of 10% or less for conforming loans but require at least 20% upfront for a nonconforming loan.
If you know you don’t have that large of a down payment ready, don’t throw in the towel. Some lenders accept lower payments.
For example, Ally typically accepts as little as 3% down for a conforming loan and 10% for a nonconforming loan.
Conventional mortgage interest rates
Conventional mortgage rates are usually a little higher than government-backed rates. But government loans come with fees that could end up costing you more than the higher rate would. If you’re trying to decide between a conventional or government-backed mortgage, do the math rather than assume the lower rate is the better option.
Here are the factors that affect your conventional loan interest rate:
Economy
Rates typically decrease in response to a struggling economy, because low rates encourage people to borrow and can stimulate the US economy.
When the economy is thriving, there’s usually a higher demand for borrowing. Rates go up as a result to slow down the influx of applications.
Where you live
You may have noticed that houses are more expensive in cities than in rural areas, or more expensive in certain cities and states than others. But where you live affects your interest rate, too. Interest rates are usually higher in areas with a higher cost of living, but the difference shouldn’t be huge.
Personal finances
Your credit score, debt-to-income ratio, and down payment don’t just determine whether you’ll qualify for a conventional mortgage — they also help determine your interest rate.
The higher your credit score, the lower your rate. You could get a great rate with a score of 760 or higher. To increase your score, try to pay off debts, make all your monthly payments on time, and use a low percentage of your available credit.
You can get a better rate with a lower debt-to-income ratio. The two main ways to lower your ratio are to a) pay down debts, and b) earn more.
The more you have for a down payment, the lower your rate could be. If you don’t have much saved for a down payment, consider taking the time to accumulate more before you buy.
Term
You’ll need to choose between a fixed-rate or adjustable-rate mortgage.
A fixed-rate mortgage locks in your rate for the entire life of your loan. Although US mortgage rates will increase or decrease over the years, you’ll still pay the same interest rate in 30 years as you did on your very first mortgage payment.
An adjustable-rate mortgage, or ARM, keeps your rate the same for the first few years, then periodically changes over time — typically once a year.
Right now, you’ll pay a lower rate with a fixed-rate mortgage than with an ARM. There isn’t much point to choosing an ARM these days, but that could change.
Term length
You’ll also choose a term length, or how many years you’ll spend paying back the loan.
For fixed-rate mortgages, a 30-year term is the most common option, but most lenders also offer 15-year and 20-year loans. Some have even more term lengths to choose from.
A 5/1 ARM is the most common type of adjustable-rate mortgage. You’ll pay the same rate for the first five years, then your rate will change once per year. Most lenders also have 7/1 and 10/1 ARMs.
The longer your term, the higher your rate will be.
Points
At closing, you can choose to pay a fee to receive mortgage points. The more points you have, the lower your rate will be.
One mortgage point is typically 1% of your mortgage. If your loan is $100,000, one point would cost you $1,000.
One point will usually drop your rate by 0.25%.
For example, you buy a home with a $100,000 mortgage at a 3.5% interest rate. You pay $2,000 at closing for two mortgage points, so your rate drops by 0.5% total. You’ll now only pay 3% on your loan.
