When shopping for a mortgage, there are many types of loans. A conventional loan is the most common option for homebuyers. Understanding how conventional loans work can help you make a smart home buying decision. Here’s what you need to know. If you want to buy a home, a financial advisor could help you create a financial plan for your needs and goals.
What Is a Conventional Loan?
A conventional loan is not backed by a government agency. Other popular loans are government-backed. These include FHA loans (insured by the Federal Housing Administration), VA loans (backed by the Department of Veterans Affairs) USDA loans (backed by the U.S. Department of Agriculture).
Conventional loans are offered through banks, credit unions, mortgage companies and other private lenders. And even though they are not backed by a government agency, some conventional mortgages are guaranteed by Fannie Mae and Freddie Mac, which are government-sponsored enterprises.
Conventional Conforming vs. Non-Conforming
Conventional loans fall into two categories: conforming and non-conforming. Here’s what each stands for:
Conforming: A conforming conventional loan sticks to the rules and loan limits set by Fannie Mae and Freddie Mac.
Non-conforming: A non-conforming conventional loan doesn’t follow the rules set by Fannie Mae and Freddie Mac. Essentially, that means the lender won’t be able to sell their mortgage to these large enterprises. But it means you can borrow more than the conforming loan limit.
Neither a conforming loan nor a non-conforming loan is inherently better than the other. But conforming loans are much more common options for homebuyers.
What a Conventional Loan Requires
As a borrower, you’ll face more stringent requirements with a conventional loan than the other loan types on the market. Here are four requirements to consider:
Down payment. You won’t find any no-down-payment options through a conventional mortgage lender. But you will still find low down payment options. Typically, you can put down as little as 3% on a conventional mortgage. But you’ll usually pay private mortgage insurance if you put down less than 20%.
Credit score. In general, you’ll need a credit score of at least 620 to qualify for a conventional loan. However, a higher credit score will allow you to tap into better interest rates.
Loan limits. Many conventional loans are considered “conforming.” A conforming conventional loan has limits. As of 2022, a conforming conventional loan cannot exceed $647,200. But these limits are often increased on an annual basis.
Debt-to-income ratio. Lenders generally won’t accept borrowers that have a debt-to-income ratio higher than 43%. But most prefer borrowers who have an even lower ratio.
How Does a Conventional Loan Work
When you want to apply for a conventional loan, here are five things you can expect to provide during the process:
Down payment. As discussed, you’ll have to make a down payment for a conventional loan. Although it doesn’t need to be the touted 20%, you’ll need to put down at least 3%.
Proof of income. When you apply, you’ll need to provide your mortgage lender will plenty of paperwork. A critical piece of the puzzle is proof of your income. You can provide this proof through tax returns, pay stubs or W-2s.
Proof of assets. The lender will need to see proof of your existing assets to ensure you have the cash reserves necessary for homeownership. This can be in the form of bank account statements or investment account statements. If you received the down payment as a gift, you’ll need to provide a gift letter.
Employment verification. Borrowers must prove a stable work history and current employment. If self-employed, current business information is required.
Closing costs. All mortgage types have closing costs and a conventional loan is not an exception. These expenses can require thousands of dollars to finalize your loan.
Advantages and Disadvantages of a Conventional Loan
Every mortgage product comes with pros and cons. A conventional loan is no different.
Here are three advantages to consider with conventional loans:
- Low down payment options. You may only need to put down 3% to obtain your conventional loan.
- Fewer requirements: A conventional loan won’t come with the strings of a government-backed loan. For example, you won’t encounter the notoriously extensive FHA inspection. The minimal requirements usually make conventional loans a faster option.
- Cancellable mortgage insurance. If you put down less than 20%, you’ll have to pay for private mortgage insurance. But it’s easy to cancel when you’ve built 20% equity in the home.
Here are two disadvantages to consider with conventional loans:
- Higher credit score requirements. Conventional loans have higher credit score requirements than some government-backed loans.
- Stricter debt-to-income ratio requirements. Lenders require borrowers to have a lower DTI ratio than other loan types.
Bottom Line
A conventional loan is an accessible option for many homebuyers. But it’s not the right fit for everyone. Make sure to consider both the advantages and disadvantages before taking out a loan.
Tips on Getting a Mortgage
- Want to make sure that a mortgage fits into your long-term financial plans? Talk to a financial advisor to create a financial plan for your homeownership needs and goals. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A monthly mortgage payment is a big commitment for any budget. Consider using SmartAsset’s free mortgage calculator to see how a mortgage payment would fit into your budget.
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