What Is a Conventional Loan?

A conventional loan is the most popular type of mortgage in the United States. In fact, conventional loans accounted for roughly 80% of the home loans that closed in August 2021, according to Ellie Mae.

Backed by private lenders rather than the federal government, conventional loans can be used to buy or refinance homes.

Read on for more about conventional mortgages, including how they work and how to qualify — which could be more difficult during the coronavirus pandemic.

[ Read: Best Mortgage Lenders. ]

What Is a Conventional Loan?

A conventional loan is not backed by the federal government; rather, it is issued by a private lender, such as a bank, credit union or other financial institution. It typically has stricter credit requirements than a government-backed loan. That’s because the lender takes on more risk without a guarantee from a government agency if a borrower cannot pay.

Conventional loans fall into two categories: conforming or nonconforming.

— A conforming loan meets the requirements to be sold to Fannie Mae or Freddie Mac, the government-backed housing finance giants that buy mortgages from lenders and sell them to investors. Conforming loans must not exceed loan limits set by the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac. If you want a one-unit property, that amount in 2021 for most of the United States is $548,250 and $822,375 in high-cost areas.

— A nonconforming loan fails to meet the criteria for purchase by Fannie or Freddie. A jumbo loan, for instance, is nonconforming because it exceeds the loan limits set by the FHFA.

Is a Conventional Loan Good?

A conventional loan can be a good choice, depending on your financial situation.

Generally, conventional loans are best for buyers of homes under $500,000, and if you have good credit, you will qualify for the lowest possible interest rates, says David J. Wilk, assistant professor of finance and director of the real estate program at Temple University’s Fox School of Business. “There are also favorable first-time homebuyer programs where you can put down as little as 3%, which are very attractive for young people who are trying to build up their credit history and their balance sheet,” he adds. “It gives lots of people up and down the economic spectrum the opportunity to own their own home.”

Conventional financing, unlike government-backed loans, does not have geographic limitations or special requirements. A conventional loan can be more flexible than a government-insured loan but harder to qualify for, especially as the coronavirus pandemic has made getting a mortgage even more challenging.

[ Read: Best Mortgage Refinance Lenders. ]

How Does a Conventional Loan Compare With Government-Backed Loans?

Your financial profile can help you figure out which mortgage is a better fit for you.

Overall, consumers may prefer conventional loans over government-backed loans — which include Federal Housing Administration loans, Veterans Affairs loans and U.S. Department of Agriculture loans — because federal loans have additional restrictions and requirements, says Andrew Ragusa, CEO and broker at REMI Realty in Plainview, New York.

“A conventional loan removes those concerns,” he says. Here’s how the different loans compare:

FHA vs. Conventional

— FHA loans require a mortgage insurance premium. Borrowers pay an upfront fee of 1.75% of the loan amount and then MIP for the life of the loan if the down payment is less than 10%. For those who put down at least 10%, the MIP can be canceled after 11 years. As for conventional loans, applying a 20% down payment allows you to avoid private mortgage insurance, which isn’t an option on FHA loans. Your loan servicer must remove your PMI once you reach 78% equity, and you will pay no upfront mortgage fee.

— Appraisal guidelines are more rigid for FHA loans than for conventional loans. A home must meet the agency’s minimum property requirements. “If a house is 100 years old, the way it was built might not meet with today’s standards for an FHA house,” Ragusa says.

— If you are a first-time homebuyer, especially if you have fair credit and want to make a low down payment, an FHA loan might be right for you. It cannot be used to finance a second home or an investment property, however.

VA vs. Conventional

— VA loans are specifically for service members, veterans and eligible surviving spouses, whereas anyone can apply for a conventional loan. For those who qualify, it’s hard to beat the perks of a VA loan, which include no down payment requirement, low interest rates, lower closing costs and no PMI.

— VA loans require a funding fee, which ranges from 1.4% to 3.6%, depending on how much you put down and whether you’ve taken out a VA loan before. Disabled veterans, Purple Heart recipients and surviving spouses are exempt. Conventional loans do not have such a fee.

— VA loans typically have less stringent credit score requirements than conventional loans.

— In today’s competitive housing market, borrowers with VA loans are finding it harder to get sellers to accept their offers, according to reporting from The New York Times. Military families are turning to conventional loans instead.

— VA loans are only for primary residences, while conventional loans can be used for second homes or rental properties.

USDA vs. Conventional

— To qualify for a USDA loan, the property must be in an eligible rural area. Conventional loans have no such restrictions.

— USDA loans do not require a down payment, whereas conventional loans typically need at least 3% down.

— USDA loans require that borrowers have a lower income relative to the median income for the area. Conventional loans expect borrowers to have an ample income to be able to pay back their loans.

— USDA loans are only for people purchasing primary residences, and the home must meet federal housing standards.

What Are the Conventional Loan Requirements?

With a conventional home loan, you’ll borrow funds from a private mortgage lender to buy your home and pay back the loan over time with interest.

Before you apply, make sure you meet conventional loan requirements for approval, which include:

A credit score of at least 620. If you’re getting a jumbo loan, the requirement will be higher: usually at least 680.

A debt-to-income ratio limit of 45%. This means that no more than 45% of your total monthly gross pay should go toward debt payments. Some lenders may allow up to 50% if you are making a very large down payment.

Proof of income. Usually, you will need two years of documentation, including tax returns, W-2 forms or recent pay stubs, to show that you have ample, steady income to afford the loan payments.

A down payment of at least 3%. You will have to submit bank and other asset statements to show how you’ll make your down payment.

Mortgage underwriting begins once you apply for the lender to determine the risk of offering you a loan. You may be asked for additional documentation about your finances along the way.

In the meantime, the lender will appraise the property to determine its value. You may also schedule a home inspection to identify any major problems before closing.

More from U.S. News

Can You Refinance a Mortgage With Bad Credit?

How Much House Can I Afford?

Should I Work With a Mortgage Broker?

What Is a Conventional Loan? originally appeared on usnews.com

Update 11/24/21:

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