Updated on 12.15.16

What is a Conventional Loan?

A home is the largest purchase most people ever make. To underscore the importance even further, let’s not forget that most people end up paying for their home over the course of 15 to 30 years. These are just a few of the reasons it’s crucial to understand how mortgages work. By arming yourself with information, you can wind up with a mortgage that fits your needs and your budget

One piece of the puzzle is differentiating between conventional mortgages and other types of home loans. Keep reading to learn more about conventional loans, how they work, and what makes them different.

What Is a Conventional Loan?

The main detail that defines a conventional mortgage is that it’s not guaranteed by the government, though it typically meets basic lending standards determined by Fannie Mae and Freddie Mac.

Because you’re shopping for a traditional loan that isn’t federally backed, that means you can shop for a conventional loan from a private bank, credit union, mortgage broker, lender, or any other savings institution. In addition to the notable lack of government red tape, conventional mortgages may offer lower interest rates.

On the other hand, because it’s not government-backed, a conventional loan puts more risk on the lender’s shoulders, and may require a larger down payment or better credit to qualify. If you want to qualify for the best conventional loan with the lowest rate, you’ll need a very good credit score. Most applicants should strive for a score over 650 before they apply for a conventional mortgage, but the best loan terms will go to those whose FICO scores are above 740.

How Conventional Mortgages Work

Conventional mortgages can be packaged in a number of ways, but they usually come with a 15- or 30-year term. Most lenders that offer conventional mortgages require clients to put down at least 5% of the purchase price, although a 20% down payment is considered standard.

If your down payment is less than 20% of the purchase price, you’ll need to pay PMI, or private mortgage insurance, each month. This insurance, which can cost up to 1% of your home’s purchase price each year, protects the lender if you default.

If you can manage a payment of 20% or more, you can avoid PMI and the associated costs altogether. With a larger down payment at closing, you’ll also borrow less money and enjoy a lower monthly payment as a result.

In addition to coming up with a down payment, there are other fees associated with getting a conventional loan, just like any other mortgage. Those fees can include origination fees, appraisal fees, and closing costs. You may be able to negotiate with the seller of your home and get them to pay some of these costs for you.

How Much Can I Borrow with a Conventional Loan?

The amount of money you can borrow will depend on how much you earn, how large your down payment is, and the type of conventional mortgage you choose. There are two types of conventional mortgages – conforming and nonconforming.

Conforming loans must meet certain guidelines set by Fannie Mae and Freddie Mac, and fall under a specific threshold. In 2016, conforming loans for single-family homes in most areas were limited to $417,000. In certain regions of the country with a higher cost of living, conforming loans for single-family homes could be as high as $625,500 this year.

Nonconforming loans are those that are out of the ordinary – either because they’re for a large amount or have been extended to nontraditional borrowers.

One type of nonconforming loan, called a jumbo loan, is for individuals and families who borrow more money than the conforming loan threshold, for example. Since these loans tend to be riskier, they may come with higher interest rates and less comfortable terms.

Other types of nonconforming loans include loans made to people with bad credit, a large debt load, or a recent bankruptcy. These loans are considered nonconforming because they don’t meet standards set by Freddie Mac and Fannie Mae. Nonconforming loans tend to come with higher interest rates, additional fees, and heftier insurance requirements to offset the increased risk.

When a Conventional Loan Makes Sense

Because conventional mortgages aren’t guaranteed by the federal government, they’re mostly geared toward borrowers who pose less risk to the lender. If you have good or excellent credit and a down payment of at least 5% (but ideally 20%), you’re a good candidate for a conventional mortgage.

If you have a low income, have veteran status, or live in a rural area, on the other hand, you might want to consider a home loan backed by the federal government. FHA loans were created to make home ownership more attainable for low and middle-income buyers, while VA loans offer special benefits for both active duty military members and veterans. USDA loans, on the other hand, were created to make home ownership in rural areas more attractive and feasible.

The Bottom Line

If you’re ready to buy a home and don’t know where to start, you should research home loans and learn as much you can. Compare the different types of mortgages and ask yourself whether a loan backed by the federal government — such as the low-down payment mortgages found in first-time home buyer programs — might leave you better off or not.

Once you figure out which type of loan would work best for your needs, you can shop around among banks and other lenders. By shopping around for a loan with the best interest rate and terms, you can save big on the long-term costs of home ownership.

Related:

Do you have a conventional mortgage? Why or why not?

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