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What is a Conventional Loan?


What is a Conventional Loan?

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As a potential homeowner in the US, choosing a loan type may be difficult. On the one hand is the government with its federal loans and more restrictions, and on the other are private loans with fewer restrictions. But what exactly differentiates one from the other, and which should you choose when buying a home? Fort Collins mortgage lenders are the experts and can direct you to the right loan. 

To answer these questions accurately, you’ll need to understand how each loan works and which one is most suitable. This article will answer your questions about conventional loans and how they work. 

What is a Conventional Loan? 

A conventional loan is a type of mortgage or loan that is not insured or backed by a government agency. Government loans are typically backed by a government agency such as the Federal Housing Authority, Department of Veteran Affairs, or Department of Agriculture. This insures the lender in case the borrower fails to repay the loan. Most loans on the market are conventional loans. They are issued by banks, mortgage companies, and other private lenders. 

Conventional loans are not available to everyone. To qualify for a conventional loan, you’ll need to qualify for stricter requirements than with government loans. Many conventional loans conform to the loan requirements set by Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). 

How Does a Conventional Loan Work? 

A conventional loan is one of the types of mortgage products a mortgage broker offers. As a person seeking a mortgage for getting a house, a conventional loan is one of the standard options you can go for. Conventional loans offer stricter requirements on who can receive a loan, but they are less restrictive on what you can use it for. You can easily use a conventional loan to finance a second or third house, which may not be possible with certain government loans. 

You’ll need to apply at a bank, credit union, or mortgage company to get a conventional loan. You may apply with a mortgage broker specializing in several types of loans. A mortgage broker would help you compare multiple conventional loans to see which is best for you. After application, there’d be a thorough credit check to see if you meet the lender’s requirements. The lender will examine your credit score, debt-to-income ratio, and other financial positions. 

If you meet the requirements, you may then get an offer. After an agreement, your loan will contain the repayment terms, including the interest rate and the term length. The agreement may also contain other terms of the loan, such as whether it covers additional costs apart from the cost of the home. 

Types of Conventional Loans 

Two main kinds of conventional loans are common. They are:

  • Conforming loans

Conforming loans are conventional loans that meet the requirements and fall within limits set by the Federal Housing Finance Agency. Conforming loans may be bought by Freddie Mac and Fannie Mae, making them less risky for mortgage lenders. They typically have less strict requirements and lower down payments. 

  • Non-conforming loans 

Non-conforming loans are conventional loans that do not fall within limits set by the Federal Housing Finance Agency. This may be because the price of the home exceeds the FHFA’s limits or because of other factors such as a low credit score or too much debt. Non-conforming loans are riskier for lenders and typically have tighter requirements. 

How can I Qualify For a Conventional Loan? 

Because the government does not back conventional loans, lenders are taking a higher risk. Therefore, conventional loans have stricter requirements than government loans. Fannie Mae and Freddie Mac set minimum requirements for a conventional loan. Still, each lender may set higher requirements depending on their standards. To get a conventional loan, you’ll need to meet the following requirements:

  • High credit score 

Your credit score is one of the most important aspects of qualifying for a conventional loan. To get a conventional loan, you’ll need a minimum credit score of 620. However, most lenders will require you to have a higher credit score than 620, sometimes up to 700. If you have a credit score less than 620, you may want to apply for a government loan instead. 

Your credit score also affects how high your interest rate will be. People with higher credit scores tend to get lower interest rates, as lenders can trust that they’re good managers of their finances.

  • Low debt-to-income ratio 

If you’re applying for a conventional loan, you’ll need a low debt-to-income ratio. Your debt-to-income ratio is the ratio of your total monthly debt payments to your total monthly income. Typically, lenders require you to have a debt-to-income ratio of 45% or less. Certain lenders will not offer you a loan if your debt-to-income ratio is above 36%, so you’ll need to thoroughly research lenders for one that is okay. You can also work to reduce your monthly debt repayments, such as reducing your credit card expenses. 

  • A minimum down payment of 3% (with PMI) 

A great feature of conventional loans is the ability to take loans with a down payment as low as 3%. However, before paying such a low down payment, many lenders will require you to take out a private mortgage insurance (PMI). If you don’t want to take a PMI, you may ask the lender if they’re willing to consider a piggyback loan. With this option, you can make a down payment of 10% while splitting the remainder into two parts. 80% would be the primary mortgage, to be paid at the agreed rate, while the other 10% is a piggyback loan. If you want to avoid taking a PMI, you may need to pay as high as 20% on your down payment. 

  • Property appraisal 

Lenders will only want to give a loan to you if they’re sure the home is worth what they are paying. So, most lenders will require a home appraisal before giving you a conventional loan. An appraisal compares the price of similar houses on the market to determine how much a building is worth. Most lenders will do the appraisal themselves. Lenders will only be willing to give you a loan if the purchase price is at, or less than, the home’s worth. 

Getting a Conventional Loan

Obtaining a conventional loan can offer you more flexibility, but it has tighter requirements. You’ll need to ensure that you have a great credit score, a low debt-to-income ratio, and can afford the down payment. This way, you’d increase your chances of getting a conventional loan.