In the Market for a Home? This Type of Loan Could Save You Thousands
Conventional sounds so… conventional.
But the traditional path to home ownership doesn’t have to be boring — especially if it could save you thousands of dollars over the life of your home loan.
Government-backed loans — like the Federal Housing Administration (FHA) or Veteran’s Administration (VA) — might get more attention for the low (or no) down payments, but the reality is that the more people get conventional loans when buying a home.
Of the $1.63 trillion in first mortgages taken out in 2018, conventional loans claimed 45% of the market while FHA’s and VA’s combined share was 22.6%.
And although a government assistance program may seem like an easy way to home ownership, there’s a good chance that may not even be an option.
“At least a third of the people I work with are not eligible for assistance programs,” said Lisa Hamilton, an Accredited Financial Counselor and a counselor at the U.S. Department of Housing and Urban Development (HUD).
Since a home will probably be your biggest purchase, it’s in your best interest to understand how the loan works. Here’s what you need to know about a conventional home loan.
What Is a Conventional Loan?
At its most basic, a conventional loan is a mortgage that is not guaranteed or insured by any government agency.
The loans follow guidelines set by the Federal National Mortgage Association, aka Fannie Mae, and the Federal Home Loan Mortgage Corporation, aka Freddie Mac, two companies chartered by the U.S. government to help standardize mortgage lending.
Compare that to FHA loans, which are insured by the Federal Housing Administration, or VA loans, which are covered by the U.S. government.
If a loan is backed by a government agency, the government will cover your loan if you stop paying it. But that comes at a price, compared to the cost of a conventional loan. Here’s how to decide whether a conventional loan is a better fit for you.
How Do You Qualify for a Conventional Loan?
As with any loan, there are metrics you must meet to qualify for a conventional loan. When you apply for a mortgage, your lender will consider your current income (verified via paycheck stubs, W2s and tax returns) and employment status, in addition to these other criteria.
1. Down Payment
If you’ve heard anything about conventional loans, it’s probably that you need to have a 20% down payment to get one.
And although putting 20% down will still get you the best terms with the lowest interest and fewest fees, coming up with 20% for a $200,000 home would mean a home buyer would need to have $40,000 — plus additional money for closing costs, inspections and moving. That’s not an easy bar to clear for most first-time buyers.
To attract more customers, lenders have relaxed the 20% rule.
“The lending market has become more competitive, and banks have what they call ‘conventional mortgages’ with 5% down,” Hamilton said. “Or they may run a special and call it a conventional mortgage with 1% down.”
Although you may be tempted to throw every last dollar toward the down payment, hold onto enough money for an emergency fund — home ownership often comes with unexpected expenses.
If you do decide to put less than 20% down, lenders will require you to add private mortgage insurance (PMI), which is added as a monthly premium to your mortgage payment.
After you have reached 20% equity in your home, you can call you lender and ask to cancel the PMI (cancellation should happen automatically once you achieve 22% equity).
2. Credit Score
The minimum credit score for a conventional loan is 620 to 640, depending on your lender. However, if you want to take advantage of the lower down payment option, you should plan on raising your credit score as much as you can before you apply.
If you can put down 20% and raise your credit score before you apply for a loan, you’ll be able to snag even better interest rates and terms.
3. Debt-to-Income Ratio
Your debt-to-income ratio gives the lender an idea of how much of your income is going toward paying off your debt each month.
A “good” DTI for housing is around 25% while the maximum is typically 43%, according to Brent Weiss, CFP and chief evangelist of Facet Wealth.
However, lenders have been willing to go even higher, given the right circumstances, according to Hamilton.
“[Lenders] will make exceptions if you have a lot of cash reserves,” she said. “Some lenders are going as high as 55% DTI with those exceptions.”
How Much Can You Borrow? Conforming vs. Nonconforming Loans
Once you know whether you can qualify for a conventional loan, you’ll need to know how much you can borrow.
For most people, that means applying for a conforming loan. This is a type of conventional loan that meets Freddie and Fannie requirements, so lenders prefer them and thus usually offer better interest rates.
In most of the United States, the maximum conforming loan limit for 2019 is $484,350 — you can find the maximum amount for your area on this conforming loan limits map.
The majority of conventional loans are for 30 years, but it's possible to qualify for a 15- or 20-year mortgage loan, which could save you money on interest in the long run.
If you want to borrow more than the limit, you can still get a conventional loan but it will be a non-conforming jumbo loan, which can go as high as $1 million to $2 million. You’ll typically need a combination of really high credit score, large down payment and/or low DTI to qualify.
If you’re considering a non-conforming loan, it’s essential to shop around for the best rates and terms — and always ask for a loan estimate before signing anything.
What Are the Benefits of a Conventional Home Loan?
If you can qualify for a conventional loan, you can save thousands over the life of your mortgage in a couple ways.
For one, although the smaller downpayment on an FHA or VA loan might look attractive initially, both of those loans come with higher fees because the government is assuming the risk if you default on the loan.
Additionally, you can cancel the PMI for a conventional loan when you reach 20% equity in your home. If you have an FHA, you’ll pay the insurance (aka Mortgage Insurance Premium) for the life of the loan, which can really add up over 30 years.
“If your mortgage insurance is $50, $75, $100 per month, that’s quite a bit of money,” Hamilton said. “Buyers need to be aware of that added cost and how it can affect their ability to pay off the loan for that home to become a good investment vehicle.”
If you still decide to go with a government-backed loan — whether by choice or necessity — consider re-evaluating the conventional loan option in the future.
“If you go FHA, then plan to do that assessment every year, every couple of years,” Hamilton said. “Check in and decide, ‘Should I refinance? What’s the best long-term strategy?’”
Consider it conventional wisdom.
Tiffany Wendeln Connors is a staff writer/editor at The Penny Hoarder. Read her bio and other work here, then catch her on Twitter @TiffanyWendeln.