What Is a Conforming Loan?
A conforming loan is a mortgage that is equal to or less than the dollar amount established by the conforming-loan limit set by the Federal Housing Finance Agency (FHFA) and meets the funding criteria of Freddie Mac and Fannie Mae. For borrowers with excellent credit, conforming loans are advantageous due to the low interest rates affixed to them.
How a Conforming Loan Works
The Federal National Mortgage Association (FNMA or Fannie Mae) and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) are government-sponsored entities that drive the market for home loans. These quasi-governmental agencies created standardized rules and guidelines to which mortgages must conform. The term “conforming” is most often used when speaking specifically about the mortgage amount, which must fall under a certain limit, known as the conforming-loan limit, set by the Federal Housing Finance Agency (FHFA). For 2019 this limit is $484,350, an increase from $453,100 in 2018. In high-cost markets the limit is higher. The new ceiling for one-unit properties in most high-cost areas, such as San Francisco and New York City, is $726,525—or 150% of $484,350. The Housing and Economic Recovery Act (HERA) requires that the baseline conforming-loan limit be adjusted each year for Fannie Mae and Freddie Mac to reflect the change in the average U.S. home price.
Other than the size of the loan, other guidelines conforming loans adhere to include the borrower’s loan-to-value ratio (i.e., the size of the down payment), debt-to-income ratio, credit score and history, documentation requirements, etc. A conforming loan through Fannie or Freddie can have a down payment as low as 3%, and the borrower must be a first-time home buyer. In addition, private mortgage insurance (PMI) of about 1.05% per year for 30-year loans up to $484,350 is required on the loan. Part or all of the cost of the insurance is tax deductible if the borrower’s household adjusted gross income (AGI) is no more than $109,000.
Conforming loans are advantageous due to their low interest rates.
How Do Lenders Use Conforming Loans?
It is important to note that Fannie Mae and Freddie Mac do not issue mortgages. Instead, they insure mortgages issued by lenders, creating more room for banks to issue more loans than they would have otherwise been able to do without the insurance. For this reason lenders prefer to work with conforming loans, as they can be easily packaged into investment bundles and sold in the secondary mortgage market, freeing up capacity to lend more to home buyers.
Conforming Loans vs. Nonconforming Loans
Both Fannie Mae and Freddie Mac only buy conforming loans to repackage into the secondary market, making the demand for a nonconforming loan much less. Mortgages that exceed the conforming-loan limit are classified as nonconforming or jumbo mortgages. The terms and conditions of nonconforming mortgages can vary widely from lender to lender, but the mortgage rates and minimum down payment for jumbo loans are typically higher because they carry greater risk for a lender.
Special Considerations for Conforming Loans
The FHFA, which sets the conforming-loan limit on an annual basis, has regulatory oversight to ensure that Fannie Mae and Freddie Mac fulfill their charters and missions of promoting homeownership for lower-income and middle-class Americans. FHFA uses the October to October percentage increase/decrease in average housing prices in the Monthly Interest Rate Survey (MIRS) to adjust the conforming-loan limits for the subsequent year.
To conduct this survey, FHFA asks a sample of mortgage lenders to report the terms and conditions on all single-family, fully amortizing, purchase-money, non-farm loans that they close during the last five business days of the month. The survey provides monthly information on interest rates, loan terms and house prices by property type, loan type (fixed rate or adjustable rate) and lender type, as well as information on 15-year and 30-year fixed-rate loans.