What Is a Conventional Mortgage or Loan?
A conventional mortgage or conventional loan is any type of home buyer’s loan that is not offered or secured by a government entity, such as the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA) or the USDA Rural Housing Service, but instead is available through or guaranteed by a private lender (banks, credit unions, mortgage companies) or the two government-sponsored enterprises, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Conventional loans are often erroneously referred to as conforming mortgages or loans. While there is overlap, the two are distinct categories. A conforming mortgage is one whose underlying terms and conditions meet the funding criteria of Fannie Mae and Freddie Mac. Chief among those is a dollar limit, set annually by the Federal Housing Finance Agency (FHFA): In 2019, in most of the continental U.S., a loan must not exceed $484,350. So while all conforming loans are conventional, not all conventional loans qualify as conforming. A jumbo mortgage of $800,000, for example, is a conventional mortgage but not a conforming mortgage – because it surpasses the amount that would allow it to be backed by Fannie Mae or Freddie Mac.
Currently, conventional mortgages represent around two-thirds of the homeowners’ loans issued in the U.S. The secondary market for conventional mortgages is extremely large and liquid. Most conventional mortgages are packaged into pass-through mortgage-backed securities, which trade in a well-established forward market known as the mortgage TBA (to be announced) market. Many of these conventional pass-through securities are further securitized into collateralized mortgage obligations (CMOs).
How a Conventional Mortgage or Loan Works
In the years since the subprime mortgage meltdown in 2007, lenders have tightened the qualifications for loans – “no verification” and “no down payment” mortgages have gone with the wind, for example – but overall most of the basic requirements haven’t changed. Potential borrowers need to complete an official mortgage application (and usually pay an application fee), then supply the lender with the necessary documents to perform an extensive check on their background, credit history and current credit score.
No property is ever 100% financed. In checking your assets and liabilities, a lender is looking to see not only if you can afford your monthly mortgage payments (which usually shouldn't exceed 28% your gross income), but also if you can handle a down payment on the property (and if so, how much), along with other up-front costs, such as loan origination or underwriting fees, broker fees and settlement or closing costs, all of which can significantly drive up the cost of a mortgage. Among the items required are:
1. Proof of income. These documents will include but may not be limited to:
- thirty days of pay stubs that show income as well as year-to-date income
- two years of federal tax returns
- sixty days or a quarterly statement of all asset accounts, including your checking, savings and any investment accounts
- two years of W-2 statements
Borrowers also need to be prepared with proof of any additional income, such as alimony or bonuses.
2. Assets. You will need to present bank statements and investment account statements to prove that you have funds for the down payment and closing costs on the residence, as well as cash reserves. If you receive money from a friend or relative to assist with the down payment, you will need gift letters, which certify that these are not loans and have no required or obligatory repayment. These letters will often need to be notarized.
3. Employment verification. Lenders today want to make sure they are loaning only to borrowers with a stable work history. Your lender will not only want to see your pay stubs but may also call your employer to verify that you are still employed and to check your salary. If you have recently changed jobs, a lender may want to contact your previous employer. Self-employed borrowers will need to provide significant additional paperwork concerning their business and income.
4. Other documentation. Your lender will need to copy your driver’s license or state ID card and will need your Social Security number and your signature, allowing the lender to pull your credit report.
Conventional loans’ interest rates tend to be higher than those of government-backed mortgages, such as FHA loans (although these loans, which usually mandate that borrowers pay mortgage-insurance premiums, may work out to be just as costly in the long run).
The interest rate carried by a conventional mortgage depends on several factors, including the terms of the loan – its length, its size and whether it has a fixed interest rate or an adjustable rate – as well as current economic or financial market conditions. Mortgage lenders set interest rates based on their expectations for future inflation; the supply of and demand for mortgage-backed securities also influences the rates. When the Federal Reserve makes it more expensive for banks to borrow by targeting a higher federal funds rate, the banks in turn pass on the higher costs to their customers, and consumer loan rates, including those for mortgages, tend to go up.
Typically linked to the interest rate are points, fees paid to the lender (or broker). The more points you pay, the lower your interest rate. One point costs 1% of the loan amount and reduces your interest rate by about 0.25%. In general, people who plan on living in a home for a long time (10 or more years) should consider points to keep interest rates lower for the life of the loan.
The final factor in determining the interest rate is the individual borrower’s financial profile: personal assets, creditworthiness and the size of the down payment they can make on the residence to be financed.
A buyer who plans on living in a home for 10 or more years should consider paying for points to keep interest rates lower for the life of the mortgage.
Special Considerations for a Conventional Mortgage or Loan
These types of loans are not for everyone. Here's a look at who is likely to qualify for a conventional mortgage and who is not.
Who Is Likely to Qualify
People with established credit and stellar credit reports who are on a solid financial footing usually qualify for conventional mortgages. More specifically, the ideal candidate should have:
- A credit score of at least 680 and, preferably, well over 700. The higher the score, the lower the interest rate on the loan, with the best terms being reserved for those over 740.
- An acceptable debt-to-income ratio (DTI) (the sum of your monthly obligations compared to your monthly income). That number is around 36% and no more than 43%.
- A down payment of at least 20% of the home’s purchase price readily available. Lenders can and do accept less, but if they do they often require that borrowers take out private mortgage insurance and pay its premiums monthly until they achieve at least 20% equity in the house.
In addition, conventional mortgages are often the best or only recourse for home buyers who want the residence for investment purposes or as a second home or who want to purchase a property priced over $500,000.
Who Is Unlikely to Qualify
Generally speaking, those who are just starting out in life, those with a little more debt than normal and those with a modest credit rating often have trouble qualifying for conventional loans. More specifically, these mortgages would be tough for those who have:
- suffered bankruptcy or foreclosure within the past seven years.
- credit scores below 650.
- DTIs above 43%.
- less than 20% or even 10% of the home's purchase price for a down payment.