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Should You Get a Conventional Loan to Buy Your Home?

May 14, 2021

9 MINUTE READ

Should You Get a Conventional Loan to Buy Your Home?

For most people looking to buy a home, mortgages aren’t an enjoyable conversation topic. They’d rather think about what color they’ll paint the walls or what furniture they’ll buy for each room of their new home. After all, that’s a lot more fun than crunching numbers.

However, figuring out how you’ll finance your new home is crucial to the buying process. And, in order to finance that purchase, you’ll need to consider getting a loan. When considering your loan options, you may wonder whether you should opt for a federal-backed loan or a conventional loan.

Here’s what you need to know about getting one over the other.

What is a Conventional Loan?

A conventional mortgage is the most common type of loan available to buyers, with more than 70% of borrowers going this route.

In its simplest definition, a conventional mortgage/loan is any mortgage that’s issued and backed by private lenders, credit unions, and other financial firms. While the U.S. government does not back these loans, most of them comply with the Federal Housing Finance Administration (FHFA) limits and other requirements set by  government-sponsored loan companies, Fannie Mae and Freddie Mac.

Conventional loan requirements are much more restrictive than government backed-loans. As a result, you may find it challenging to get approval. For example, you typically need to have an excellent credit rating and a low debt-to-income (DTI) ratio to qualify for one. Since private entities don’t have the government as a safety net, they’re assuming the risk should you default on your loan. For instance, that’s why mortgage lenders will require you to have mortgage insurance sometimes. Private mortgage insurance, or PMI, protects the lender in case you default. You’re usually required to pay for PMI if you make a down payment that’s less than 20% on a conventional loan.

The flip side? A conventional home loan offers fixed interest, meaning it stays the same throughout the loan term. Because of this, it’s easier to predict and budget your payments with conventional loans. However, the caveat is that rates can be higher than government-backed mortgages.

There are also other perks with a conventional loan. Down payment requirements, for example, can be negotiable as long as you’re willing to get mortgage insurance. Even when you factor in insurance, you have much more control over premium payments compared to federal home loans. This can potentially save you money in the long term.

How a Conventional Loan Works

Conventional Loan Qualifications

The process for securing a conventional mortgage works is the same as any other type of loan. To get approval, you need to show the lender that you have the financial capacity to pay them back.

Specifically, you need to have:

  • A credit score of at least 620 — ideally 760 – to qualify for the best rates
  • No record of bankruptcy or foreclosure for the last seven years
  • A debt-to-income (DTI) ratio between 36% and 43% ideally. You can however go up to 50% if you have an excellent credit profile.
  • 20% down payment for the house you want to buy (some lenders might lower this threshold but will require you to get private mortgage insurance)

Signing Up For A Loan

You’ll need to submit the following conventional home loan requirements together with your application form.

First, you need to show proof of income – arguably one of the most crucial conventional mortgage requirements. Valid forms include:

  • Pay slips from your employer (either showing a 30-day period or 2 cycles of paystubs)
  • W-2 statements for a minimum of two years
  • Federal tax returns for at least the past two years
  • Statement of all your asset accounts (checking, savings, investments, etc.) for the past 60 days
  • Additional income, such as bonuses or alimony
  • Gift letters (if you received part of the mortgage payment from a friend or relative as a gift and not as a loan)

Second, you’ll provide basic information such as your driver’s license and Social Security number. The lender will use this to check your credit score.

Finally, the lender will most likely run a background check so that they can verify your employment. The lender’s goal is to determine that you have a stable work history. You should provide your work details, as well point persons they can contact. If you’ve recently switched employers, you should include information from your previous workplace, as well. Typically, lenders want to see that you have been with an employer for at least a minimum of two years. Inconsistencies in job history are usually frowned upon.

A helpful tip: If your mortgage application gets denied, you should ask for the lender’s reason in writing, usually delivered by your loan officer from their underwriting team. This arms you with the knowledge you’ll need to explore other options, so you’ll have a better chance of approval in the future.

Conventional Loan Types

In the world of conventional loans, you’ll generally find two types:

  • Conforming
  • Non-conforming

Before we proceed, let’s clear up a common misconception. Many people think that conventional and conforming loans are the same. However, that’s not accurate. Yes, all conforming loans are conventional. However, not all conventional loans are conforming.

A conforming mortgage is a loan that lenders purchase from Fannie Mae or Freddie Mac and offer to borrowers. However, any loan must conform to the criteria set by these two government-backed mortgage associations.

Specifically, the loan amount must stay within the Federal Housing Finance Agency (FHFA) limits. These limits change yearly, depending on the average house prices in a location.

Loans that exceed FHA limits are called non-conforming, or jumbo, loans. These are loans funded by private lenders and firms without going through Freddie Mac or Fannie Mae.

Non-conforming loans are meant to finance properties, such as luxury homes, with price tags north of $500,000. These loans are much more stringent than your typical conforming conventional loan. Down payment requirements, however, can be much lower (10% – 15% on average).

Conventional Loans vs. Government Loans

To decide whether conventional loans are suitable for you, you should also consider what’s on the other side of the table – government-backed loans.

Government-backed home loans are offered and guaranteed by the federal government, specifically the Federal Housing Administration (for FHA loans) and the Department of Veterans Affairs (for VA loans).

The most significant difference between conventional and government-backed loan types boils down to who assumes the risk. With conventional loans, the lender assumes the risk in case you’re unable to pay. That’s why they’re motivated to make sure that you’re financially stable, or at the very least, have some collateral in case you default.

In contrast, if you default on a government-backed mortgage, the federal agency that offered the loan will pay the lender on your behalf.

The other advantage of government-backed loans is that they have less strict requirements. They often do not have credit history checks, so individuals who may be barred from getting a conventional loan may get approved for a federal-backed loan. Government loans also have attractive features like flexible payment plans and lower interest rates.

However, because of these advantages, it can be much more challenging to get a government-backed mortgage. They offer fantastic deals, so the competition for government loans is fierce and the application process long. There are also other eligibility rules in play for which you may not qualify.

Advantages of Conventional Loans

Since conventional loans come with higher interest rates and strict requirements, you might wonder why you’d want to opt for this option. Well, they’re useful for several reasons:

  • More flexibility

Once you get a conventional loan, you’re not restricted to the house that you can finance. Conventional loans have a much higher amount you can borrow (which is where jumbo loans come in).

Also, you tend to get more options with regards to loan length and terms. You can find 15 or 20-year mortgages if you don’t want to opt for the standard 30-year loan. Lenders are also free to offer flexible terms and adjustable-rate home loans.

  • Faster applications

Applying for a conventional mortgage is much faster than getting approved for a government-backed loan. Private lenders have loans readily available with generally less demand. If you need to finance your home fast, conventional loans are the way to go.

  • Negotiable mortgage insurance

You can often cancel your private mortgage insurance (PMI) prematurely after your loan balance covers the down payment. Compare this to government-loans, like FHA, where you’ll need to pay insurance premiums throughout the loan’s life.

  • Lower fees

You can lower the funding fee on your conventional loans by up to 1.4%, depending on the down payment. In contrast, FHA loans will charge you an upfront flat fee of 1.75% for insurance premiums.

Are Conventional Loans Right for You?

Sometimes, your loan type is already decided for you. That’s because you might not meet the eligibility requirements to qualify for FHA or VA loans, which leaves you with no choice but to apply for conventional loans.

Conversely, suppose you have a low credit score or a history of bankruptcy or foreclosure. In that case, your chances of getting a conventional loan might be slim to none, and an FHA loan might be your saving grace.

But what if you qualify for both?

For most homeowners with exceptional credit scores and minimal debt, a conventional loan is better. Approval is quick, and you can save money in the long run due to the lower (or in some cases, zero) mortgage premium payments. If you plan on buying an investment home or luxury property that requires a larger loan balance, then a conventional mortgage is often your only financing option.

Regardless, it’s best to use a mortgage loan calculator to compare both loan types and see where you can save more money.

Reali Can Help

If you still can’t decide, it’s best to get professional advice. Chat with our experts today at Reali. We’re happy to answer your questions about financing your next home purchase. Or, request a free home loan quote from us today.