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Types of Conventional Loans & How They Work

A conventional loan is one that is not backed or insured by an agency of the federal government.

There are two types of conventional mortgage loans, conforming and non-conforming. Telling them apart can be kind of tricky, so we’ll outlines the differences and what you need to know to choose the mortgage that’s best for you.
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What is a Conventional Loan?

Conventional loans are insured by private lenders and not government-backed or government-insured. Examples of government-backed mortgage loans are FHA, VA, and USDA loans.
Lenders who provide conventional loans require borrowers to pay for Private Mortgage Insurance (PMI) if their down payment is less than 20% of the purchase price of the home. PMI protects the lender in case the borrower fails to repay the loan. 

Types of Conventional Mortgage Loans

There are two types of conventional loans, conforming and non-conforming, and other types of loans within each of those categories. Here is each type explained in more detail:
Conforming Conventional Loans. These loans conform to the Federal Housing Finance Agency (FHFA) loan limits for mortgages that will be acquired by Fannie Mae and Freddie Mac. In most of the U.S., the 2022 conforming loan limit for one-unit properties is $647,200.
Non-Conforming Conventional Loans. These are loans that exceed FHFA loan limits, and are therefore, non-conforming. An example of a non-conforming mortgage loan is the jumbo loan which is used to finance properties that exceed the conventional conforming loan limit.
Fixed-Rate Conventional Loans. Fixed rate mortgages have a fixed interest rate for the life of the loan.
Jumbo Loans. These loans are used to finance high mortgage amounts, often for luxury homes. A jumbo loan is a non-conforming loan, as it doesn’t conform to the requirements of Fannie Mae, Freddie Mac, and their regulator, the Federal Housing Finance Agency (FHFA).
Adjustable Rate Conventional Loans. Adjustable-Rate Mortgages (ARMs) typically start with a promotional adjustable rate then re-adjust periodically. This means your monthly mortgage payments will fluctuate higher or lower based on the financial index that the ARM is tied to.

Low Down Payment Conventional Loans

Options include:

  • The Freddie Mac Home Possible® mortgage, which offers qualified very low- to low- income borrowers a 3% down payment financing option.
  • The Fannie Mae HomeReady® mortgage for credit-worthy low-income borrowers, allows 3% down payment.
  • Loans requiring a 5% down payment are also available.
Conventional Renovation Loans. Fannie Mae’s Conventional HomeStyle Renovation Loan gives people the funding to renovate and rehab a new or existing home by including financing in their conventional purchase or refinanced home loan.

Sub-Prime Conventional Loans. These loans are ideal for people with very low credit scores. The loans may have terms that add additional risk, such as an Adjustable Rate Mortgage (ARM) with a very low introductory rate and a higher reset rate that could become unaffordable to credit-challenged borrowers. Interest-only loans may also be sub-prime, as the borrower pays-down the interest but not the principal and may end up with a large payment at the end of the loan term. These loans are high risk to the lender as well.
Conventional Portfolio Loans. These are loans made by a lender and then held in the lender’s portfolio and not sold on the secondary loan market. The borrower may pay a higher interest rate to cover the lender’s risk of holding and servicing the loan.
Amortized Conventional Loans. This is any loan that, if paid as per the loan terms, will “fully amortize” or be paid off at the end of the term. A non-amortized loan would be one that is not paid off at the end of the loan term, for example, an interest-only loan at has a principal balance left at the end.

Advantages of Conventional Loans

  1. Faster Loan Underwriting. Because conventional loans have standard requirements, they are easier for the lender to process and approve.
  2. More Options. Borrowers have more options, including 15, 20, or 30-year loans.
  3. Optional Escrow Accounts. Most new mortgages require that money be set aside in an escrow account for payment of the homeowners insurance and property tax. These amounts are included in the monthly mortgage payment. Not only is this convenient for the borrower, it reduces risk for the lender. Some lenders will allow the borrower to pay their own homeowners insurance and property tax if there is a 20% down payment on the original transaction or the borrower reaches 20% equity in their home.
  4. Security. Most conventional loans have a fixed interest rate, so borrowers can be secure knowing how much their monthly payments will be.
  5. Can Be Used on All Property Types. Whether you’re buying a house or condominium, a conventional loan can get the deal done.
  6. Private Mortgage Insurance (PMI) May Not Be Required. For buyers who can make a down payment of more than 20%, PMI may be waived by the lender.

Disadvantages of Conventional Loans

  1. Higher Down Payment Requirement. Because conventional loans are not government-insured, lenders may change a higher interest rate to cover their risk.
  2. Higher Credit Score Requirement. Lenders also protect themselves for borrower risk by charging higher interest rates. You may need at least a 620 credit score to qualify for a conventional loan.
  3. Debt-To-Income (DTI) Ratio. Before approving someone for a mortgage, the lender will calculate DTI to determine if the borrower has the ability to repay the loan. DTI is your total monthly expenses divided by your total monthly income before taxes. Lenders typically require a DTI from 36% to 43%.
  4. PMI Insurance. Conventional loans with less than 20% down require Private Mortgage Insurance (PMI) to protect the lender if the borrower fails to repay the loan.

How to Decide Which Conventional Loan is Right for You

Deciding which mortgage type is right for you can be based on your income, how much you can afford in monthly mortgage payments, the type of property, the price of the home, and the financial institution’s lending criteria that will identify which mortgage options work best for your unique situation. Here are some tips for deciding how much house you can afford.

What about Non-Conventional Loans?

Non-conforming mortgages differ in several ways, including:
  1. Debt-to-income (DTI) Ratio. Conforming loans can go to a maximum DTI of 43%, while non-conforming may go to 50%, allowing people with higher debt and lower income qualify.
  2. Credit Score. Conforming loans require a minimum 620 credit score. Non-conforming loans will allow individuals with lower credit scores to qualify.
  3. Loan Limit. The 2022 conforming loan limits is up to $647,200 in most areas of the United States.

Where to Get a Conventional Loan?

Credit unions, banks, and online lenders all offer a wide range of conventional loans. Online or digital lenders can be a reliable source for attaining a mortgage, however, they are not regulated to the extent that traditional banks and credit unions are regulated. Learn how to choose the right mortgage lender.
Credit unions are safe and backed by the National Credit Union Administration (NCUA), an independent agency created by the U.S. government to regulate and protect credit unions and their owners. Credit unions are financial co-operatives that provide loans and savings to their members, but typically with better interest rates and lower fees. Learn more about credit union safety.

How to Apply for a Conventional Loan

Getting a mortgage can be easy, as long as you’re prepared. Here are some of the basic steps to getting a mortgage.
  1. Gather your documents. This includes paystubs/proof of income, W-2s or 1099s, proof of debt, and proof of assets.
  2. Check your credit score. Knowing your credit score before you apply for a mortgage can save you time. If you find your credit score is low (below 580), you’ll likely need to build your credit score to qualify for a mortgage. Check it for free here.
  3. Get pre-approved for a mortgage. Start by talking to a mortgage loan professional about your homeownership goals. To get pre-approved, you will need to provide the documents mentioned above, and the mortgage professional will ask your permission to check your credit score. Once approved, you will receive a “pre-approval letter.”
  4. Find the house you want. Bring your pre-approval letter (or a copy) when you shop for a house. Home sellers and real estate agents often prefer to work with buyers who are pre-approved for a mortgage, and your offer will be looked at more favorably.
  5. Apply for the mortgage. Once your offer is accepted you will complete the application process that includes getting an appraisal on the home and other steps that your mortgage professional and real estate agent can guide you through.
  6. Closing. Once your application is approved, the loan is clear to close. These days, many closings are done virtually with funds wired to the seller. A Title Company, chose by the seller, will typically manage the closing.

Why Savvy Consumers Choose CU SoCal

For over 60 years CU SoCal has been providing financial services, including mortgages, Home Equity Loans, HELOCs, car loans, personal loans, credit cards, and other banking products, to those who live, work, worship, or attend school in Orange County, Los Angeles County, Riverside County, and San Bernardino County.
Please give us a call today at 866.287.6225 today to schedule a no-obligation loan consultation with a CU SoCal Member Services specialist.
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