What is a Conventional Mortgage?

A conventional mortgage is kind of like an uninsured apartment rental...

If you rent an apartment from a landlord, and the landlord doesn’t have rent guarantee insurance, they have no protection if you stop paying your rent. Because of this, landlords will want to be extra careful about who they accept as tenants. Similarly, in a conventional mortgage, the loan isn’t insured by the government, so it may be harder to get approved.

A conventional mortgage or loan is a mortgage or loan that is not part of a government program and isn’t insured by the federal government. If the borrower defaults, the lender won’t have government protection against losses. This makes conventional loans riskier for lenders, and that makes getting approved for one more difficult.

Conventional loans can either be conforming or non-conforming loans. A conforming loan stays within the bounds of Fannie Mae and Freddie Mac’s lending requirements, such as the maximum loan amount, while a non-conforming loan does not. Generally, the fees, terms, and interest rates for conforming loans are more standardized than those for non-conforming loans. However, since non-conforming loans don’t abide by Fannie Mae and Freddie Mac’s requirements and limits, borrowers can take out larger loans, aka jumbo loans, to finance more expensive homes.

A conforming loan is a type of conventional loan. All conforming loans are conventional loans, but the opposite is not always true.

Conforming loans are conventional loans (loans that are not insured by the federal government) that meet the lending criteria set out by Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation). In short, the amount of the loan must fall below a specific threshold for a loan to be considered conforming.

Another way to think about conforming loans is that they are loans small enough to be purchased by Fannie Mae or Freddie Mac. These two government organizations purchase loans to hold in portfolios or to package into mortgage-backed securities (MBS) that are sold on the open market. Only conventional conforming loans can be part of their portfolios or MBSs.

As of 2021, the conforming loan limit for a single-unit property in most counties is $548,250. However, in counties where the cost of housing is particularly high, the limit can be as high as $822,375.

A conventional loan is a loan that is not part of a specific government program or insured by the federal government. Federal Housing Administration (FHA) loans are part of a specific government program and are guaranteed by the federal government, so they are non-conventional loans.

FHA loans have less stringent approval criteria than conventional loans. Borrowers with FICO credit scores as low as 500 can get approved. They also require smaller down payments. Borrowers with credit scores above 580 need only pay a 3.5% down payment.

In contrast, conventional mortgage lenders typically require a credit score of at least 620 and a down payment of no less than 5% (you must have a credit score of at least 720 to qualify for a down payment this low).

Since FHA loans are aimed at borrowers who may not be in ideal financial standing, they are riskier than conventional loans. Because of this, they also may be more expensive. Borrowers will need to pay for mortgage insurance until they build up enough equity in their homes; there may be higher interest rates depending on the down payment, and there are upfront funding fees for FHA and VA loans.

In some cases, conventional loans can be just as expensive as a non-conventional loan, if not more expensive; low down payments will also generally lead to needing mortgage insurance and paying higher interest rates. But, on average, conventional loans tend to be cheaper.

In everyday language, mortgages and mortgage loans are used interchangeably. However, they are actually two different things: A mortgage is an agreement that provides a piece of real property as collateral for a loan; a mortgage loan is a loan that goes with this agreement.

Mortgages loans are secured loans — They are backed by a piece of property. In a mortgage agreement, the borrower (the mortgagor) grants the lender (the mortgagee) the right to seize and sell their property if the borrower defaults on the loan (can’t pay it back). This agreement secures the loan by lowering the risk profile for the lender: If the borrower can’t pay back the loan, the lender will sell off the house and take the profits to cover its losses.

Typically, a conventional mortgage borrower will need to pay a down payment of at least 5% upfront. Then, they will make monthly mortgage payments over a set period of time, generally 15 or 30 years. Some lenders will also require that the borrower take out private mortgage insurance (this is more likely with smaller down payments).

In addition to paying off the cost of the house, borrowers will also need to pay interest on their loans. Borrowers can choose between fixed-rate and adjustable-rate mortgages. In a fixed-rate mortgage, interest rates stay the same throughout the entire life of the loan. In an adjustable-rate mortgage, the interest rate can fluctuate over the loan’s lifetime.

There are four documents that are required when closing on a conventional mortgage:

Promissory note: This document is an agreement that you sign to agree, or “promise,” that you will repay the loan according to the loan terms. The promissory note will include information on:

• The amount of the mortgage loan
• The interest rate or the initial interest rate for an adjustable-rate mortgage
• The consequences for not making the monthly payments on time
• The ways in which the interest rate can change if you’re signing for an adjustable-rate mortgage

Mortgage/Security Instrument/Deed of Trust: This document grants the lender (the mortgagee) the right to seize the property for foreclosure if the borrower doesn’t pay back their loan (defaults). Different states have varying names for this document with small differences. Some states require mortgage agreements, while others require deeds of trust.

Initial escrow disclosure: This document sets out the payments you will need to make into your escrow account each month. The escrow account is typically used to make the monthly principal and interest payments, mortgage insurance premiums, and to pay for property taxes.

Right to cancel form: If you are applying for a mortgage refinance, this document states that you have three days to cancel. In some cases, such as if the lender didn’t provide required disclosures, this can be extended up to three years.

According to Freddie Mac, the average annual interest rates (as of February 18, 2021) for conventional conforming loans are:

• 30-year fixed-rate mortgage: 2.81%
• 15-year fixed-rate mortgage: 2.21%
• 5/1 adjustable-rate mortgage: 2.77%

The above figures are averages, so your actual interest rate may vary. Keep in mind that these are average interest rates, not average APRs (annual percentage rates). Interest rates refer to the annual cost of a loan without fees, and APRs refer to the annual cost of a loan with fees included.

When calculating your interest rate, lenders take multiple factors into account, such as your credit history, down payment amount, and general financial standing. As a general rule, the higher your credit score, and the higher your down payment, the lower your interest rate will be.

Furthermore, shorter mortgages tend to have lower interest rates than longer ones. Adjustable-rate mortgages often have lower initial interest rates than fixed-rate mortgages, but this rate may fluctuate over time and become higher.

Non-conforming conventional loans may have more variance as far as interest rates go as they are less standardized in general.

Over the past few years, conventional loan requirements have become more strict. To qualify for a conventional loan, you will generally need to tick a few boxes:

• Be able to make a down payment: Conventional loans typically require down payments of no less than 5%. For a $200,000 house, for example, that’s $10,000. However, you’ll need a high credit score to qualify for such a small down payment amount. Lenders generally prefer larger down payments of 10-20%. Making a larger down payment will also generally lower your interest rate, and you’ll likely avoid private mortgage insurance.
• Have at least a 620 credit score: The minimum credit score to take out a conventional loan is 620. As your credit score increases, you will be eligible for lower minimum down payments and lower interest rates.
• No recent bankruptcy or foreclosure: Having a recent bankruptcy or foreclosure is a big red flag for mortgage lenders — It signifies that you already have a history of problems paying back your debts on time. If you’ve recently undergone bankruptcy or foreclosure, you likely will not qualify for a mortgage.
• A low debt-to-income (DTI) ratio: Lenders typically require borrowers to have debts that account for no more than 41–43% of their gross income.
• Miscellaneous requirements: Mortgage underwriters can use some degree of discretion when evaluating mortgage applicants. Some lenders may want to see other proof of good financial standing. This will vary from lender to lender.

The minimum credit score for a conventional loan is 620. In contrast, some non-conventional loans, such as FHA loans, require a minimum credit score of only 500. However, meeting these minimums are not a guarantee of approval — Lenders will still take other factors, such as your debt-to-income (DTI) ratio, into account.

As your credit score increases, the loan typically will become less expensive, and your chances of approval will increase. Higher credit scores qualify for lower minimum down payments and typically have lower interest rates.

Anyone who has had a recent bankruptcy or foreclosure, a credit score below 620, does not have a low enough debt-to-income (DTI) ratio, or cannot afford the minimum 5% down payment will not qualify for a conventional loan.

Even when all these requirements are met, there is always a chance that the lender will turn you down at their discretion. Since the 2008 housing market crash, lenders have become increasingly careful about whom they approve for mortgage loans. Overall, lenders want to see that an applicant has a strong financial foundation and a high likelihood that they will be able to pay the mortgage on time without defaulting.