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What Is a Conventional Loan for a House?

Nice Pennsylvania homeThe USDA, FHA, and VA home loan programs are mortgages that are backed by the Federal government. These programs require an upfront mortgage insurance premium and a monthly MIP (aka PMI) payment (except the VA loan).
The conventional loans are not backed by the government. Conventional loans are mortgages that meet the underwriting (approval) guidelines of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Corporation (Freddie Mac). The conventional loan is the mortgage that your father and grandfather applied for when they bought a house. They went to the local bank and made a down payment of 5%, 10%, 15% or 20%.

After the bank or mortgage broker processes the mortgage, the loan is usually sold to either Fannie Mae or Freddie Mac. The lender must meet the Fannie or Freddie's underwriting guidelines in order to sell the mortgage to these companies. Conventional mortgages are often called "conforming" loans because the loan "conform" to the Fannie or Freddie's guidelines.

Here are some of the lending guidelines and highlights for the conventional mortgage.

Minimum down payment for a conventional loan

Fannie Mae requires a 5% down payment on most loan products; however, Fannie Mae offers two 3% down payment programs. Here's a comparison of the 3% down payment mortgages:

HomeReady 97% LTV Conventional 97%
First-time home buyer requirements None At least one borrower must be a first-time home buyer
Income limits 80% of area median income in all census tracts No limits
Gift Funds Gift funds may be used for the down payment and closing costs. There is no borrower required minimum amount for the down payment and closing costs. Same
Flyer Frequently Asked Questions Conventional 97%

Credit score requirement

The minimum credit score is 620

Loan term (length of the mortgage)

Fully amortizing fixed rate program has terms of 10, 15, 20, 25 and 30 years

Number of units

Conventional financing is limited to 1 - 4 owner occupied units and one unit (single family) for second homes. Approved condos and PUDs are eligible.

Mortgage insurance on a conventional loan

Confused emoticonThe conventional home loans require private mortgage insurance when the down payment is less than 20%. Private mortgage insurance is offered by who else, private mortgage insurers. The cost is determined by the down payment (or equity in the case of a refinance), credit score, location of the property, and a few other factors. The FHA and USDA require monthly mortgage insurance, although, the monthly cost is not affected by the credit score or the location of the home. The conventional PMI expense can be substantial with a low credit score. Read more about PMI and MIP

Upfront mortgage insurance premium

The conventional loans do not require "upfront" mortgage insurance. For an FHA loan with the minimum down payment, the upfront cost is 1.75% of the loan amount. For example, if the loan amount is $100,000, the borrower is required to pay (or finance), $1,750. The USDA's upfront cost is 1% of the loan, or $1,000 for a $100,000 loan amount. The Veteran loan has different upfront costs that are based on service eligibility and down payment.

Seller paid closing costs

Fannie Mae and Freddie Mac permit the home seller, Realtor®, builder, and lender to pay a percentage of the buyer's closing costs. The amount of the seller assistance is limited by the down payment percentage.
Read more about seller paid closing costs

Maximum loan amount for a conventional mortgage

Each year the the Federal Housing Finance Agency (FHFA) establishes the maximum loan limit for Fannie Mae and Freddie Mac. Most US counties have the following loan limits for 2020:

  • 1-unit home - $510,400
  • 2-units (duplex) - $653,550
  • 3-units - $789,950
  • 4-units - $981,700

There are exceptions for high cost US counties. See conventional loan limits for 2020

Loan amounts that exceed the lending limits are known as jumbo loans. Jumbo loans may be called conforming if the loan complies with the underwriting guidelines of Fannie and Freddie, with the exception of the loan amount (i.e. Conforming Jumbo Loan). Since the jumbo loan exceeds the lending limit, the loan cannot be sold to Fannie Mae or Freddie Mac, consequently, the loan is retained by the lender. There is risk when large mortgages are listed on a bank's balance sheet. If the borrower defaults on the mortgage, the bank loses money. Because of the risk, banks charge a higher interest rate for jumbo loans.

Combo or piggyback loans

One way to avoid the jumbo mortgage interest rate and eliminate private mortgage insurance is to obtain a second mortgage for the difference between the maximum lending limit and the total loan amount. For example, let's say that the sales price of the home is $600,000 and the borrower has a 10% down payment. Structuring the loan as follows would keep the 1st loan amount at the maximum lending limit and avoid the increased jumbo interest rate.

Conventional lending limits are higher than FHA mortgages. The USDA home loan program does not have a lending limit, however, there are income limits with USDA loans that usually constrains the maximum mortgage amount. The maximum VA mortgage is the same as the single family conventional limit.

Piggyback Loan
Sales Price $600,000
Down Payment 10%
Loan Amount $540,000
Less 1st mortgage $453,100
2nd mortgage $86,900

Another benefit of the combo or piggyback loan is to reduce the private mortgage insurance costs.

A piggyback second mortgage is a home equity loan or home equity line of credit (HELOC) that is made at the same time as your main mortgage. Its purpose is to allow borrowers with low down payment savings to borrow additional money in order to qualify for a main mortgage without paying for private mortgage insurance.

Typically, borrowers with a down payment less than 20 percent of the homes price will need to pay for mortgage insurance. For example, a borrower that can afford a 10 percent down payment would typically pay for the first 10 percent of the homes price with their down payment, and the remaining 90 percent of the price with a mortgage that requires mortgage insurance.

When using a piggyback mortgage, lenders structure the loans differently. For example, the same borrower might pay for the home with: a 10 percent down payment, 80 percent main mortgage, and a 10 percent piggyback second mortgage. In this scenario, the borrower is still borrowing 90 percent of the value of the home, but the main mortgage is only 80 percent. The piggyback second mortgage typically carries a higher interest rate, which is also often adjustable. These programs are offered under a variety of lender-specific brand names, but follow the same basic structure.
SOURCE: Consumer Financial Protection Bureau (CFPB)

See piggyback calculator: Blended interest rate calculator: 80-15-5, 80-10-10 and 80-20 loans

Debt to income ratio

Lenders use a formula to determine the maximum loan payment/loan amount. The formula is known as debt to income. There are two parts to the formula, the payment limit is called the front end ratio and the monthly debt and proposed mortgage payment is known as the back end ratio. The maximum borrowing limit is similar to the government backed mortgages. 45% is the maximum debt-to-income ratio (DTI) for a conventional loan.

Is a conventional mortgage right for you?

The conventional home loan is a good choice for borrowers with a 10% down payment or greater. However, if the credit score is below 680, an FHA or USDA home loan may be the better choice because the monthly mortgage insurance premium will be higher than the FHA program. Learn more about PMI and MIP

The interest rates tend to be higher with conventional mortgages than with the government backed loans. The reason is due to the lack of federal backing and associated risk. But, with an excellent credit score and meaty down payment, the conventional mortgage is the better mortgage.

Rotating question mark Frequently Asked Questions About Conventional Loans

Q. Are conventional loans bad?
A. Conventional loans are a good choice for home buyers with a 20% down payment (or close to it), because there is no upfront (initial) mortgage insurance and there is no monthly insurance premium with a down payment of 20%. Mortgage insurance never falls off on the FHA and USDA programs. Another benefit of the conventional loans is the loan size. The loan amount exceeds the FHA loan programs. The USDA and VA have similar borrowing limits.

Q. Can I switch from an FHA loan to a conventional loan?
A. To change from an FHA loan to a conventional loan requires a refinance from the current mortgage. All the requirements for a new (conventional) mortgage apply (i.e. income, credit, debt to income ratios, etc.)

Q. Can you buy a house as is with a conventional loan?
A. Conventional loans are a little more forgiving than the government backed mortgages (FHA, VA, and USDA), however, since the house is the collateral for the mortgage, the lender will require the house to be habitable and structurally sound.

Q. Can you get down payment assistance on a conventional loan?
A. There are numerous assistance programs for home buyers. Most down payment and or assistance grants require the borrower(s) to meet income limits of 80% of the median area income. HUD’s Office of Policy Development and Research (PD&R) provides an easy to use look up tool for county income. The assistance programs usually have exceptions for over limit borrowers who purchase in low to moderate areas. Contact a local HUD approved housing counseling agency for any available assistance programs.

Q. How long does a conventional loan take to close?
A. The processing time period is usually constrained by third party providers (i.e. appraisers, title and settlement companies) and lender loan volume. Expect 45 days, however, in a brisk market, 60 to 90 days is not unusual.