Takeaways
- First-time homebuyers should do their research before selecting any mortgage.
- Conventional loans are not issued by Fannie Mae or Freddie Mac.
- Two predictors of securing a conventional loan are your credit score and down payment.
- There are conforming and non-conforming conventional loans.
For anyone financing their home, the range and number of loan options can be intimidating. But don't let that phase you. Getting a clear understanding of the basics is critical to selecting the right mortgage for your financial situation. Declutter the noise to make sense of conventional home loans, a popular choice among borrowers. Let’s look at the definition of a conventional loan and what you need to know about each of the most popular types of home loans.
What is a Conventional Home Loan?
A conventional home loan is a mortgage not insured or guaranteed by the government. Instead, conventional loans are backed by private lenders such as banks, credit unions, and mortgage companies, with the potential for the loan to be sold to government-sponsored entities like Fannie Mae and Freddie Mac.
Conventional loans stand out for their flexibility and diversity, giving access to homeownership to a broad spectrum of borrowers. These types of loans are available in various sizes, terms, and structures. Conventional loans can finance primary residences, secondary homes, or investment properties.
Conventional loans typically require a higher credit score and a larger down payment than government-backed loans, such as the Federal Housing Authority, Veteran Affairs, or United States Department of Agriculture loans. Borrowers must meet strict criteria with their credit history, debt-to-income ratio, employment history, and overall financial health. If you qualify for a conventional loan, however, you may benefit from lower interest rates and eliminate the need for private mortgage insurance.
Smart Tip:
The need for private mortgage insurance goes away in most loans once you have achieved a certain level of equity in your home.
6 Types of Conventional Loans
Fixed-Rate Loans
Fixed-rate loans are one of the most straightforward and popular types of conventional loans. As the name suggests, these loans offer a fixed interest rate throughout their term. As a result, your monthly mortgage payments remain the same over the life of the loan. The advantage of a fixed-rate loan is that it provides stability and predictability for your budget. Loan terms can vary, but the most popular term lengths are 30-year and 15-year fixed-rate loans. Given the same home price and interest rate, the longer the loan term, the lower the monthly payment, but the higher the total interest paid over the life of the loan.
Smart Money-> 15-Year vs. 30-year Fixed Mortgages
Adjustable-Rate Mortgages (ARMs)
Unlike fixed-rate loans, adjustable-rate mortgages (ARMs) have interest rates that fluctuate over time. Initially, ARMs offer a lower interest rate than fixed-rate mortgages, but after a certain period (typically 5, 7, or 10 years), your interest rate adjusts annually based on specified benchmark interest rates.
With an ARM, your total interest rate is the sum of a fixed margin (charged by your lender) plus an adjustable-rate component (usually pegged to a specific index such as the Secured Overnight Financing Rate). Your interest rate adjustment can either increase or decrease your monthly mortgage payments. ARMs can be a suitable option for those expecting a future increase in income or planning to sell their home before the rate adjustment period.
Conforming Loans
Conforming loans are conventional loans that adhere to guidelines set by the Federal Housing Finance Agency (FHFA). The conforming loan limit in 2023 for most of the U.S. is $726,200, a significant increase from $647,200 in 2022, reflecting an average 12.21% rise in U.S. house prices1. Conforming loan limits are adjusted annually (announced every November) to reflect the state of the housing market.
High-cost areas have a higher limit of $1,089,300. Special regions, including Alaska, Hawaii, Guam, and the U.S. Virgin Islands, also have this baseline limit2. Conforming loans, favored by lenders and borrowers, can be sold to Fannie Mae or Freddie Mac.
If you are trying to purchase a home that requires you to borrow more than the conforming loan limit, you need a jumbo loan (more on that below).
Non-Conforming Loans
Non-conforming loans are conventional loans that do not meet the FHFA's guidelines, often because the loan amount is higher than the conforming loan limit. Non-conforming loans cannot be sold to Fannie Mae or Freddie Mac, which typically makes them riskier for lenders. To compensate for this, lenders charge non-conforming loans higher interest rates compared to conforming loans.
Jumbo Loans
A specific type of non-conforming loan, a jumbo loan, is for home purchases exceeding the conforming loan limits set by the FHFA. As a result, jumbo loans finance luxury properties and homes in highly competitive real estate markets, such as New York City, San Francisco, Austin, and Chicago.
Lenders often require an exhaustive credit history, a low debt-to-income ratio, and a significant down payment for these loans due to the increased risk. In return, jumbo loans allow borrowers to access much higher loan amounts (think millions) that are unavailable through conventional loans.
Subprime Loans
Subprime loans are a kind of conventional loan offered to borrowers with lower credit scores who may not qualify for prime-rate loans. These loans carry a higher risk for the lender, as they are offered to borrowers deemed more likely to default based on their credit history. Consequently, subprime loans typically come with higher interest rates and fees. It's critical for borrowers considering subprime loans to consider the long-term financial implications and ensure they can handle the repayment structure before opting for a subprime loan.
Smart Summary
The type of loan you can qualify for is largely dependent on your credit history. Whether you are completely debt-free or have a very high debt-to-income ratio, getting your debt under control before applying for a loan will decrease your house costs in the long run. Consider your long-term financial goals and contemplate talking with a financial advisor before making one of the biggest financial decisions of your life.
Frequently Asked Questions
With mortgages, there is no one size fits all. The best type of loan depends on your financial situation, the cost of the house you want to buy, and the size of your down payment. Check out the best mortgage rates available to you.
If you are in the market to buy a home, as a first-time home buyer or serial purchaser, research the best interest rates available. Get your financial house in order and make your debt-to-income ratio attractive to lenders.
Saving a down payment of at least 20% of the purchase price is a smart money move. It eliminates the need to pay private mortgage insurance and forces the financial discipline necessary to save. As you save for your down payment, stash your cash in a high-yielding savings account.
Once you have started to save cash for a down payment, you are often left wondering where to store these funds. Putting your down payment funds in a high-yield savings account is a smart money move. It allows your funds to accrue interest income, putting more money back into your pocket. Here is how to open an online high-yield savings account.
