What is a Conventional Loan?

Jason Kauffman | September 19, 2022

Conventional loans remain one of the most common and versatile loan types you’ll find in the mortgage marketplace. They have down payment options that start at 3% down and go up from there (read more below). They allow for primary residences as well as second homes and investment properties.

Historically, all conventional financing was not secured by or offered by a government entity – rather a private bank, credit union, or other private lending institution. Over the past 15 years it became more commonplace for loans to be underwritten with the intention being for the lender to sell the loan to one of the two big Government-Sponsored Enterprises (GSE) – Freddie Mac and Fannie Mae. Loans made to follow these GSE’s guidelines are referred to as Conforming (versus conventional).

As we discuss Conventional loans moving forward, we are going to hone in on the conforming guidelines of Fannie and Freddie as these are the guidelines that drive most of the conventional loans that are being made at the time of this article.

Down Payment

Conventional loans offer so much flexibility when it comes to the down payment required as a borrower. Something to remember is that because the guidelines for conventional mortgages allow for primary residences, second homes, and investment properties, the down payment requirements change depending on the borrower’s intended usage.

For people purchasing a home as their primary residence, there are programs available with both Fannie Mae and Freddie Mac that allow for you to do as little as a 3% down payment (HomeReady and HomePossible). These programs both allow for a reduced down payment as long as you meet certain requirements:

• You must meet the program income limits; 80% of the area median income (AMI)
• You must be qualifying for the loan with your income or with other borrowers that intend to occupy the home with you
  • If you have a non-occupying cosigner on these two programs, you are required to do a 5% down payment.
• You may own another financed residential property (in addition to the subject property) at the time of closing; This also means you do not have to be a first-time homebuyer

Outside of this income restricted 3% down loan program, both Freddie and Fannie both have a 3% down program for first time homebuyers that isn’t income restricted.

One of the common fallacies to debunk is that Conventional loans do not require a 20% down payment. If you do a conventional loan with less than 20% down, you will have to carry private mortgage insurance.

Private Mortgage Insurance

Private mortgage insurance (PMI) is the tool that allows lenders to be comfortable lending to borrowers that choose to do a down payment less than 20%. The reason it makes lenders more comfortable is because mortgage insurance protects the lender from the costs they would incur due to foreclosure. The estimated cost to foreclose varies, but estimates over a decade ago put the cost around $50,000 per foreclosure. The private mortgage insurance is what covers the lenders foreclosure costs in case of a default.

PMI can be structured in a number of different ways for you as the consumer, but the most common practice is as a monthly amount that is fixed until the balance of your loan reaches 78% of the original value. There are options to pay mortgage insurance upfront as a one-time payment, and with some lenders you can do a hybrid premium and monthly payment.

Second Homes and Investment Properties

These occupancy types typically carry higher interest rates than loans for primary residences. There are also different rules about how much you need to come up with for a down payment. The reason for the higher rate aligns with the risk concern (and historical data) that someone is less likely to pay the mortgage on their second home and investment property when they have a financial hardship. Conversely, they are more likely to pay the mortgage on the home they live in as their primary residence. This perceived risk results in higher down payment requirements and higher rates for homes that have this occupancy classification.

A nice feature of purchasing a home as an investment property is that you are allowed to qualify with 75% of the projected rental income. This can reduce the burden of qualifying for the payment on an investment property since a portion of the income for the renter is taken into account.

Why wouldn’t it make sense to go with a Conventional loan?

There are many different situations where conventional financing might not make sense. The most common reason that it wouldn’t make sense is that conventional financing has cost adjustments to the rate and private mortgage insurance that are tiered heavily based on credit score. So if you are doing a lower down payment and your credit score is in the mid 600’s, there are likely better options on an FHA (or other) type of loan.

If you are a veteran and looking to do a VA Loan with no down payment, there will be benefits to go with VA financing over Conventional financing. Financing for eligible veterans doesn’t have private mortgage insurance and the rates are often lower than conventional financing. This isn’t always the case and Conventional financing is worth looking into if you are a veteran that has a 20%+ down payment to bring to the table.

Maybe you’re not a veteran, have a lower credit score and need a lower down payment option. FHA loans have lower monthly mortgage insurance costs than private mortgage insurance and the rates are generally lower than conventional financing options.

Many people are looking to purchase in a rural area where USDA financing is available. This type of financing allows for no down payment as long as you meet certain income limits based on where you’re purchasing.

There are lots of reasons you may or may not choose to go with a conventional loan. Per usual, there are so many ins and outs to the caveats that make Conventional financing the right choice for your particular situation, you should reach out to a mortgage professional to discuss how your situation fits.