Real Estate Terms

Conventional Loan Definition

According to the 2021 census, around 76% of new home sales were obtained through conventional loans. Conventional loans or mortgages are not part of any government program and are not federally guaranteed. These loans offer a wide range of options for property buyers, but they are difficult to acquire too. Since these loans are not backed by a government guarantee, they are riskier. Let’s read more about what you should know about conventional loans for real estate exam preparation.

What Is a Conventional Loan?

A conventional loan is provided by a private lender and is not a part of any government program like VA or FHA. A conventional loan is guaranteed but by the private sector. These loans are available through conventional lenders, including financial institutions, credit unions, banks, and online lending platforms. Through a conventional loan, the borrower can get a large amount of money from any lender to cover an expense. If the loan amount is used to purchase a property, it is called a conventional mortgage. The term ‘conventional’ is used to indicate loans other than FHA loans, VA loans, or Jumbo loans.

Conventional loans can be conforming or non-conforming. Conforming conventional loans comply with the guidelines Fannie Mae and Freddie Mac set. Both are government-sponsored organizations that buy mortgages from lenders. According to these guidelines, there is a maximum amount called baseline on the amount the borrower takes. This amount changes every year according to the changing housing prices. For example, in high-cost localities, the loan limit is very high. Non-conforming conventional loans exceed the loan limits. These loans are also called jumbo loans provided by private institutions or lenders.

How Do Conventional Loans Work?

A conventional loan works the same way as any other loan, but the lender is from the private sector. The lender purchases a property for the borrower and gives title to the borrower; however, they put a lien on the property, which remains until you repay the full amount.

In the loan agreement, the borrower promises to pay back the loan with interest in an agreed period. Interest is the rate that the borrower pays in percentage, and banks make money through charging interest. Interest rates can either be fixed or variable, and the rate depends on your personal financial profile. With fixed-rate mortgages, the interest rate remains the same throughout the term. Whereas in adjustable-rate mortgages, the interest rate changes according to the changes in the market conditions.

Requirements for a Conventional Loan

To meet the requirements of a conventional loan, the borrower must consider a few factors. Plus, the eligibility criteria for conventional loans are more difficult than government-backed loans. The following are the requirements of a conventional loan:

Credit Score

To qualify for a conventional loan, the borrower must have a minimum score of 620. However, that’s the minimum score, which doesn’t guarantee that the lender will offer the best rates and terms on the loan. A good credit score will improve the chances of an increased loan amount, better rates, and repayment terms according to your requirements. If the borrower wants the best deal, the score should be 740 or higher.

Loan Size

Loan size is important in determining which loan is best for you. The agencies set the size for the conforming loans, which changes the limits every year. The loan limit for high-priced societies in the U.S. is $822,375. However, getting a jumbo loan is a better option if a higher loan is required.

Down Payment

With a conventional loan, the lender will not give you the total percentage of your property’s purchase price. While government-insured loans offer full payment for purchasing houses, conventional loans require a down payment. A down payment is anywhere between 3 to 5% for most of the primary residences. So, if a house costs $400,000 and the down payment is 5%, the borrower has to pay $20,000.

Debt-to-income Ratio

A lender will evaluate the borrower’s debt-to-income ratio to decide whether to provide a conventional loan or not. The debt-to-income ratio is determined by calculating other factors contributing to the debt, such as the other loans you must pay monthly. Most lenders prefer a debt-to-income ratio below 43%, and some might allow it up to 50%.

Lender’s Mortgage Insurance

Lender’s mortgage insurance or private mortgage insurance protects the lender in case the borrower defaults on the loan. Besides paying the 3 to 5% down payment, you must also pay the private mortgage insurance.

Advantages of Conventional Loans

Some benefits of conventional loans include lower overall costs, higher loan limits, and flexibility for some borrowers. Besides that, the borrowers get more control over mortgage insurance. With conventional loans, the borrower gets more choices in loan structure. For example, you can find different loan terms, including 30, 20, and 15 years. Plus, Flexible repayment terms allow borrowers to choose a wider range of time frames.

Another big benefit of a conventional loan is that the mortgage insurance is cancellable. Conventional loans allow you to buy investment properties as well as second homes, which means you can buy any type of property. As compared to government-backed loans, these loans have a lesser down payment which is a minimum of 3%, while the FHA loan offers a 3.5% minimum down payment.

Conventional Loan Examples

Example 1: Let’s take an example of a person who obtains a conventional loan from a private lender. The property that he wants to purchase costs $425,000. Following are the details of the property purchase through a conventional loan:

  • Home Price: $425,000
  • Interest Rate: 6%
  • Loan Term: 30 years
  • Down Payment: 5%

Since a conventional lender doesn’t pay the total home price, the borrower has to pay $21,250 as a down payment (5% of the home price). Thus, the loan amount, in this case, is $403,750, which the borrower has to pay in 30 years.

Example 2: Let’s consider a person who wants to choose between a conventional loan and an FHA loan. The borrower has a good credit score, has a stable income, and is looking for the most cost-effective option for buying a property. Following are the two options he has for buying a home that costs $200,000:

FHA Loan:

  • Home price: $200,000
  • Down payment: 3.5%
  • Loan term: 30 years
  • Interest rate: fixed, 4.625%
  • APR: 5.714%
  • Total loan amount: $193,000

Conventional Loan:

  • Home price: $200,000
  • Down payment: 20%
  • Loan term: 30 years
  • Interest rate: fixed, 4.625%
  • APR: 4.728%
  • Total Loan Amount: $160,000

After discussing with a loan officer, the person decided to go for the conventional loan because it is more cost-effective. Since he has a good credit score and can pay a down payment of 20%, a conventional loan is a better option for him in this scenario. 

Conventional Loan Frequently Asked Questions

Is a Conventional Loan Better than an FHA Loan?

Choosing between government-backed loans and conventional loans depends on the financial position. Conventional loans are harder to qualify for but if the borrower has a good credit score and DTI (Debt To Income) ratio, getting these loans is easy. These loans are more cost-effective if a person has a stable income. Besides that, FHA loans are government-insured and are a safer option. Both loans have advantages and disadvantages, and it depends on the borrower’s requirements to choose between them.

What Types of Properties Can Be Purchased With Conventional Loans?

With conventional loans, buyers can purchase single-family homes, townhomes, investment properties, second vacation homes, and condos. People can buy almost any type of home with conventional loans. However, the standard housing type also differs from state to state. For example, getting a loan to purchase a log cabin in Los Angeles is difficult.

Does The Borrower Pay a 20% Down Payment on a Conventional Loan?

Conventional loans require some down payment, unlike government-backed loans. However, it isn’t necessary to pay 20% down on a conventional loan; the down payment can be as low as 3%. While a higher down payment looks too much at the start, it decreases the overall cost of the loan. If the borrower pays a higher down payment, the remaining cost of the loan is smaller as compared to if the down payment is lower.

What to Know for the Real Estate Exam

Conventional loans are not backed by government agencies or housing programs such as VA or FHA. These loans are of two types; fixed-rate and adjustable-rate. In conventional loans, if the borrower is paying less than a 20% down payment, then the lender will ask for PMI (Private Mortgage Insurance) to reduce the risk. If the borrower has a good financial position and can pay a large down payment, the lender will offer better and more flexible loan terms. To sum it up, conventional loans have strict qualification requirements, but they are a good option if the borrower has a stable income, a strong credit profile, and minimal debt. To learn more about other real estate finance terms, check out our Real Estate Vocab for more easy-to-understand definitions.  

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