6 Tips for Understanding Conventional Mortgages
A conventional mortgage is a home loan that isn't backed by the government. If that's all a borrower knows about the loan, they might consider a different option. However, the actual details behind these mortgages are more complicated. Those who want to understand conventional mortgages should keep the following in mind before they either apply for one or rule it out entirely.
Lenders Have Fewer Options
A government home loan is not one that's granted directly by the government; it's one that's backed by the government. For example, if the borrower can't pay back the loan, the government will pick up the rest of the funds. The more protected a lender is, the more likely they are to extend those protections to their borrowers.
This is why conventional mortgages are not as lenient as VA, USDA, or FHA home loans. When there's no guarantee on the loan, the lender has to ensure they have contingency plans against a potential default.
PMI Applies to Conventional Loans
Private Mortgage Insurance (PMI) is a type of insurance policy that will cover a lender's cost if a homeowner can't pay their mortgage. The lender can sell the property if forced to repossess the home in a short sale or foreclosure, but they'll still have to pay a real estate agent to sell the home, an auctioneer to organize an auction, etc.
The buyer will pay for this policy even though it doesn't actively benefit them, and this cost gets added into the monthly home payments. The perk of a conventional loan is that PMI costs generally disappear after a homeowner has reached 20% equity in their home.
Credit Scores Matter
Credit scores are going to be checked regardless of which loan a borrower gets. However, the standards for conventional loans tend to be higher, regardless of whether it's a straight score or a debt-to-income (DTI) ratio. The actual limits are imposed by the lender, but tend to be at least 640 for a credit score and less than 50% for a DTI.
In the past, a borrower would also have to come up with a substantial down payment alongside the rest of the requirements, but the rules have changed to allow some conventional mortgages a chance against FHA loans. However, for a borrower to get the best rates and terms, they should have excellent financial health.
Loan Rates Will Vary
Variable rates are not specific to conventional mortgages, but interest rates have a tendency to shift. This means that a hopeful home buyer might check for a conventional home rate in the morning, only to find it's changed in the afternoon. Therefore, it is important for borrowers to keep that in mind while shopping around.
Fixed-Rate Mortgages Are Recommended
Adjustable-rate mortgages start off with low rates for a reason: the lender is essentially making room in the event that the rates will go up. Many buyers who plan to keep their home for a few decades tend to choose fixed-rate mortgages, so they can be assured of their mortgage payment every month. (There's always a possibility to refinance if a much lower rate comes along.)
Nonconforming vs. Conforming Loans
There are two main types of loans that every borrower should know:
- Conforming loans: These loans fit the recommendations of government-controlled Fannie Mae and Freddie Mac.
- Non-conforming loans: Any loan that falls outside these standards is known as a non-conforming loan. These loans are more likely to be given to those with a bankruptcy on file or those with large debts that still need to be paid off.
The definition of a conforming loan will be different in every area and will have different limits. Conforming loans will generally have more reasonable terms than a nonconforming loan will.
From nonconforming conventional loans to FHAs to ARMs, there are many home loan options available on the market today. The variety can become overwhelming to even the most organized of buyers, which is part of the reason why it's important to have the basics down before getting started.