Updated December 2023
A Conventional Loan is the most common form of mortgage loan, so understanding how a Conventional Loan works is vital for many looking to purchase a new home. In this post, we’ll detail what a Conventional Loan is, the requirements you need to meet to qualify, and outline some alternatives.
What Is a Conventional Loan?
A Conventional Loan is any mortgage loan not insured or guaranteed by the government. Conventional Loans can be conforming or nonconforming — we’ll explore the difference in the next section.
Other forms of mortgage loans include FHA, VA, or USDA Loans.
Not sure which type of loan is right for you? Request a free consultation with one of our Loan Officers.
Conforming vs. Nonconforming Loans
The first and most common form of Conventional Loan is a Conforming Loan. This is a loan that meets the standards set by government-sponsored enterprises Fannie Mae and Freddie Mac. In addition to this, they also meet the standards set by the Federal Housing Finance Agency (FHFA). These standards include the maximum mortgage loan limit, credit score requirement, and the accepted debt-to-income ratio.
Fannie Mae and Freddie Mac are the largest purchasers of mortgage loans on the secondary mortgage market, according to The Motley Fool, so mortgage customers often favor them.
In contrast, a Nonconforming Loan does not meet the standards set by Freddie Mac, Fannie Mae, and the FHFA. Mortgage lenders must, therefore, keep these loans on their books or look for other investors to buy them. Examples of nonconforming loans include FHA Loans and Jumbo Loans.
What Are the Requirements of a Conventional Loan?
Conventional Loans are the closest you can get to a “standard” mortgage. Thanks to their competitive rates and the fact they’re widely available, Conventional Loans are the most popular mortgage option for home purchases and refinancing.
To qualify for a Conventional Loan, you need to meet the following minimum requirements:
- A minimum credit score of around 680. The specific score required depends on a number of factors, including the amount you’re borrowing and the debt-to-income ratio.
- Your debt-to-income ratio should be less than 43%.
- You should not have any major issues on your credit report, such as bankruptcy.
- A down payment of at least 3%.
- A total loan amount of $766,550 or less (from January 2024). The loan limit varies by location and is subject to change, so it’s important to check the Federal Housing Finance Agency (FHFA) website to find out the latest limit.
Now we know the minimum requirements of a Conventional Loan, let’s explore further what each of these factors means and how to discover if you’re eligible.
Credit Report Requirements
The standard minimum credit score requirement for a Conventional Loan is 620. However, it’s important to note that different lenders may have varying credit score requirements. In some cases, your lender might accept a slightly lower score — but expect a higher interest rate change to compensate for the increased risk. On the other hand, if your credit score is much higher than the minimum requirement, you might be offered lower interest rates.
If your credit score is less than the standard minimum requirement of 680, you might qualify for an FHA Loan instead. FHA Loans do not impose additional fees or higher interest rates on customers with lower credit scores, so it could be a preferable option.
You should also not have any major issues on your credit report. This could include foreclosure or bankruptcy. If you’re unsure whether an issue could impact your eligibility, consider speaking to an experienced Loan Officer before proceeding.
We advise reviewing your credit score before applying for a mortgage loan. This way, you can start your mortgage journey with knowledge of your current score and which loans you might qualify for.
Debt-to-Income Ratio
The debt-to-income ratio (DTI) is a metric calculated by comparing the buyer’s total monthly debts, including mortgage costs, to their gross monthly income. Your DTI will be used to assess whether you are likely to be able to afford a mortgage loan.
The DTI requirement varies from lender to lender; however, most prefer the ratio to be 36% or lower of the buyer’s income. While 43% is usually the highest DTI a lender will accept, some Conventional Loans may allow a ratio as high as 50%.
To calculate your debt-to-income ratio, you need to add up all of your monthly loan payments, as well as child support or alimony payments. You then simply need to divide the sum by your gross monthly income.
Loan payments that contribute to your DTI could include:
- Car loans
- Your projected mortgage payment
- Student loans
- Credit card minimum payments
- Personal loans.
You can use a debt-to-income ratio calculator such as this tool by Bankrate to find out your percentage.
Down Payment
A down payment is a sum of money homebuyers are required to pay upfront to secure the property and get accepted for a home loan. Repeat and first-time homebuyers often only need a down payment of 3% for a conventional mortgage. However, this requirement varies from lender to lender.
The most common down payment requirements for a Conventional Loan are:
- Repeat homebuyers who are buying a primary residence typically require a minimum 5% down payment.
- If you choose to finance your home purchase with an adjustable-rate mortgage, a 5% down payment is usually necessary.
- Buying a second home often requires a 10% down payment.
- Purchasing a multi-unit property (rather than a single-family home) typically necessitated a 15-25% down payment. However, Fannie Mae has recently lowered its requirement to only 5%.
For most Conventional Loans, if your down payment is less than 20%, your lender will likely require you to take out private mortgage insurance (PMI). This protects the lender in the case of your loan defaulting. While PMI does result in higher monthly mortgage payments, it can allow you to be approved for a Conventional Loan with a lower down payment. What’s more, once your home attains a minimum equity of 20%, you can cancel your PMI.
If you’re not sure which properties and loans you can afford based on your down payment, We’d recommend using a mortgage calculator that allows you to enter your desired down payment amount and interest rate and find out what your monthly mortgage payments might be.
Conventional Loan Limits
The final common requirement for a Conventional Loan relates to how much money you can borrow. As of January 2024, the Conforming Loan limit for one-unit properties will be $766,550. This limit is determined annually by the Federal Housing Finance Agency (FHFA) and may be higher in certain high-cost regions.
If you require a loan amount that exceeds the standard limit, you may need to pursue a Nonconforming Loan, such as a Jumbo Loan. To find out the Conventional Loan limit in your area, you can use this map tool provided by the FHFA.
Proof of Income
As part of your mortgage application, you also need to provide evidence of your current income. To meet this requirement, you should be ready to submit some or all of the following documents:
- 30 day’s worth of pay stubs
- W-2 forms for the past two years
- Tax returns for the past two years (if self-employed)
- Bank statements covering the past two years
- An offer letter if you’re starting a new job
- Proof of education (for recent graduates).
Seasonal income can also be accepted as part of a Conventional Loan application, but you will be required to provide supporting evidence from tax returns for the past two years. Alimony can also be considered if it is documented in a divorce decree, provided you provide proof of a recurring payment method.
Closing Cost Limits
In addition to Conventional Loan limits, the standards set by Fannie Mae and Freddie Mac also set out a maximum amount of seller-paid closing costs. It’s important to note that sellers cannot contribute more than the actual closing costs.
Typically, sellers and other interested parties can contribute the following amounts based on the home price and down payment amount:
- Less than 10% down payment: 3% of purchase price
- 10 to 25% down payment: 6% of purchase price
- More than 25% down payment: 9% of the purchase price.
Closing costs should not typically reach 6% of the sale price. Generally, closing costs for a Conventional Loan range from 2-3% depending on location and the amount borrowed.
Alternatives to Conventional Loans
If a Conventional Loan is not the right option for you, there are many alternative options. Here are the most common alternatives on the market at the moment.
FHA Loans: These loans are offered by the Federal Housing Administration (FHA) and allow customers with a lower credit score or small down payment the opportunity to purchase a home. FHA Loans have quite flexible qualification requirements.
VA Loans: If you have served in the armed forces, are an active-duty service member, or a surviving spouse, you could benefit from a VA Loan, which helps veterans move into their dream homes. These loans are guaranteed by the Department of Veterans Affairs and often provide favorable terms, including no down payment requirement and competitive interest rates. Check your VA Loan eligibility today.
USDA Loans: Offered by the United States Department of Agriculture (USDA), this loan option caters to customers who want to purchase a home in eligible rural areas. USDA Loans offer 100% financing options and often have lower interest rates than Conventional Loans.
Jumbo Loans: Jumbo Loans are specifically designed for properties valued above the Conventional Loan limit for a Conforming Loan. This alternative is designed for large, high-value properties and has different qualification requirements and interest rates,
Adjustable-Rate Mortgages (ARMs): Conventional Loans have fixed interest rates, which means you’ll pay the same amount of interest for the duration of your loan. In contrast, ARMs will charge different interest rates periodically. Your interest rates for this type of mortgage will often be lower early on and then increase. They could be a great option if you’re interested in selling or refinancing your home within a specific timeframe.
Pros and Cons of a Conventional Loan
Pros
One advantage of a Conventional Loan is it’s quite attainable for first-time homebuyers, with many lenders accepting a down payment as low as 3%. If you can afford a higher payment, you don’t need to worry about private mortgage insurance — and if you do, you can cancel it down the line. This makes this option flexible for customers with a range of budgets.
A lesser-known benefit of Conventional Loans is that they can be used for a number of different types of homes, including second homes, vacation properties, or rental properties.
Cons
The main disadvantage of Conventional Loans is that while first-time homebuyers can benefit from a relatively low down payment, this type of loan generally requires a higher down payment than other loan programs. What’s more, you need a higher credit score and lower debt-to-income ratio to qualify, so you’ll need to be relatively financially stable to apply for the loan. Those with lower credit scores who would like a Conventional Loan will usually face higher interest rates.
Talk to Our Loan Officers to Discover Your Best Option
Choosing the right mortgage loan for you isn’t easy. That’s why our expert Loan Officers are ready to help you understand the options available for you and support you as you begin your homebuying journey.
Article Sources
- The Motley Fool — “Conforming & Nonconforming Loans: Here’s the Difference” Feb 23, 2023
- Forbes — “Conventional Loan: What You Need To Know To Qualify” Sep 22, 2023
- Federal Housing Finance Agency — “FHFA Announces Conforming Loan Limit Values for 2024” Nov 28, 2023
- USA.gov — “Learn about your credit report and how to get a copy” Nov 7, 2023
- Investopedia — “Debt-to-Income (DTI) Ratio: What’s Good and How To Calculate It” Aug 21, 2023
- Bankrate — “Debt-to-income ratio calculator” Dec 4, 2023
- CNBC — “What is a down payment on a home, and how much is required?” Jul 13, 2022
- The Mortgage Reports — “Conventional loan down payments: How much do you need?” Dec 6, 2022
- Yahoo! Finance — “What are ARM (adjustable rate mortgage) loan requirements in 2023?” Aug 23, 2023
- The Mortgage Reports — “Buying a Second Home: What You Need to Know in 2024” Nov 9, 2023
- The Mortgage Reports — “Fannie Mae Introduces 5% Down Payment Option for Multifamily Homes” Oct 5, 2023
- Federal Housing Finance Agency — “FHFA Announces Conforming Loan Limit Values for 2024” Nov 28, 2023
- Federal Housing Finance Agency — “Conforming Loan Limit Values Map” Dec 4, 2023
- US Department of Housing and Urban Development — “The Federal Housing Administration (FHA)” Dec 5, 2023.
