When you apply for mortgage financing, you’ll typically apply for a conventional loan first. This type of financing is the traditional mortgage loan – the one that requires a 20% down payment or you pay PMI, but also the one with great rates and terms.
Conventional loans aren’t your only option when financing a home, but they can be an attractive option if you qualify. They are tougher to qualify for because you need great credit and a low debt ratio. Lenders don’t get a government guarantee for these loans so if a borrower defaults, they could lose a lot of money.
Here’s what you must know about qualifying for conventional loans.
What are Conventional Loans?
Conventional loans are loans you can get from any lender with at least 3% down on the loan. You need good credit and to prove you can afford the loan without a high risk of default.
Lenders fund the loans themselves and then sell them to Fannie Mae or Freddie Mac who sell the loans on the secondary market. Because of the ability to sell the loans to Fannie Mae and Freddie Mac, conventional lenders must ensure the loans they fund are low risk or Fannie and Freddie will not buy the loans from them, which would hurt the lender’s ability to fund further loans.
Who Offers Conventional Loans?
The good news is that you can get a conventional loan at just about any lender since they are the most common loan product. With the strict guideline Fannie Mae and Freddie Mac set, lenders are at a low risk of default, which means you can find them at local banks, online lenders, and mortgage brokers.
It’s always a good idea to get quotes from several lenders when looking at conventional loans, though. Since lenders fund the loans themselves, they can have their own requirements and charge their own rates and fees. Look for the loan with the payment you can afford, but also the smallest overall cost at the end of the loan’s term.
Who is Eligible for a Conventional Loan?
Unlike government-backed loans like FHA and VA loans, anyone can qualify for a conventional loan. You don’t have to be a part of a specific group or have a certain amount of income. There isn’t a qualifying period for a conventional loan – you either qualify or you don’t.
You can be a first-time homebuyer or have owned a home before to get a conventional loan. You don’t even have to live in the home to use this financing option. You can use it to buy an investment home or vacation home too – the requirements are simple.
How to Qualify for a Conventional Loan
Qualifying for a conventional loan is tougher than most other loans because there isn’t a government guarantee. This means lenders are on the hook for the loan if you default. Because of this, lenders often have tough requirements, such as:
Minimum 660 credit score
The credit score lenders require varies by lender but expect to need good credit history with no recent late payments or collections. Lenders will also look at your credit usage, type of credit you have, and how often you apply for new credit to decide if you qualify.
Maximum 36% debt-to-income ratio
Conventional lenders typically require a lower debt-to-income ratio to decrease the risk of default. Your DTI compares your monthly debts to your monthly income. Your debts shouldn’t take up more than 36% of your income to reduce your risk of default.
Stable income and employment for 2 years
Lenders like to see you at the same job for 2 years with increasing income over that time. If you changed jobs within that time but stayed within the same industry and/or took a job that paid more money you may still qualify. Just try to avoid having any employment gaps or reductions in income in the last 2 years.
Enough assets for your down payment and closing costs
You must prove to lenders that you have enough money to cover the required down payment and closing costs. You might need anywhere from 3% – 20% down on the home depending on your qualifying factors. You must prove you have the funds, that they belong to you, and that they are available for use to close on the home.
Down Payment Funds for a Conventional Loan
All conventional loans require a down payment, but it’s not as high as you might think. If this is your first home, you’ll need just 3% down on the home. If you’ve bought a home before, you’ll need at least 5% down.
If you put less than 20% down, though, you’ll pay mortgage insurance (more on this below), so keep that in mind as you structure your loan.
Most conventional lenders allow you to use gift funds for your down payment too. This varies by lender and works best when you have good credit. If you use gift funds, make sure you follow the lender’s guidelines including getting a gift letter from the donor stating the funds are a gift and not a loan. You and the donor must also provide a paper trail of the funds to prove the funds are yours to use.
What about Mortgage Insurance?
Like we said earlier, if you put down less than 20% on a conventional loan, you’ll pay Private Mortgage Insurance. This is different than the mortgage insurance you’d pay on a government-backed loan, though.
PMI is insurance through a private insurer. You must pay the premiums until you owe less than 80% of the home’s value. You can request that the lender cancel the PMI once you reduce the principal balance to 80% of the home’s current value, but the lender may require a new appraisal to confirm it.
If you don’t cancel by then, by law the lender must cancel your PMI when you owe 78% or less of the home’s original value.
Pros and Cons Conventional Loans
Like all loan programs, there are pros and cons to conventional loans that you should understand.
Pros:
Low interest rates
Conventional loans often have the most attractive interest rates out of any loan program. The rates can vary by lender, but if you shop around, you’ll find the lowest rates out of most loan programs available to reward you for your good qualifying factors.
You can use the loan for any purpose
Conventional loans aren’t just for your primary residence purchase. There aren’t any requirements for you to live in the home to have the financing. You can use it to buy a vacation home, investment home, or your primary home without the worry about how long you live in it.
PMI doesn’t last forever
If you don’t put down 20% on the home, you won’t pay Private Mortgage Insurance forever. You only pay it until you owe less than 80% of the home’s value. You can then request that the lender cancel it. As long as you’ve made your mortgage payments on time, lenders typically oblige.
Cons:
You need great credit
It’s hard to qualify for a conventional loan if you don’t have great credit. It doesn’t have to be perfect, but most lenders want a credit score of at least 660 to qualify. The higher your credit score is, the lower the interest rate you’ll get and the less PMI you’ll pay as it’s based on your credit score.
You need at least 3% down
If you’re buying your first home, you need at least a 3% down payment and if you’re buying a subsequent home, you need at least 5% down. This is similar to an FHA loan that requires a 3.5% down payment, but some loans don’t require a down payment at all, so this could be a disadvantage for some.
Stricter qualifying requirements
Besides great credit, conventional loans require a low debt-to-income ratio, stable income, no recent public records or collections, or any other financial issues. You must prove you are a great borrower and have a low risk of default to get approved and each lender has its own requirements.
Key Takeaway
Conventional financing is the most common type of financing, and it often has the most attractive terms. Understanding how it works and how you qualify can help you save the most money on your mortgage financing.
