A conventional loan or mortgage is a home loan funded and backed by a private institution. The loan is not insured by the federal government and the borrower is required to meet certain criteria and provide insurance to guarantee the loan themselves. These are the most common type of home loan out there, and are typically what people think about when getting a home loan.
How a conventional loan works
Any potential borrower can go to a bank or lending institution and apply for a conventional loan. You do not need to have a prior banking relationship with an institution to get a loan from them. Lenders will assess your creditworthiness by checking your credit, analysing your income and your debt, and reviewing your full financial portfolio including savings, retirement, and investments. If you meet the criteria, you will be pre-approved for a specific loan amount that you can then go house shopping with. When the home purchase is finalized, you sign an agreement with the lender that you will pay back the loan, typically over a 15 to 30 year period.
Conventional loan vs. Government-backed loan
How to qualify
While each lending institution will have its own specific criteria, in general they are looking for similar things:
Credit score: Your credit score is the accumulation of your life’s credit and debt payment. It is a number between 300 and 850. The higher the number, the better your score. Private lenders are looking for borrowers with good to excellent credit which usually means a score of above 720. The highest credit scores help you qualify for the lowest interest rates. Even if you have a score of less than 720, other financial factors can balance it out and you may still be eligible for a conventional loan.
DTI: DTI is your debt to income ratio. Lenders want to know that you have enough of your income not tied up with previous debts, and that the addition of a monthly mortgage payment will not put you in a position where you’re likely to default. Typically lenders want to see a DTI of less than 36%. For example if you gross $5,000 a month and your monthly debt including your mortgage comes to $1,700, your DTI would be 34% ($1,700/$5,000 = .34 or 34%).
Down Payment: Conventional loans can go as low as a 3% down payment, but generally want closer to 10% to 20%. The amount you put down affects your monthly payments and your PMI (private mortgage insurance). Borrowers who put down at least 20% do not have to provide additional mortgage insurance since the amount is large enough that the lender feels secure. Less than 20% requires PMI which is added into your monthly payments and is typically .55% to 2.25% of your total loan value. By adding PMI you will be increasing your monthly payments.
Tips for getting the best deal
Shop around: Most lending institutions will be able to offer the same interest rates since they are set by the federal reserve, but they will all have slightly different income and credit requirements, and different fees involved with loan origination and closing. Contact two to three lenders to see who can get you the best deal.
Know your financial history: It’s great to know your credit score and numbers like your DTI before you apply. If either of these fall below the minimum criteria (around 700 for credit, and 36% for DTI), you’ll have time to start improving them before filling out applications with lenders.
Start saving: Lenders like to see borrowers with a significant nest egg. This not only lets them know you’ll be able to supply a down payment, but it shows you are good with money and have enough in the bank to shield against unforeseen events in the future.
Alternatives to a Conventional loan
If you can’t qualify for a conventional loan, there are options with government-backed loans. These are loans designed for borrowers who may need extra help with qualifying. These programs will require you to work with a government-approved lender. Here are the three main ones:
FHA Loan: These loans are the easiest to qualify for and are backed by the Federal Housing Administration. They offer down payments of as low as 3.5% with a credit score of at least 580, but do require significant PMI.
USDA Loan: These are loans backed by the U.S. Department of Agriculture and are available for borrowers looking to purchase a home in a rural or suburban area. These can be acquired with a 0% down payment, but still require PMI.
VA Loan: These are loans backed by the Department of Veterans Affairs and are available to past or current service members or their surviving spouses. They offer loans with 0% down and no PMI.