The first thing you must do when you’re ready to purchase a new home is secure a mortgage. It’s called pre-qualification, and it’s an essential first step. Without a lender’s pre-approval letter, you may not be able to shop for a new home. Some sellers won’t accept offers from buyers who don’t have a prequalification letter. Some sellers won’t even show their homes to a buyer who doesn’t have proof of funds or a prequalification letter from a lender. Whether you have a conventional loan or a different version of a loan is less important than the fact that you have a pre-approval before shopping for a new home.
When it’s time to find a lender and a loan, you must know what kind of loan you’re getting. There are conventional loans and government-backed loans. A government-backed loan is one in which the federal government backs the loan. For example, an FHA or VA loan are both backed by the government.
A conventional loan, on the other hand, is given to you by a lender and it is not federally backed. It does meet all the requirements in place by the largest mortgage buyers in the nation, which are Fannie Mae and Freddie Mac, but it doesn’t entail nearly as much paperwork or time as a federally-backed mortgage.
What Is a Conventional Loan?
A conventional loan is one that’s offered by a private lender. Your local bank or credit union, for example, might provide you with a conventional loan for a mortgage. They will eventually sell your mortgage to a Government Sponsored Entity, which you might see referred to as a GSE during the mortgage process. Rather than being insured by the federal government, this type of loan is insured by a private mortgage insurance company.
If you do not have down payment of at least 20 percent of the value of the home, you will pay private mortgage insurance on your new mortgage. This could range anywhere from .5 to 1 percent of the entire cost of your loan annually. It’s expensive, and it can make your home unaffordable. You’ll pay this until you pay of 20 percent of the value of your home.
This is a great loan for those who make a good living, don’t have much debt, have a good to excellent credit score, and who want to apply for a much more expensive mortgage than federally-backed loan limits allow. Conventional loans are offered all the time to those who can afford them, and there are numerous pros and cons associated with this type of loan.
Is There a Need for Conventional Loans?
Yes, there is a need for conventional loan options for many buyers. While the concept of federally-backed loan options enamors many people, they are not always an option for those who have a high income and a low debt-to-income ratio.
Most federally-backed loans come with lower loan limits, the homes must meet specific requirements, and they are not valid on a second home or rental home purchases. The conventional loan is meant for those who can afford to purchase a home with no federal assistance.
Requirements Of A Conventional Loan
To apply for a conventional loan, you must meet specific loan requirements. These requirements are strict, but many potential homebuyers easily meet them.
The Pros of A Conventional Loan
A conventional loan has many benefits to offer buyers that other loans do not have to offer. Perhaps the notable benefit is that you can buy a home with a large down payment of 20 percent or more to avoid paying private mortgage insurance, but you can also buy a home with a conventional mortgage and a down payment of only 3.5 percent with PMI. You do have options even if you lack a significant down payment.
The other biggest benefit of a conventional loan is you can buy any home you want. There are no limits to the kind of house you can buy. Whether it’s a single family home, a duplex, a home with two to four units, a condo or a townhouse, you can buy whatever you want. You can also buy a second home, a vacation home, or a rental home with a conventional mortgage. There are no occupancy requirements associated with this type of loan option.
The Cons of A Conventional Mortgage
As stated above, there are always a few downsides to everything in life. The downside of a conventional mortgage is that you do have to pay private mortgage insurance (PMI) if you don’t put down at least 20 percent of the loan value at closing. This is expensive.
You also have to have a higher credit score to secure a loan of this nature than you do a government-backed loan. The higher down payment limits are often deal breakers for many buyers, too. Finally, low-income borrowers need not apply for a conventional mortgage loan.
5 Things You Should Know About Conventional Loan
Now that you’re aware of the specifics of a conventional mortgage, it’s time to get to know the little details most people ignore. These are the little details you need to pay attention to before you apply for a traditional mortgage.
Your Credit Score Matters
As mentioned previously, your credit score must be at least 620 or higher. However, you should also know that many lenders will not issue a conventional mortgage loan to anyone who has a 620 credit score.
You’re too close to the cusp of being a risky buyer, and the lender will look at your debt-to-income, your income, and many other factors, too. If you aren’t practically perfect in all the above categories, you may not qualify.
Furthermore, your credit score determines your interest rate. You may only need a credit score of 620 to qualify for this mortgage, but your interest rate will be high. It may be so high you can no longer afford to spend as much on a home as you were approved to spend.
Debt-To-Income Limits Matter
You read above that your DTI must be at or below 43 percent, but many lenders have other requirements of their own. For example, some lenders will require you have a debt to income ratio of only 28/36. If you can pay off something to meet this requirement, you can apply for the loan. Otherwise, you may be denied.
PMI Can Affect The House You Buy
Let’s say your lender approved you to buy a home for $500,000, but you only have 5 percent to put down. That’s $25,000, and you’re financing $475,000. If your PMI Payment is 0.825 percent of that annually, you’re spending approximately $350 per month on PMI on top of your mortgage, taxes, and insurance.
Your monthly payment is approximately $3,563. If you cannot afford that, you may have to look at homes that are well below the amount you were approved to borrow so your payment is affordable.
Let’s say you put down 20 percent of the value of the home. That’s $100,000 as a down payment. You’re now paying no PMI, and you’re only paying for a $400,000 loan. This means your monthly payment is reduced by more than $800. That’s significant savings monthly and over the life of your loan.
You Must Have Assets
You will not find a lender who approves you for a conventional mortgage if you do not have assets in the bank. Your lender must know that you can afford to keep your house if something happens to you or your employment after closing. You must be able to prove to the bank that you have a nest egg that will allow you to continue making your mortgage payments if you lose your job after you close.
There Are Some Housing No-Nos
Unlike a federally-backed loan in which your home must meet strict requirements that fall into categories such as house type, age, and condition, these requirements are far more lenient with a conventional mortgage. However, there are still some requirements. If you’re purchasing a tiny home or an older manufactured home, for example, you may find your lender will not offer a loan.
You Cannot Always Buy What the Bank Tells You
You cannot always buy the house that the bank tells you that you can afford though this is true of any mortgage. You must find out what you can afford to pay monthly, and that amount must include any maintenance, HOA fees, and insurance and taxes. Now you know what you can afford, and it might not be nearly what the bank told you is affordable for your budget.
Purchasing a home using a traditional mortgage option is the best option for many buyers, but you must know what you’re getting yourself into before you sign on the dotted line. Compare options and be sure you listen to what your loan officer has to say. This is a major purchase, and it’s one you do not want to regret when you complete your purchase.