How Conventional Mortgages Work
A conventional mortgage is offered by a bank and not insured by the federal government, such as VA, FHA and USDA. The qualifications are more strict because it is a slightly higher risk for the bank. A higher down payment or a lower debt to income ratio may be required to qualify. The interest rate that you pay will be based on the prime mortgage rate and your credit score. These conventional mortgages can have either a fixed rate or a variable interest rate.
Most lenders would consider a conventional mortgage as a loan that conforms to the guidelines set forth by Freddie Mac and Fannie Mae, the two government sponsored enterprises (GSEs) that provide liquidity in the mortgage market.
Conventional home loan mortgages include portfolio loans, construction loans, and even subprime loans. But again, whenever a lender refers to a “conventional loan” they are most likely referring to conforming mortgages that are eligible for purchase by Fannie Mae and Freddie Mac.
Understanding Fannie Mae and Freddie Mac
These publicly traded companies and Government Sponsored Enterprises (GSEs) are the largest source of mortgage money in the United States. Fannie Mae was originally introduced as part of President Roosevelt’s New Deal, but was later privatized in 1968. Freddie Mac was created in 1970. The sole purpose of the two agencies is to securitize mortgages and provide liquidity in the mortgage markets.
The biggest difference between a conventional mortgage and other mortgage programs is the required down payment. Government-backed mortgages have low down payment requirements to help home buyers move into a home. For example, you could get an FHA mortgage with just 3.5 percent down and a VA mortgage with no down payment. Banks have different requirements for the down payment on a conventional mortgage, ranging from 5 to 20 percent.
Conforming vs. Non-Conforming
Conventional loans can be either conforming or non-conforming. Conforming loans are for an amount under a specified maximum. In most cases, this is for a single family home. The amount is sometimes higher in certain metropolitan areas, or when purchasing a multi-family home. Non-conforming mortgages are for higher amounts, typically called a jumbo loan.
Choosing a Mortgage
When choosing a mortgage, a borrower is advised to weigh the advantages and disadvantages of each type of loan. A borrower with a good credit history and enough cash for 20% down payment can get the lowest interest rates with a conventional loan. Traditionally, lenders have required that home buyers be able to make a down payment of at least 20% of a home's purchase price to get a home loan or mortgage. However, if the mortgage is insured, the home buyer can often qualify with a down payment of as little as 3 to 5 percent of the purchase price.