Types of Conventional Mortgage Loans and How They Work

Highlights:

• Conventional mortgage loans are backed by private lenders instead of by government programs such as the Federal Housing Administration.
• Conventional mortgage loans are divided into two categories: conforming loans, which follow certain guidelines outlined by the Federal Housing Finance Agency, and non-conforming loans, which do not follow these same guidelines.
• If you're looking to qualify for a conventional mortgage, aim to increase your credit scores, lower your debt-to-income ratio and save money for a down payment.

Conventional mortgage (or home) loans come in all shapes and sizes with varying interest rates, terms, conditions and credit score requirements. Here's what to know about the types of conventional loans, plus how to choose the loan that's the best first for your financial situation.

What are conventional loans and how do they work?

The term “conventional loan” refers to any mortgage that's backed by a private lender instead of a government program such as the Federal Housing Administration (FHA), U.S. Department of Agriculture (USDA) or U.S. Department of Veterans Affairs (VA). Conventional loans are the most common mortgage options available to homebuyers and are typically divided into two categories: conforming and non-conforming.

Conforming loans refer to mortgages that meet the guidelines set by the Federal Housing Finance Agency (FHFA^®). These guidelines include maximum loan amounts that lenders can offer, along with the minimum credit scores, down payments and debt-to-income (DTI) ratios that borrowers must meet in order to qualify for a loan. Conforming loans are backed by Fannie Mae^® and Freddie Mac^®, two government-sponsored organizations that work to keep the U.S. housing market stable and affordable.

The FHFA guidelines are meant to deter lenders from offering oversized loans to risky borrowers. As a result, lender approval for conventional loans can be challenging. However, borrowers who do qualify for a conforming loan generally benefit from lower interest rates and fewer fees than they would receive with other loan options.

Non-conforming loans, on the other hand, don't adhere to FHFA standards, and cannot be backed by Fannie Mae or Freddie Mac. These loans may be much larger than conforming loans, and they may be available to borrowers with lower credit scores and higher debt-to-income ratios. As a trade-off for this increased accessibility, borrowers may face higher interest rates and other expenses such as private mortgage insurance.

Conforming and non-conforming loans each offer certain advantages to borrowers, and either loan type may be appealing depending on your individual financial circumstances. However, because non-conforming loans lack the protective guidelines required by the FHFA, they may be a riskier option. The 2008 housing crisis was caused, in part, by a rise in predatory non-conforming loans. Before considering any mortgage option, review your financial situation carefully and be sure you can confidently repay what you borrow.

Types of conventional mortgage loans

There are many types of conventional mortgage loans, but here are some of the most common:

• Conforming loans. Conforming loans are offered to borrowers who meet the standards set by Fannie Mae and Freddie Mac, such as a minimum credit score of 620 and a DTI ratio of 43% or less.
• Jumbo loans. A jumbo loan is a non-conforming conventional mortgage in an amount higher than the FHFA lending limit. These loans are riskier than other conventional loans. To mitigate that risk, they often require larger down payments, higher credit scores and lower DTI ratios.
• Portfolio loans. Most lenders package conventional mortgages together and sell them for profit in a process known as securitization. However, some lenders choose to retain ownership of their loans, which are known as portfolio loans. Because they don't have to meet strict securitization standards, portfolio loans are commonly offered to borrowers with lower credit scores, higher DTI ratios and less reliable incomes.
• Subprime loans. Subprime loans are non-conforming conventional loans offered to a borrower with lower credit scores, typically below 600. They typically have much higher interest rates than other mortgage loans, since borrowers with low credit scores are at a higher risk of default. It's important to note that a proliferation of subprime loans contributed to the 2008 housing crisis.
• Adjustable-rate loans. Adjustable-rate mortgages have interest rates that change over the life of the loan. These mortgages often feature an initial fixed-rate period followed by a period of fluctuating rates.

How to qualify for a conventional loan

How can you qualify for a conventional loan? Start by reviewing your financial situation.

Conforming conventional loans generally offer the most affordable interest rates and the most favorable terms, but they may not be available to every homebuyer. You're generally only eligible for these mortgages if you have credit scores of 620 or above and a DTI ratio below 43%. You'll also need to set aside cash to cover a down payment. Most lenders prefer a down payment of at least 20% of your home's purchase price, though certain conventional lenders will accept down payments as low as 3%, provided you agree to pay private mortgage insurance.

If a conforming conventional loan seems beyond your reach, consider the following steps:

• Strive to improve your credit scores by making timely payments, reducing your debt and maintaining a good mix of revolving and installment credit accounts. Excellent credit scores are built over time, so consistency and patience are key.
• Improve your DTI ratio by reducing your monthly debt load or finding ways to increase your income.
• Save for a larger down payment — the larger, the better. You'll need a down payment totaling at least 3% of your home's purchase price to qualify for a conforming conventional loan, but putting down 20% or more can exempt you from expensive private mortgage insurance.

If you don't meet the above criteria, non-conforming conventional loans may be an option, as they're typically offered to risky borrowers with lower credit scores. However, be advised that you will likely face higher interest rates and fees than you would with a conforming loan.

With a little patience and a lot of hard work, you can lay the groundwork to qualify for a conventional mortgage. Don't be afraid to shop around to find the right lender and a home loan that fits your unique financial situation.