What is a Conventional Loan
A conventional mortgage or conventional loan is any type of home buyer’s loan that is not offered or secured by a government entity. Instead, conventional mortgages are available through private lenders, such as banks, credit unions, and mortgage companies. However, some conventional mortgages can be guaranteed by two government-sponsored enterprises; the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Conventional mortgages typically have a fixed rate of interest, which means that the interest rate does not change throughout the life of the loan. Conventional mortgages or loans or not guaranteed by the federal government and as a result, typically have stricter lending requirements by banks and creditors.
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These types of loans are not for everyone. Here's a look at who is likely to qualify for a conventional mortgage and who is not.
Who May Qualify
People with established credit and stellar credit reports who are on a solid financial footing usually qualify for conventional mortgages. More specifically, the ideal candidate should have:
Credit Score
A credit score is a numerical representation of a borrower's ability to pay back a loan. Credit scores include a borrower's credit history and the number of late payments. A credit score of at least 680 and, preferably, well over 700 can be required for approval. Also, the higher the score, the lower the interest rate on the loan, with the best terms being reserved for those over 740.
Debt-to-Income
An acceptable debt-to-income ratio (DTI). This is the sum of your monthly debt payments, such as credit cards and loan payments, compared to your monthly income. Ideally, the debt-to-income ratio should be around 36% and no more than 43%. In other words, you should spend less than 36% of your monthly income on debt payments.
Down Payment
A down payment of at least 20% of the home’s purchase price readily available. Lenders can and do accept less, but if they do, they often require that borrowers take out private mortgage insurance and pay its premiums monthly until they achieve at least 20% equity in the house.
In addition, conventional mortgages are often the best or only recourse for homebuyers who want the residence for investment purposes, as a second home, or who want to purchase a property priced over $500,000.
What is an FHA Loan
A Federal Housing Administration (FHA) loan is a mortgage that is insured by the Federal Housing Administration (FHA) and issued by an FHA-approved lender. FHA loans are designed for low-to-moderate-income borrowers; they require a lower minimum down payment and lower credit scores than many conventional loans.
In 2020, you can borrow up to 96.5% of the value of a home with an FHA loan. This means you'll need to make a down payment of 3.5%. You'll need a credit score of at least 580 to qualify. If your credit score falls between 500 and 579, you can still get an FHA loan as long as you can make a 10% down payment.1 With FHA loans, your down payment can come from savings, a financial gift from a family member, or a grant for down-payment assistance.
Because of their many benefits, FHA loans are popular with first-time homebuyers.
It's important to note that with an FHA loan, the FHA doesn't actually lend you money for a mortgage. Instead, you get a loan from an FHA-approved lender, like a bank or another financial institution. However, the FHA guarantees the loan. Some people refer to it as an FHA insured loan, for that reason.
In order to secure the guarantee of the FHA, borrowers that qualify for an FHA loan are also required to purchase mortgage insurance, and premium payments are made to FHA. Your lender bears less risk because the FHA will pay a claim to the lender if you default on the loan.
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Your lender will evaluate your qualifications for an FHA loan as it would any mortgage applicant. However, instead of using your credit report, a lender may look at your work history for the past two years (as well as other payment-history records, such as utility and rent payments). As long as you've re-established good credit, you can still qualify for an FHA loan if you've gone through bankruptcy or foreclosure. It's important to keep in mind that, as a general rule of thumb, the lower your credit score and down payment, the higher the interest rate you'll pay on your mortgage.
Along with the credit score and down payment criteria, there are specific lending FHA mortgage requirements outlined by the FHA for these loans. Your lender must be an FHA-approved lender and you must have a steady employment history or have worked for the same employer for the past two years.
If you're self-employed, you need two years of successful self-employment history; this can be documented by tax returns and a current year-to-date balance sheet and profit and loss statement. If you've been self-employed for less than two years but more than one year, you may still be eligible if you have a solid work and income history for the two years preceding self-employment (and the self-employment is in the same or a related occupation). You must have a valid Social Security number, reside lawfully in the U.S., and be of legal age (according to your state laws) in order to sign a mortgage.
Usually, the property being financed must be your principal residence and must be owner-occupied. In other words, the FHA loan program is not intended to be used for investment or rental properties. Detached and semi-detached houses, townhouses, rowhouses, and condominiums within FHA-approved condo projects are all eligible for FHA financing.
Your front-end ratio (your mortgage payment, HOA fees, property taxes, mortgage insurance, and homeowner's insurance) needs to be less than 31% of your gross income.16 In some cases, you may be approved with a 40% ratio.
Your back-end ratio (your mortgage payment and all other monthly consumer debts) must be less than 43% of your gross income.16 However, it is possible to be approved with a ratio as high as 50%. Also, you need a property appraisal from an FHA-approved appraiser, and the home must meet certain minimum standards. If the home doesn’t meet these standards and the seller won’t agree to the required repairs, you must pay for the repairs at closing. (In this case, the funds are held in escrow until the repairs are made).
Special Circumstances
Mortgage Insurance Premiums
An FHA loan requires that you pay two types of mortgage insurance premiums (MIP)—an upfront MIP and an annual MIP (which is charged monthly). In 2020, the upfront MIP is equal to 1.75% of the base loan amount.11
You can either pay the upfront MIP at the time of closing or it can be rolled into the loan. For example, if you’re issued a home loan for $350,000, you’ll pay an upfront MIP of 1.75% x $350,000 = $6,125. These payments are deposited into an escrow account that is set up by the U.S. Treasury Department; if you end up defaulting on your loan, these funds are used to make mortgage payments.
Although the name is somewhat misleading, borrowers actually make annual MIP payments every month. (In other words, annual MIP payments are not made annually.) The payments range from 0.45% to 1.05% of the base loan amount. The payment amounts also differ depending on the loan amount, length of the loan, and the original loan-to-value ratio (LTV). The typical MIP cost is usually 0.85% of the loan amount.12
For example, if you have a $350,000 loan, you will make annual MIP payments of 0.85% x $350,000 = $2,975 (or $247.92 monthly). These monthly premiums are paid in addition to the one-time upfront MIP payment.
You will make annual MIP payments for either 11 years or the life of the loan, depending on the length of the loan and the LTV.13
You may be able to deduct the amount you pay in premiums; however, you have to itemize your deductions—rather than take the standard deduction—in order to do this.
What is a Conforming loan
A conforming loan is one that meets the standards of loan guidelines established by government-sponsored enterprises Freddie Mac and Fannie Mae. The most well-known conforming loan guideline is the size of the loan. There are two different types of conforming loan size limits: standard and high-cost area. Standard areas in the United States have a conforming loan limit of $510,400 for a one-unit property, as of 2020.
However, there are high-cost areas of the country that have higher loan limits. Most high-cost areas have maximum loan limits for a one-unit property around $765,600, as of 2020. Conforming loans must also meet other guidelines related to a borrower’s loan-to-value ratio, debt-to-income ratio, credit score and history, documentation requirements, etc.
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Conforming loans usually have lower interest rates than non-conforming loans because they are easily bought and sold on the secondary mortgage market. They tend to be a less risky investment for lenders.
If you are in need of a large loan amount you may need a jumbo loan. A jumbo loan is a non-conforming loan because it exceeds the county’s general or high-loan limit.
If you don’t qualify for a conforming loan, getting an FHA loan might also be a good alternative because their loan limits vary by county.
What is a NON-Conforming loan
A non-conforming mortgage or non-conforming home loan is a mortgage that does not meet the guidelines for conforming loans set by by Fannie Mae and Freddie Mac. Conforming loan amount limits are typically $417,000 for a single-family home, though they can be higher in some high-cost areas. Loans that exceed this amount are also called jumbo loans.
FHA VS. CONVENTIONAL
It may not always seem clear whether to apply for a FHA loan or conventional loan. FHA loans have typically been known as loans for first-time homebuyers, filled with extra paperwork and complexity since it’s a government-insured program. But borrowers can use multiple FHA loans for purchasing or refinancing a home loan. However, FHA loans usually may not be used for second homes or investment properties, unless they have been approved by the Jurisdictional HOC.
As a borrower, the additional paperwork for FHA loans is minimal and probably undetectable. The appraiser does have an additional duty to point out any health and safety hazards that are present and require them to be fixed prior to closing. The difference in processing time required for FHA loans — as compared to conventional loans — is negligible.
The major advantage to selecting an FHA is that easier credit standards must be met to obtain financing. Typically, FHA requires a low down payment amount, lower credit scores are allowed, less elapsed time is needed for major credit problems (foreclosures and bankruptcies) and, if needed, you can use a non-occupant co-borrower (who is a relative) to help qualify for the loan using blended ratios. Blended ratios are debt-to-income ratios that equally blend the borrower’s and non-occupant co-borrower’s income and monthly payments to qualify for the loan. Except for HomeReady mortgages, conventional loans do not allow non-occupant co-borrowers.