The process of shopping for a home loan can be very overwhelming- especially if you happen to be unfamiliar with all the mortgage terms, programs and understanding all the finance information that a consumer must consider. This is a process that should never be rushed. Since buying a home can be the single largest investment many consumers will make in their lifetime, I'd like to break-down a popular mortgage loan type chosen by consumers, called a "Conventional Loan," and how this loan type may benefit you.
Definition of a Conventional Loan
When you apply for a home loan, most consumers have a couple of loan options available. One of those options is a Conventional Mortgage Loan; the second, is a Government-backed loan. Government-backed loans are federally insured by the Federal Government, whereas Conventional Mortgage Loans are not directly insured by the government. Conventional loans can only be offered through private entities such as banks, local credit unions or mortgage lenders such as, Sierra Pacific Mortgage.
Conventional Loan Characteristics
Now that you are aware of the two common loan choices available, we're going to specifically discuss more about what makes a conventional loan unique.
Down Payment Requirements
A down payment for a conventional loan can be anywhere between 3 and 25-percent of a home's value depending on the borrower's credit, how they intend to use the property, and the borrower's financial condition. Traditionally, conventional loan programs required a 20-percent down payment, but depending on the lender's unique lending programs available, a borrower may be able to put as little as 3-percent as a down payment for a conventional loan. Keep in mind, this option is typically only available to those borrowers who can demonstrate exceptional credit as well as a strong overall financial profile to compensate for the reduced down payment amount.
For a borrower who wants the best program and rates that a lender is able provide (all other factors aside), a traditional 20-percent down payment is still a borrower's best option, in most cases. For example, a 20-percent down payment on a $200,000 home loan would require a $40,000 down payment from the borrower at closing- already, this is a large chunk of change! If saving for a 20-percent down payment is not in your budget, then be sure to talk to your mortgage professional. They may have the ability to present other programs that require less down, or present you options from Government-backed loans with the FHA or even VA, for qualified borrowers.
More Stringent Credit
A borrower's credit pays an integral role when qualifying for a conventional loan. For many, three small digits can mean the difference of a "yes" or a "no" answer from a lender. Why is a credit score important? Those three-digit numbers, commonly referred to as a FICO score, paint an overall financial picture of how well the borrower will repay their debts back to a lender. FICO Scores can range from 300 up to 850. A higher number corresponds to a borrower who demonstrates a higher likelihood of repaying debts as agreed, whereas a person with 300 FICO score, is considered to be more risky and likely to miss repaying debt payments when due.
Credit scores for conventional programs will vary among lenders. Many lenders tend to require a minimum of 620 in order to qualify for a conventional loan. Borrowers who have a score of 720+ might fall in a lenders' best tier for rates (all other factors aside.) Again, lenders may have different "buckets" that borrowers might fall into, so be sure to inquire and shop your loan scenario with several different lenders to find the right one for you.
As an example, let's say a lender received permission from the borrower to pull their credit. The borrower's credit scores are 730, 740, and 755 from the three major credit bureaus. The lender will use the median (middle-most) score, of 740, when evaluating the borrower's credit worthiness for the loan. Because the borrower's high score demonstrates to the lender a high likelihood of the borrower repaying past obligations when due, they are less of a risk to the lender. Therefore, the lender is able to offer a lower market interest rate for the loan. Keep in mind that some lenders may require a borrower to have a higher credit score if they plan on providing less than a 20-percent down payment, too.
Paying your bills on time, having stable income and a high credit score still won't get you a mortgage loan if a lender determines that you live 'too close to the edge.' For a borrower to qualify for a conventional loan, their mortgage payments and monthly non-mortgage debts obligations must fall within certain ranges. These rangers are known as Debt-to-Income qualifying ratios, or simply DTI ratios
The first qualifying ratio a borrower will need to meet for a conventional loan is a "front-end ratio." The front-end ratio, also called the housing ratio, shows what percentage of the borrower's income would go toward their housing expenses, including their monthly mortgage payment, real estate taxes, homeowner's insurance and association dues.
To calculate the front-end ratio, the lender will take all the expected housing expenses and divide it by how much the borrower earns each month before taxes (gross monthly income). They multiply the result by 100 and voila, we have the borrower's front-end DTI ratio as a percentage. For instance, if a borrower has expected housing-related expenses that total $1,000 and a gross monthly income of $4,000, their DTI is 25-percent.
In addition to a borrower's front-end ratio, a borrower will also need to also qualify for a second ratio known as a "back-end ratio." The back-end ratio shows what portion of the borrower's income is needed to cover ALL their monthly debt obligations, including those listed in the front-end ratio. This might include items such as car loans, student loans, child support, credit card bills, and all the housing related expenses.
For instance, suppose a borrower has a $250 per month for a car loan, $50 per month in student loans, and about $100 per month in credit card bills, plus the $1,000 in housing related expenses mentioned earlier. That adds up to $1,400 in monthly debt obligations that the borrower is expected to pay. Based on the gross monthly income of $4,000, this borrower's back-end ratio would be 35-percent.
Recommended DTI Ratios
Lenders typically want a borrower's front-end ratio to not exceed 28-percent; and a back-end ratio of 36 percent, or lower. Depending on the borrower's credit score, savings and down payment, lenders might be willing to accept higher DTI ratios, but limits will also vary depending on the type of loan. For conventional loans, most lenders will put more focus on a borrower's back-end ratio
Fixed Rate vs ARM
Now that you know some basics of what a conventional loan requires: a down payment that can range between 3 to 25-percent (depending on the program), a strong credit score, and solid DTI ratios, the next step is to consider what type of Conventional loan you are looking for. Conventional loans can either have a fixed rate product or have an adjustable mortgage rate.
Fixed Rate Mortgage Loans
Fixed Rate Mortgage Loans are often referred to as "plain vanilla" mortgage products, due to their ease of comprehension and popularity among borrowers. They are popular among consumers because they really only have two distinct key features. First, the interest rate remains fixed for the entire life of the loan. Second, the borrower's monthly payments remain relatively the same. Property taxes and homeowners insurance costs may fluctuate the monthly payment a slightly, but generally, monthly payments will remain very stable throughout the entire loan term.
Most lenders offer fixed rate mortgage terms that range between 10, 15, 25 and 30 years, with the 15 and 30-year mortgage terms being the most requested among consumers.
Remember, that the longer the mortgage term, the more interest the borrower will end up paying. For example, at the beginning of a 30-year mortgage, a large percentage of the borrower's monthly payment is used for paying just the interest. As the loan is amortized or paid down, more of the monthly payment is applied to the loan's principal portion. A typical 30-year fixed-rate mortgage takes about 22.5 years of level payments to pay about half of the original loan amount.
Adjustable Rate Mortgages (ARM)
A second type of conventional loan is an Adjustable Rate Mortgage, also known as an ARM. An ARM still has a term of 30 years, but features a lower introductory rate for a period of 3, 5, 7 or 10 years. Once this introductory period passes, the borrower's mortgage rate may have periodic adjustments that are tied to a specific benchmark such as LIBOR or a U.S. Treasury T-Bill index.
For example, with a 5/1 ARM loan, a borrower's interest rate would be at a low-fixed rate for a period of 5-years. After that, the low-introductory rate has the potential to fluctuate either up or down each subsequent year for the next 25 years. This might be good or bad for a borrower. If the benchmark rate decreases, so will the borrower's monthly payment. Conversely, if the same benchmark adjusts higher, so goes the borrower's monthly payment. Although most ARM loans do feature a lifetime cap, or maximum interest rate that the loan can reach, it can pose to be a significant disadvantage to a borrower's budget, should rates rise too sharply.
Despite disadvantages, ARM loans do have an appeal to some borrowers. For instance, 3/1 ARMs and 5/1 ARMs generally provide the lowest interest rates and monthly payments during the initial rate period- which is ideal for those borrowers who don't want a long-term mortgage, or plan on moving before the end of the introductory period. 10-Year ARMs are also an increasingly popular option because they combine significant savings for the initial rate period with longer protection from market-based interest-rate fluctuations.
ARM loans are certainly more complex than that of a traditional fixed-rate loan, but they do offer unique benefits to some borrowers. If you are considering this loan type, be sure your mortgage professional understands all your financial goals and time horizons and most importantly, be sure to fully educate yourself about all of the ARM features, margins, caps, and adjustment indexes before committing to this conventional mortgage type.
Benefits of going Conventional
If you’ve managed your money and credit responsibly, this can pay off in a big way when you are ready to buy a home. Individuals who have excellent credit scores and sizable down payment amount, will have the opportunity to receive the most favorable interest rates and payment options available from lenders.
Build Equity Faster
The higher 20-percent down payment requirement for a plain-vanilla conventional loan can help a borrower to build equity faster, too.
Conventional Mortgages are not bound to many of the bureaucratic regulations, allowing Lenders to process conventional mortgages faster than government-insured loans. For instance, FHA loans require a property to meet strict eligibility guidelines as far as price, location and habitability of the property.
Possibility of No Mortgage Insurance
If you are trying to avoid the added cost of having to pay any Mortgage Insurance Premiums (MIP), then a conventional 20-percent down may be the best option. Because standard conventional loans require a higher down payment amount, generally a borrower will not need to pay any MIP. Conversely, if you plan on putting less than 20-percent down for a conventional loan, most lender programs may require a borrower to pay MIP. Talk to your mortgage professional, they may have ways to structure a loan so that a borrower does not have to pay a monthly MIP.
If you expect your income to remain steady and can afford the larger down payment size, Conventional Mortgage Loans may cost a borrower less over time, than their government-insured counterparts. For example, some FHA loan products require a mandatory monthly mortgage insurance requirement to be paid by the borrower that will last the entire loan term. This can add up to a significant amount of money if the loan fully amortizes.
Drawbacks of using a Conventional Loan
Large Down Payment and Higher Credit Scores
Most conventional loans programs offered by lenders will require a minimum credit score of 620 and a down payment of at least three to 20-percent. Lender programs will all have different minimums that a borrower must meet in order to be approved for a loan, so be sure to shop around. Remember, conventional programs that allow a borrower to put less than the standard 20-percent down payment might also have private mortgage insurance costs, too.
For borrowers who may have past credit issues and who lack a substantial down payment, it may be more beneficial to the borrower to explore other government-backed mortgages products instead. Government-backed FHA loans accept borrowers with lower credit scores and only a 3.5 percent down payment. While qualified VA borrowers might be able to obtain a VA loan with no down payment at all.
Fees for originating a conventional loan are set by the mortgage lender, and not by the federal government. Fees may vary widely among lenders, so be certain to comparison shop with several lenders to ensure you are getting the best rate and fees for which you qualify for. Some lenders may charge an origination fee, (percentage of the loan amount), while other lenders may charge flat fees to cover the processing of the loan (like us).
Is a Conventional Loan Product best for me?
If you are a borrower with good credit, have a sizable amount of savings for a down payment, and have little to moderate debt, then you may be an attractive borrower for a lender to offer you a conventional loan. With a conventional loan, you might have the ability to obtain a loan at a lower cost and have it processed faster than with a government-insured loan.
However, before you decide to apply for a conventional loan, make sure to co