When you're considering how to fund your home purchase, the sheer number of mortgage types and loan options can make your head spin. It's tempting to head straight for the loan option with the lowest rate, but it's worth pausing to consider your options in detail, starting with a conventional loan.
Conventional loans involve any type of mortgage not backed by a government agency. They're designed to be accessible for most homebuyers but often have stricter down payment and credit requirements than government-backed loans. If you're in the market for a mortgage, conventional loans are usually the first place to start before you explore other options. Let's explore the pros and cons of conventional financing.
What are the Benefits of a Conventional Loan?
Here are some advantages involved with conventional loans:
More Options
Because conventional loans aren't backed by a government agency, lenders have more freedom to offer flexible options in terms of loan interest rates, terms and more. You'll have more freedom to choose whether you want fixed- or variable-rate financing, and you can typically avoid the extra cost of mortgage insurance if you put down a large enough amount (usually 20%).
With a government-backed loan, mortgage insurance is often included, and rate and term options may be more limited. Most government-backed loans also require that the home you purchase with the loan be your primary residence. A conventional loan allows you to avoid many of these restrictions.
Higher Loan Limits
The lack of government involvement also means you'll usually be able to access more funds with a conventional loan. The limit on an FHA loan, which is one type of government-backed loan, currently sits at $1,209,750 for high-cost areas. For a conventional loan, on the other hand, you may even be able to borrow up to $2 million in some markets if your credit score is high enough.
It's important to note that conventional loans fall into two categories: conforming and non-conforming. A conforming loan adheres to criteria, including loan limits, set by agencies like Fannie Mae and Freddie Mac, which purchase existing mortgages. The limit on a standard conforming loan ranges from $806,500 to $1,209,750, depending on where you live. Some counties may also allow conforming jumbo loans for higher amounts. If you need a larger conforming loan than what's offered in your area, you may be able to secure a non-conforming jumbo loan for up to $2 million, but this may come with higher rates and more difficult qualifications.
Whether you choose a conventional loan or not, deciding on your loan limit comes down to what you can afford. Try out our home affordability calculator to determine a reasonable loan limit for your situation.
Flexible Interest Rates
Conventional loans can offer more flexible interest rates, especially if you have a strong credit history. These loans also carry fewer extra costs, such as mortgage insurance or loan origination fees. Because these tend to be lower than with government-backed loans, your total annual percentage rate (APR) — the annual cost of your loan, including interest and fees as a percentage of your total loan amount — will usually be lower than with a government-backed loan.
Lower Mortgage Insurance Payments, or None at All
One of the biggest benefits of conventional loans is their flexibility in terms of private mortgage insurance (PMI). This is an extra fee you'll pay on your monthly payment to offset the risk for your lender if you have less than 20% equity in your home. Government-backed loans, which are usually best for homebuyers with a low down payment, typically include mortgage insurance and may even require it for the full life of your loan, even after you've built up more than 20% equity.
Most conventional loans, on the other hand, will lower the cost of mortgage insurance if you put down more upfront. Plus, once you reach 22% of the home's appraised value, your PMI payment will usually automatically fall off.
Low Down Payment
Although government-backed loans are primarily known for their low-down-payment options, conventional loans can also work well for buyers who don't have much cash. Conventional loans are available for homebuyers with as little as 3% down. This is known as a Conventional 97 or 97 Percent Loan-to-Value Mortgage, and it's designed to make conventional loans accessible for more first-time homebuyers. Keep in mind, though, that a lower down payment means you'll need to pay for PMI, and it will be attached to your loan for a longer period.
Access to Your Loan Amount Faster
Taking government agencies out of the picture means less red tape for finalizing your mortgage. You won't have to file as much paperwork, and there are fewer parties reviewing all the details before you can be cleared to close. Because of all this, you can usually close on conventional loans faster than on their non-conventional counterparts.
What are the Disadvantages of a Conventional Loan?
While conventional loans have many benefits, they aren’t the best option for every situation. There are some downsides to consider, too. Here are a few of the biggest ones.
Slightly Higher Interest Rates
Although conventional loans can come with lower rates, this is generally only true if you have a high credit score. A lower credit score means more risk for your lender. Because of that, they'll charge you more to cover that risk, especially since a conventional loan doesn't have a government agency as a safety net. Once your score dips below 680, you could find that government-backed options offer more competitive rates.
May Require Mortgage Insurance
As mentioned above, you'll most likely have to pay mortgage insurance on a conventional loan if you put down anything less than 20% upfront. It's worth noting, however, that government-backed mortgages from the FHA, USDA and VA all have their own versions of mortgage insurance. If you bring less than 20% to the table, you'll typically have to compensate your lender for the extra risk in some form or another.
You Need A Higher Credit Score
A government-backed loan may be your only immediate option if you have a low credit score. Fannie Mae's minimum qualifying score for a fixed-rate conventional loan is 620. Anything less is considered too risky for most lenders, so they'll want that added security of a government agency to offset their risk. For instance, some lenders offer FHA loans for buyers with credit scores as low as 500 if they can put down 10% of the home cost.
Your Financial History Will Be Examined More Closely
Although the process for government-backed loans may take longer and involve more third parties, that doesn't mean securing a conventional loan is a walk in the park. Your lender is counting solely on you to ensure the loan is repaid, so they'll scour your financial history in greater detail to ensure you'll be a reliable borrower.
Additionally, suppose you have any major red flags in your financial past, such as bankruptcy or foreclosure. In that case, you may have to wait longer to qualify for a conventional loan than a government-backed loan.
Higher Closing Costs
As noted above, conventional loans tend to have lower closing costs (and be cheaper in general) than government-backed options. However, the downside of conventional loans is that they don't offer as much flexibility to help you avoid paying those costs upfront.
Government loans often allow you to roll closing costs into your loan. With a VA loan, for example, you can roll your funding fee and other costs into the loan to limit what you'll pay out of pocket on closing day. Conventional loans don't explicitly allow you to do this. In some cases, you can find a way around it by asking for seller credits, but that's more difficult to do in a seller's market. If you don't have much money to bring to the table, a conventional loan may not be the best option for you.
Weighing Conventional Loan Pros and Cons
Is a conventional loan good? It depends. Conventional loans have many advantages. If you have a high credit score, a conventional loan can give you access to the best rates and the most flexible loan terms on the market. For buyers with lower scores or less cash to bring to the table, though, it's worth exploring government-backed loan options. It's always a good idea to compare the pros and cons of conventional loans to other options to find the best loan for you.
