What Is a Conventional Loan?

Written by Kim PinnelliReviewed by Nathan Brown, CFP®Updated: 29th Apr 2022
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Conventional loans are the most popular loan option, but how do they work, and who qualifies? They aren’t a loan for everyone since they have stricter qualifying requirements.

If you qualify, though, it can work to your advantage since most people save a significant amount of money with a conventional loan versus any other mortgage type.

What Is a Conventional Mortgage?

Conventional loans aren’t government-backed loans like FHA or VA loans. They are for good credit borrowers with low debt ratios.

Conventional loans may meet the Fannie Mae or Freddie Mac guidelines since they are most often the investors of these loans.

In other words, they buy the loans from lenders to give lenders more liquidity to offer more loans. But not all loans conform to Fannie Mae or Freddie Mac guidelines.

Another common conventional loan option is jumbo loans (loans for more than $548,250). These loans exceed Fannie Mae or Freddie Mac’s loan limits, so they aren’t conforming, but they are conventional because they aren’t government-backed but instead funded by a private lender.

>> More: Best Mortgage Lenders

How Do Conventional Mortgages Work?

A conventional loan works just like any other loan. You apply for the loan with a lender (I suggest applying with at least 3 lenders) and provide your qualifying documentation. You’ll typically provide:

  • Paystubs covering the last 30 days
  • W-2s for the last 2 years
  • Tax returns for the last 2 years if you’re self-employed
  • Asset statements for the last 2 months
  • Approval to pull your credit

Lenders pull your credit and assess your application. They’ll verify your income and assets using the documents you provide and decide if you meet the conventional loan guidelines.

If approved, they’ll order an appraisal and title work on the home to ensure the home qualifies too. For the home to qualify, it must be worth at least as much as you offered to pay, and the title must be clear of any liens aside from the current owner’s mortgage.

Conventional Loan Requirements

Conventional loans have slightly stricter guidelines than government-backed loans because there isn’t a guarantee like FHA or VA loans have.

If an FHA or VA borrower defaults on their loan, the FHA or VA pays the lender back a portion of the amount they lost on the deal.

There isn’t any such guarantee with conventional loans. However, if you put less than 20% down, the lender will require PMI (Private Mortgage Insurance), which covers the lender until you owe less than 80% of the property’s value. You can cancel PMI once your LTV is less than 80%.

Credit Score

Each lender differs, but most online mortgage lenders require at least a 620 – 640 credit score. The better your credit is, the better terms you’ll get.

A low credit score means you’re a higher risk of default, and the lender may not approve you, or if they do, it will be at a higher rate.

Debt-to-Income Ratio

Most lenders allow a DTI of up to 45%. Typical conforming guidelines require a DTI of 36% or less, but most lenders have some leniency, especially if you have good credit.

Your DTI is your total debt payments (reported on your credit report) divided by your gross monthly income (income before taxes). The less debt you have, the lower your DTI will be.

Private Mortgage Insurance

If you have a Fannie Mae or Freddie Mac conventional loan, you’ll pay Private Mortgage Insurance if you put down less than 20% on the home.

PMI is insurance that covers the lender should you default on your loan. The amount you pay depends on your credit score and LTV. The higher your credit score and the lower your LTV, the less you’ll pay.

If you have a solid payment history and pay your balance down to less than 80% of the home’s value, you can request a cancelation of PMI. If you don’t request it, the lender must cancel it once you have a 78% LTV – it’s the law.

Down Payment

Conventional loans have lower down payment requirements than most people realize. First-time homebuyers need just 3% down, and subsequent homebuyers need only 5% down.

The more money you put down, the better terms you’ll get, and the less interest you’ll pay over the life of the loan, but it’s nice knowing you can get by with such a low down payment if necessary.

What Types of Conventional Loans are Available?

Private lenders offer a few types of conventional loans:

  • Fannie Mae loans – These loans conform to Fannie Mae guidelines. Fannie Mae offers 12 loan products, including a low-income loan and a home renovation loan. Fannie Mae buys loans primarily from institutional lenders.
  • Freddie Mac loans – Freddie Mac buys loans primarily from smaller lenders. Freddie Mac also has more loan programs (a total of 20), giving borrowers a little more flexibility.
  • Jumbo loans – If you need to borrow over $548,250, you’ll need a jumbo loan. You’ll still need good credit and a low debt ratio, but you may qualify for a private lender’s jumbo loan, which they underwrite, fund, and keep on their books. Fannie Mae and Freddie Mac don’t buy them.

What Are the Advantages of Conventional Loans?

  • Low-interest rates – Conventional loans often have the most competitive interest rates, typically lower than government-backed loans like FHA loans.
  • Low down payment requirements – You can get a loan with as little as 3% – 5% down.
  • PMI premiums don’t last forever –Flexible Loan Structure

Most lenders offer both fixed and adjustable-rate loans. They also offer various terms from 10 years to 30 years.

Wider Selection of Properties to Buy

Unlike government loans, you don’t need to occupy the property. You can get a conventional loan for second homes and investment properties too.

You can use conventional financing on almost any property type, including single-family homes, townhomes, condos, manufactured homes, and PUDs.

You May Not Need Mortgage Insurance

If you put down less than 20% on the home, you’ll pay PMI, but you won’t need mortgage insurance if you put down more than 20%.

Even if you need it, it doesn’t last forever since you can cancel it as soon as you owe less than 80% of the home’s value.

Conventional Loans vs. FHA Loans

FHA loans have more flexible guidelines than conventional loans. Known as the first-time homebuyer’s loan, FHA loans are great for anyone with less-than-perfect credit. Their credit score requirements are as low as 580, and all borrowers need only a 3.5% down payment.

The tradeoff with FHA loans, however, is the mortgage insurance requirement. FHA loans require mortgage insurance for the life of the loan. You’ll pay both upfront mortgage insurance and annual mortgage insurance paid monthly.

All borrowers pay 1.75% of the loan amount upfront and 0.85% of the average annual balance monthly. This insurance lasts until you pay off the loan or refinance it.

FHA loans are only for primary residences, though – you cannot use them on second homes or investment homes.

>> More: FHA vs. Conventional Loans

VA Loans vs. Conventional Loans

VA loans are only for veterans or surviving spouses of military veterans. This loan program has the most flexible guidelines for veterans.

The VA doesn’t have strict credit score requirements, and they don’t require a down payment. This means veterans can secure 100% financing even with a low credit score.

VA loans don’t charge mortgage insurance either. The only fee veterans pay is an upfront funding fee which varies depending on whether you’ve used your benefit before. The first time you use it, the fee is the lowest, and it increases from there.

Like FHA loans, VA loans are only for primary residences, they aren’t intended for second homes or investment homes.

>> More: Best VA Mortgage Lenders

Conventional Loans vs. USDA Loans

USDA loans are another government-backed loan option, but for low to moderate-income borrowers. You can make too much money and not qualify for a USDA loan.

Like FHA and VA loans, USDA loans are only for primary residences, and in this case, they are only good for borrowers who don’t currently own a home.

You must buy a home in a ‘rural area, but the USDA has a much looser definition of rural than most people.

USDA loans require a 640-credit score but do not require a down payment. They also have slightly stricter DTI requirements of no more than 41%.

Like FHA loans, USDA loans require mortgage insurance for the life of the loan, but at a lower rate of 0.35% of your annual average balance.

Are Conventional Home Loans a Good Choice?

If you have the credit and down payment needed for a conventional loan, you’ll typically save the most money. Here’s why.

Government-backed loans are great, but many of them have insurance requirements that last for the life of the loan.

Conventional loans offer competitive interest rates, and you can cancel the PMI if you put down less than 20% on the home.

Bottom Line: What Is a Conventional Loan?

If you’re eligible for a conventional loan, get at least 3 quotes from different lenders. See what options you have and how much you can save by getting the loan with the lowest interest rate and closing fees.

Even if you don’t have 20% to put down on a home, a conventional loan can save you thousands of dollars over the life of the loan.

Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.