Buying a home is the most complex financial project most Americans will ever undertake; certainly the most expensive. Since very few consumers have the cash on hand to buy property, banks and the government offer several different options for financing a mortgage.
The most basic of these is the conventional loan. This is a mortgage issued without the backing of a government agency. It is a transaction entirely between the borrower and the lender.
Here’s how it works.
What Is a Conventional Loan?
A conventional loan is one issued by a private lender with no government insurance. A wide variety of private lenders can offer conventional loans, from banks and credit unions to dedicated mortgage financing companies.
The main difference between a conventional loan and a government insured loan are the borrower requirements. A conventional loan typically requires a higher credit score than a government-backed mortgage. Where federal programs can help people with credit scores as low as 500, a private lender will typically look for scores of at least 650 or higher before issuing a conventional loan. For borrowers with credit scores below 700, lenders will typically charge high interest rates.
The down payment requirements for a conventional loan are typically higher. A private lender working without government insurance will usually want a down payment of between 5% and 20% of the property’s value. This effectively prices many would-be homeowners out of the market, particularly in urban areas.
In Boston, for example, the median price of a new home is $585,000. Over a 30-year mortgage (excluding interest) this comes to $1,625 a month, considerably less than the median rent of $2,450 for a one-bedroom. Yet many residents are effectively priced out of buying a home even though they pay more in rent than they would for a mortgage. They don’t have $117,000 in cash lying around for a down payment, and don’t have any good way to get it.
This is the problem that many government programs try to solve by minimizing or eliminating down payments.
Relatively few borrowers qualify for government-insured mortgages. Applying for a federal program can be a somewhat difficult task, and only specific, narrowly defined groups of people qualify for any individual program.
While the terms of a conventional loan can be strict, any consumer can apply for one. As a result, conventional loans are generally easier and quicker to get.
For consumers with good credit and the resources to pay a down payment, this often makes conventional loans a better option than government insured programs. For consumers with weak credit or who can’t afford a down payment, federal programs might help them access loans they otherwise couldn’t get.
The federal government runs several programs to help certain Americans buy a home. These are generally based around either categories of people that the government wants to help (such as veterans) or public policy goals (such as economic aid for rural areas).
Federal programs generally help borrowers with low credit get loans that they otherwise couldn’t qualify for, typically by either distributing the loan directly or by guaranteeing it. They also can help borrowers avoid significant down payments. The most significant federal mortgage programs are:
Veterans Affairs Loans – This program insures loans for veterans, active service military personnel and their families. Qualifying individuals can get mortgages without a down payment. A VA loan can also waive certain other costs such as mortgage insurance.
Federal Housing Authority Loans – This program is aimed at low-income consumers with poor credit scores. It helps them to get a mortgage with a low down payment, even if they would ordinarily be rejected. It tends to require that the borrower pay additional forms of mortgage insurance to cover the risk of default.
U.S. Department of Agriculture Loans – This program offers or insures loans for low-income people looking to buy a home in qualifying rural areas. The goal is to help boost the local economies in typically depressed regions. Qualifying borrowers can often get a mortgage without any down payment and with lower than normal credit scores.
Good Neighbor Next Door Loans – This program helps law enforcement, firefighters, emergency medical technicians and grade school teachers to buy homes in designated revitalization areas. If someone holds one of these professions, the GNND program will help them buy a qualifying property for half of its list price so long as they commit to living there for at least three years.
Government mortgage programs rarely distribute funds themselves. Instead they work through private lenders. The government will insure a loan, and help to structure it according to the terms of the program. As a result, these programs typically help lower the credit requirement for a mortgage, the down payment or both.
Types of Conventional Loans
There are two main types of conventional loans: conforming and non-conforming.
A conforming loan is one which meets the standards set by Fannie Mae and Freddie Mac. These are government-sponsored organizations which boost liquidity for mortgage lenders by creating a secondary market for mortgages. They buy and sell mortgages, helping to make sure that lenders remain well capitalized and willing to issue new loans. Neither Fannie Mae nor Freddie Mac issues loans on its own.
The most significant rule for a conforming loan is that it must meet the dollar limit set by the Federal Housing Finance Agency. In 2019 this dollar limit is $484,350. For certain high-value areas such as New York and San Francisco the dollar limit can be raised by up to 150% ($726,525). The FHFA also sets certain rules regarding credit scores, debt-to-income ratios and down payments which a conforming loan must adhere to.
Fannie Mae and Freddie Mac insure conforming loans by purchasing them from the lender and reselling them on the secondary market. This lets banks issue mortgages more easily, as they have confidence that they will get paid when one of these two companies buys the loan.
A non-conforming loan is one which does not meet these standards set by Fannie Mae and Freddie Mac through the FHFA. Typically this means that it exceeds the maximum dollar amount for a mortgage, creating what is known as a “jumbo mortgage,” meaning it is higher than $484,350. In high-value areas where the conforming loan limit can be raised by up to 150%, a loan for more than $726,525 would be considered a jumbo mortgage.
Neither Fannie Mae nor Freddie Mac insure non-conforming loans. As a result lenders require higher credit scores and larger down payments before issuing one. Non-conforming loans are significantly less common than conforming loans.
Generally a conforming loan requires the lender to have a debt-to-income ratio below 50% (meaning that the monthly payments are less than half the borrower’s income) and a credit score of at least 620. When a lender issues a mortgage to someone who does not meet these qualifications, such as someone with a credit score below 620, it is called a subprime mortgage.
This is also a non-conforming loan. Neither Fannie Mae nor Freddie Mac will insure it and they don’t create a secondary market for these loans. Lenders generally charge higher interest rates for these loans.
Subprime mortgages were made famous by the 2008 financial crash, when investors bought and sold financial products based on high-interest, low-credit housing loans. When homeowners began defaulting on their loans, this created a ripple effect that caused substantial losses across consumer and investment banks alike.