If you're considering buying a home with a conventional loan, you're not alone. Conventional loans are the most popular financing options for families interested in buying a home in the US.
They appeal to a wide variety of borrowers, including first time and established buyers, move up and downsizing borrowers, families looking to add a vacation home, and investors managing multiple real estate assets.
The option of a fixed, steady mortgage payments make these loans an attractive option for families who want to invest in their future, and still be able to consistently predict what their expenses might be in future years.
What is a conventional home loan?
A conventional loan refers to loans that adhere to guidelines set forth by Fannie Mae and Freddie Mac. These two large agencies create a secondary market for mortgage backed securities by backing loans with an insurance policy that makes them attractive to large investors across the globe. .
Fannie Mae and Freddie Mac are private (although heavily regulated) entities, and this is the primary difference between conventional and government loans; all government loans are ultimately backed and insured by government agencies such as HUD (Housing and Urban Development), USDA (Department of Agriculture), and the VA (Veterans Affairs administration).
It is common and arguably true that, adjustable rate mortgages, non-conforming loans, and jumbo loans are also referred to as conventional loans, but for the purposes of this tutorial, we’re limiting the conversation to conventional conforming loans with a fixed rate.
Just to clarify, Fannie Mae and Freddie Mac do insure adjustable rates mortgages as well, but we will not be focusing on those products in this piece.
Conventional Loan Requirements
Lenders considering your eligibility for a conventional loan will look at several different areas of your life on paper, and the type of home you intend to buy with the proposed home loan.
Here’s the quick list of requirements with a more detailed explanation of each below:
- 3% - 20% (or greater) down payment
- 620 credit score or higher
- Sufficient credit history
- Adequate cash reserves in the bank (varies from zero to several months worth of monthly payment).
- Suitable debt-to-income ratio (ceilings vary from 43%-49% max)
- 2 years verifiable employment history
Down Payment (3% - 20%)
Unlike some government backed loans (such as a VA loan), conventional loans do require some down payment. Rules for how much you need for a down payment change from time to time, and even the rules about how you acquire the money for your down payment can change. It’s not surprising that confusion exists around how much money you really need and what you really need to save for a down payment on a conventional loan.
For 2018, conventional loans require anywhere from a 3% to 20% down payment. It’s a common misconception that you have to have a full 20% down payment to qualify for a conventional loan, and this simply isn’t true.
You can meet the down payment requirement for a conventional loan with as little as 3% down. The only caveat is you’ll have to pay private mortgage insurance (PMI) until you have 20% equity in the home, according to its original appraised value. If you come to the table with enough down payment, you can avoid PMI right off the bat, and reduce the cost of your loan overall.
Conventional loans also have a wide range of mortgage insurance options, including lender-paid mortgage insurance where the lender pays the mortgage insurance on your behalf. This is commonly referred to as a no-mortgage insurance loan by aggressive advertising mortgage companies, but that type of advertising is misleading.
A conforming loan with less than 20% down is required by fannie and freddie to have some form of mortgage insurance. Lender paid mortgage insurance builds your mortgage insurance into your interest rate (it’s still there, you just don’t see it on your monthly statement).
Credit Score > 620
Your credit score is an important factor in determining what type of loan you might qualify for. For conventional loans, your median credit score is required to be above 620. They take the middle score reported by each of the credit reporting agencies, and use that to determine your eligibility.
What if your score is below 620?
Having a score below 620 doesn’t disqualify you from getting a home loan in general. You can either work on your credit score and bring it up above 620, or explore other home financing options, such as an FHA loan, that has a lower minimum credit score requirement.
What if your score is way above 620?
Congrats! There might be some additional benefit to having a considerably higher median credit score than the minimum. Having a score as high as 740 or above will help you avoid fees sometimes charged to borrowers whose credit scores are closer to 620.
If your credit score is below 720 and you are putting less than 20% down you should have a mortgage professional show you a comparison of a government backed loan and a conventional loan to ensure a conventional loan is the best option for your future.
Adequate Credit History
Your credit history is slightly different than your credit score. It’s not so much a number that grades your credit, but a story that outlines the details of your history as an official borrower of money.
What are the lenders looking for?
During the underwriting process (when the lenders are verifying all the info you provided in the application for your loan), lenders are looking at your credit report to glean an historical picture of how you’ve treated previous debts in your life.
And there’s a lot more information there than just your credit card payments. Your credit report shows anything from student loans to how many recent inquiries there have been on your credit. The underwriters verifying your information against your loan application will be looking at this information to help predict how likely you might be to pay back any money you borrow from them.
Items that look good in your credit history:
- Regular monthly payments on credit card, student loans, and other mortgages
- Payments made on time
- Payments made above the minimum amount
- A moderate number of accounts
- Old accounts that are well established
- No foreclosures or bankruptcies
- Accounts that are below the maximum credit limit
Items that don’t look so hot in your credit history:
- Delinquent accounts
- Patterns of late payment
- Closed accounts
- Lots of new accounts
- Foreclosures & short sales
- No activity at all
Having a few issues here and there isn’t the end of the world, and probably won’t hurt your chances of getting a loan. The most important thing is that your recent habits be responsible, even if your way-back-when habits weren’t.
Banks put much more emphasis on your recent credit history, particularly the past 12 to 24 months, and typically want a borrower to have two open, good standing accounts that have been open for 12 or more months at the time of application.
Some activity is better than no activity
Make sure you have SOME recent activity. Having a credit report with no information on it doesn’t give lenders any indication at all whether you’ll be a good borrower or a lousy borrower, and banks don’t like uncertainty.
Likewise, if your credit is poor, don’t just pay off your debt and vow to never use a credit card again. The ability to borrow money on credit is a valuable investment tool, and there may come a time when you’d like to use it to leverage a financial opportunity. If you don’t show some responsible payment habits after a slough of not-so-great ones, the only information a lender might have on hand to evaluate your creditworthiness will be decades old mistakes that may not reflect the responsible financial being you have become.
Does a bankruptcy, short sale or foreclosure mean you can’t get a conventional loan?
Just because lenders prefer you don’t have bankruptcies, short sales, and foreclosures on your report, doesn’t mean they preclude you from ever getting a conventional loan. There’s a waiting period afterward, and some exceptions for special circumstances, but eventually you’ll be eligible again.
As of April 2018, the waiting period before you can qualify for a conventional loan after bankruptcy depends on several factors, including the type of bankruptcy you filed for, whether or not a previous home was included in the bankruptcy.
- Chapter 7 Bankruptcy: 4 years waiting period after discharge date (2 years for special circumstances)
- Chapter 13 Bankruptcy: 2 years waiting period after discharge date.
As of April 2018, getting a conventional loan after a foreclosure typically requires you wait 7 years and obtaining a mortgage after a short sale typically takes 4 years. Some banks will make exceptions and shorten this period to 3 years for a foreclosure and 2 years for a short sale if there were extenuating circumstances, such as a death in the family, or serious illness. This exception is taken very seriously and it is difficult to prove verifiable extenuating circumstances.
- Foreclosure - 7 years waiting period (3 years for special circumstances)
- Short sale - 4 years waiting period (2 years for special circumstances)
What if you don’t know what your credit looks like!?
Luckily, this is an easy fix. If you’re ready to start shopping for a house, just talk to a mortgage professional who can run your credit, find out what your needs are, and help you sort out which loan options are available to you.
If you’re just starting to think about buying a house, and aren’t ready to talk to someone yet, you can do the research yourself by requesting a free credit report from each of the credit reporting agencies. You can contact TransUnion, Equifax, and Experian individually, or use annualcreditreport.com to get all three.
It’s important to investigate what your credit looks like and monitor changes to your reports, not only so you can plan your home purchase, but also to make sure nothing fishy is going. Identity theft can happen to anyone, and many people who don’t monitor their credit only find out they have been a victim when they apply for a loan and discover someone else has ruined their good name.
Required cash reserves varies depending upon your credit score, debt to income ratio, and most importantly, occupancy. Primary homes typically don’t require reserves for Ficos above 680, and only a month or two worth of house payments below that.
Second homes and investment properties always have a reserve requirement, which varies depending upon the number of financed properties someone owns.
Sourcing your down payment and cash to close
It’s important to make sure any money in your accounts can be traced to their source, and explained. Banks will check to see where the money came from, whether it be a gift from a family member, a paycheck, or a withdrawal from your 401K. You’ll run into problems getting a conventional mortgage if it looks like the money in your account just magically appeared from nowhere. Deposits less than 50% of your typical monthly income aren’t required to be sourced.
Can you use gift money?
Gift funds are a popular tool borrowers can use to help buy a home. Buyers often use monetary gifts from their family or other eligible sources to pad their down payment, or pay closing costs and other fees. The rules for using gift funds when you borrow with a conventional loan require documentation (usually a letter), and a paper trail to prove where the funds came from.
Rules about who is allowed to gift money depend on which lender is giving you a loan. Some restrict gift funds to only family member donors, while others allow charitable donations from organizations to count as eligible gift funds.
Your lender will have all the details on this, should you decide a conventional loan is the right path for you, and guidelines surrounding gift funds are always changing, so always check with your mortgage professional before moving any money.
Measuring your debt-to-income ratio is a way for the banks to determine how much of your current monthly income is already spoken for by other debts. Getting approved for a conventional loan usually requires that your monthly outgoing payments on debt related obligations (including the proposed mortgage you are applying for) doesn’t amount to more than that a set amount of your total income for the month.
Debt to income ratio maximums depend upon several factors, including FICO score, down payment, and occupancy. Typically debt to income maximums fall between 43 and 49% of your gross monthly income.
Verifiable Employment History (2 years)
Conventional loans typically require 2 consecutive years of employment at the same job or in the same industry. That means you could have had two or more different jobs in 2 years, but if they were both doing the same type of work, it would be likely be acceptable.
This isn’t a hard-line rule in the conforming loan regulations though, so it’s really more accurate to say that lenders ‘prefer’ to see a consecutive 2-year employment history. Lenders understand that sometimes gaps in employment history can be easily explained, and sometimes even make you a more qualified candidate. Common exceptions to the 2-year employment rule often include:
- Time away from work for medical reasons or injury
- Maternity leave
- Continuing education in your chosen profession
6 months gaps in employment tends to be a sticking point for underwriters and they will often ask for explanations and documentation to explain the unemployment period. If you do have a large gap in employment in the past 2 years, a current strong employment situation will dramatically help your efforts.
Property requirements for a conventional loan
When you’re buying a home with a conventional loan, it’s not just your financial health the lenders will be evaluating. The property itself has to meet certain criteria to be eligible for a standard conforming loan, and for lenders to consider it a worthy risk. Conventional loans are for single family residences between 1-4 units and cannot be used to purchase a business, farm, or apartment complexes.
Eligible Property Uses
One of the advantages of using a conventional loan, as opposed to a government backed loan, is the flexibility in type of property you can buy with it. Government backed loans are pretty much restricted to owner-occupied properties only. Conventional loans can be used to purchase a variety of non owner-occupied single family homes.
In addition to a primary residence, a conventional residential loans can be used to purchase a:
- Second home
- Rental property
- Investment property
- Vacation home
The rules governing conventional loans put a limit on the amount of money that can be borrowed. They set a baseline limit based on the number of units the house has and the geographic location, increasing the base amount in areas that have a higher median price for housing.
Here’s how things look as of April 2018:
2018 Maximum Base Loan Amount
Contiguous States, District of Columbia, and Puerto Rico
Units 1 $453,100
Units 2 $580,150
Units 3 $701,250
Units 4 $871,450
Alaska, Guam, Hawaii, and the US Virgin Islands
Units 1 $679,650
Units 2 $870,225
Units 3 $1,051,875
Units 4 $1,307,175
2018 Maximum High Cost Area Loan Amounts
Contiguous States, District of Columbia,*
Units 1 $679,650
Units 2 $870,225
Units 3 $1,051,875
Units 4 $1,307,175
Alaska, Guam, Hawaii, and the US Virgin Islands
Units 1 $1,019,475
Units 2 $1,305,325
Units 3 $1,577,800
Units 4 $1,960,750
*Note: a few states and Puerto Rico don’t have any high cost areas for 2018
Here in the Roseville and Sacramento area where we have our main offices, we are surrounded by high-value counties like Placer and El Dorado counties, that allow borrowers to obtain financing for the higher-than-average home prices here.
Many areas in Southern California and other popular Central California areas near the San Francisco bay are also included in the list of places with increased loan limits for conventional borrowers.
Maximum borrowing limits vary county by county, so check with your mortgage professional for the most current maximums.
We’re distinguishing between price and value here because that’s how the banks look at it. A person can list their house for any price, but the bank wants to make sure the agreed upon price does not exceed the house’s true market value according to a professional, certified appraiser.
The way the banks look at it, if they’re lending money for a house worth $400,000, it had better be worth at least that much in the real world. In order to be sure their investment in your property is actually as valuable as the seller says it is, they require an appraisal to verify the property’s value.
Before you can close on your loan and get your keys, your future home will have to pass a test: the appraisal.
What happens during the appraisal?
During an appraisal, an independent appraiser comes to the house, inspects and evaluates it and collects data about the house in a report. When they report back, they deliver an appraisal report that estimates what the current value of the home would be on the market.
Here are some of the details an appraiser looks at when assembling this report:
- Home’s exterior and interior building materials
- Age of the home
- Style of the home
- Neighborhood the home is in
- Number of bedrooms and bathrooms
- Square footage of home
- Number of garage spaces
- Age and condition of the home
- Aesthetic quality of the home and its surroundings
- And even which utilities and services are available there
Comments from the appraisers inspection are included, and they compare (comp) at least three homes in the general vicinity that roughly match the details of the house in question. Sold comparables carry much more weight than pending or listed comparables.
What if the house appraises for more or less than the sale’s price?
When determining a home’s value banks use the LOWER of the appraised value or sales price. If a house appraises for more than sales price you can sleep well at night knowing you got an exceptional value on your home but it will not materially change your loan in any manner. If your home appraises for less than the sales price it may or may not affect your loan.
Homes that appraise low may need to have an adjusted sales price or more mortgage insurance might be required if additional down payment is not an option.
Appraisals are a good insurance policy for you as a buyer. The last thing you’d want is to buy a house only to find out you overpaid. An appraisal is a good way for the lender to have assurances their investment in your home is safe, but it also gives you peace of mind knowing you aren’t spending more than you should for a house.
How to apply for a conventional loan
If you’ve read this guide, you’ve got the tools to decide with relative certainty whether this type of home financing is an avenue you’d like to explore further. You understand why a conventional loan might be a benefit, and whether or not your financial position would allow you to buy your home with one.
Step 1: Decide if a conventional loan meets your needs
The first step to apply for a conventional loan is to decide if it is an option for you.
You can evaluate your needs and if these benefits would help you reach your goals:
- a fixed interest rate with predictable payments
- options for how long you’d like to take to pay off your loan
- saving money by avoiding or reducing fees and mortgage insurance
- Options for how you want to use your purchase
Step 2: Review your eligibility
This is where you’d usually call a mortgage professional you trust to go over your current financial situation, look at your credit, and get pre-approved to see what kind of interest rate you’d qualify for. You and your loan officer would review your goals and numbers, and map out available loan options.
If you’re not quite there, you can still get an idea of your eligibility using the guidelines we’ve explained here. See if you can answer these questions for yourself:
- Do you have a credit score of 620 or above?
- Is there anything on your credit report that might be a red flag to lenders?
- Do you plan to purchase a house that is under the conventional loan limits for your county?
- Do you have a down payment that can cover at least 3% of your purchase?
- How are your cash reserves? Do you have at least enough in the bank to cover your first couple of mortgage payments?
- Do your current monthly debt obligations account for 43% or less of your total income per month?
- Can you show 2 years of steady income in the same industry, or an acceptable reason for a gap?
If you have the answers to those basic questions, you’re ready to talk to your loan officer and find out how much you can borrow, and start shopping for a home. With your pre-approval letter in hand, you’ll be prepared to pounce on the right house when you find it, and be home before you know it!