What Is Conventional Loan?
FHA loans, VA loans, USDA loans are often called government loans because mortgage lenders who originate these types of mortgage loans are guaranteed by the government. FHA loans is insured by the Federal Housing Administration, a subsidiary of the United States Department of Housing and Urban Development and VA loans is guaranteed by the Department of Veteran Affairs. In the even if the mortgage loan borrower defaults on a FHA loan, the Federal Housing Administration will insure the mortgage lender who originated the FHA loan against the loss of the mortgage loan. Same with VA loans. If a VA mortgage loan borrower defaults on a VA loan and the VA loan goes into foreclosure and the VA mortgage lender who originated the VA loan goes into default, the Department of Veteran Affairs will guarantee the VA mortgage lender who originated the VA loan the loss. The concept is the same with USDA loans where if the USDA loan goes into default, the mortgage lender who originated the USDA loan will get insured by USDA. Any mortgage loans that is not backed and insured by a government entity is called a conventional loan.
Conventional loans conform to Fannie Mae or Freddie Mac lending guidelines. Fannie Mae and Freddie Mac are also known as Government Sponsored Enterprises, GSE, and are corporations which were created by the federal government. The role of Fannie Mae and Freddie Mac to purchase mortgage loans that meet their guidelines from mortgage lenders throughout the country, package them up as Mortgage Backed Securities ( MBS ) and re-sell them to Wall Street and institutional investors on the secondary market.
Conventional Loan Basics
To qualify for government loans, you need to follow the government agency that is insuring the government loan. For example, if you want a FHA loan, mortgage lenders require that you follow FHA guidelines such a 3.5% minimum down payment, 46.9%/56.9% debt to income ratios, minimum of 580 FICO credit scores, 2 year employment history, 2 year residential history, and other minimum FHA lending guidelines. With conventional loans, conventional mortgage loan borrowers need to follow Fannie Mae lending guidelines. Many mortgage loan borrowers question why they need to follow any mortgage lending guidelines for a conventional loan if conventional loans are not guaranteed or insured by the federal government. The reason they need to follow Fannie Mae or Freddie Mac mortgage lending guidelines is because a private mortgage lender initially funds the conventional mortgage loan. The private mortgage lender than re-sells the conventional loan to Fannie Mae or Freddie Mac so they can unload their warehouse line of credit so they can re-use their warehouse line of credit to fund other mortgage loans. In order for Fannie Mae or Freddie Mac to purchase mortgage loans from private mortgage lenders, the mortgage loans needs to meet Fannie Mae and/or Freddie Mac mortgage lending guidelines.
Pros And Cons Of Conventional Loan
One of the greatest advantages of a conventional loan is that there is no private mortgage insurance with a 20% down payment on a home purchase or 80% loan to value on a refinance mortgage. FHA loans require an upfront mortgage insurance premium of 1.75% and a lifetime 1.35% annual FHA mortgage insurance premium which can be quite costly. You cannot cancel the FHA mortgage insurance premium no matter how low your loan to value is unless you pay off or refinance your 30 year fixed rate FHA insured mortgage loan. With conventional loans, private mortgage insurance is required for any mortgages with higher than 80% loan to value, however, the annual private mortgage insurance is normally half of those of FHA mortgage insurance premium and you can request that the private mortgage insurance be canceled once your property is meets 80% loan to value. A new appraisal will be required.
Conventional loans have tougher mortgage lending guidelines than FHA loans. Minimum down payment required to qualify for a conventional loan is 5% versus FHA where the minimum down payment is 3.5%. Minimum credit scores to qualify for a conventional loan is 620 FICO whereas with FHA loans, the minimum credit score is 580 FICO. The maximum debt to income ratios are capped at 45% with conventional loans whereas the cap on FHA loans is 56.9%.
Waiting period guidelines after a bankruptcy, foreclosure, deed in lieu of foreclosure, or short sale are much stricter with conventional loan programs than with FHA loans. You need to wait 4 years after a bankruptcy to qualify for a conventional loan whereas you only need to wait 2 years to qualify for a FHA loan. You need to wait 7 years to qualify for a conventional loan after a foreclosure where you only need to wait three years to qualify for a FHA loan after a foreclosure. You need to wait four years after a short sale and/or deed in lieu of foreclosure to qualify for conventional loan whereas you need to wait three years after short sale and/or deed in lieu of foreclosure to qualify for FHA loan.
Bottom line is if you have great credit and a strong financial profile, the conventional loan route is the best way to go. Those with weaker credit and financial profile, FHA loan will probably the best route to take and eventually refinance their FHA loan into a conventional loan. The most important benefit of conventional loans over FHA loans is due to mortgage insurance premium.
Related> Conventional loan refinance