What Does “Conventional Loan” Mean, And Should I Get One?

Often used interchangeably with terms such as "traditional mortgage" or "standard mortgage," a conventional loan is a type of mortgage loan that is not insured or guaranteed by the government.

Instead, conventional loans are backed by private lenders and investors whose main goal is to make a profit. This is different than an FHA loan, for instance, a government-sponsored program whose primary mission is to offer affordable and attainable homeownership.

As such, conventional loans are generally harder to qualify for. And, mortgage insurance is not subsidized and can get quite expensive for lower-credit borrowers.

Should You Get A Conventional Loan?

Choosing to get a conventional loan largely depends on your financial status and homeownership goals. If you have a strong credit score, stable income, and can afford a substantial down payment, a conventional loan might be an excellent fit due to potentially lower interest rates and the absence of an upfront mortgage insurance premium.

However, conventional loans can be harder to qualify for than government-backed loans due to their stricter requirements. If you have a lower credit score or a smaller down payment, a government-insured loan like an FHA loan might be a better option.

What Are Conventional Loan Rules?

Conventional loans are subject to a set of stringent rules defined by Fannie Mae and Freddie Mac. These high-level rules provide a standard for potential borrowers to adhere to when applying for a conventional loan. Here are a few:

Credit Score: Borrowers should ideally have a credit score of at least 620. Higher credit scores may result in better interest rates and lower mortgage insurance costs.

Debt-to-Income Ratio (DTI): The borrower's total monthly debt payments plus their future housing payment should not exceed 43% of their pre-tax income. This is known as a 43% debt-to-income level, or DTI. In certain cases, a borrower may be approved with a DTI of up to 50%.

Employment History: A stable employment history, typically a minimum of two years with the same employer, is preferred. Those who are self-employed need two years of filed tax returns showing adequate income from their business.

Down Payment: Conventional loans often require a down payment of at least 3%. However, if the down payment is less than 20%, private mortgage insurance (PMI) is necessary.

Property Standards: The property being purchased must meet certain conditions for safety, soundness, and security.

How Does Someone Apply For A Conventional Loan?

Applying for a conventional loan doesn't involve direct communication with Fannie Mae or Freddie Mac. Instead, prospective borrowers apply through a mortgage lender—typically a bank, credit union, mortgage broker, or other financial institution—that is certified by one or both of these agencies.

The lender will examine the loan application according to Fannie Mae and Freddie Mac guidelines, including an evaluation of the borrower's credit score, employment history, and debt-to-income ratio.

The lender will require documentation of income and assets, a property appraisal, and other relevant information. All of this information is run through a software program provided to lenders by Fannie or Freddie. The system returns an approval decision. All facts entered into the system are verified by a human underwriter.

If the computer and the human agree that you’re credit-worthy, your loan is approved.

Is A Conventional Loan Better Than An FHA Loan?

Whether a conventional loan is better than a Federal Housing Administration (FHA) loan can depend on the borrower. Both loan types have their own unique advantages and drawbacks.

Conventional loans, for instance, often have more stringent credit and income requirements but may offer lower interest rates for those with excellent credit. They also don't require an upfront mortgage insurance premium (MIP) like FHA loans. However, if the borrower's down payment is less than 20%, they will likely need to pay for private mortgage insurance (PMI).

PMI is often more expensive that MIP on a monthly basis, except for those with credit scores above 740 or putting 5-10% down. The advantage, though, is that you will only have to pay for it until you reach 20% equity in your home.

FHA loans, on the other hand, are often more accessible for borrowers with lower credit scores or smaller down payments. They also allow for higher debt-to-income ratios. However, they require both an upfront and a monthly mortgage insurance premium, which can make them more expensive over the life of the loan.

Unlike with conventional loans and PMI, you will have to pay MIP for the entire life of the loan.

For an in-depth breakdown of the pros and cons of both conventional and FHA loans, be sure to check out our review of FHA vs. Conventional Loans.

See If You Qualify For A Conventional Loan

The best way to see if you qualify for a conventional loan is to get pre-approved by a certified lender. This process involves providing some financial information to a mortgage lender, who will then give you a ballpark estimate of the loan amount for which you might qualify.

Ultimately, understanding the ins and outs of conventional loans and how they compare to other mortgage options can empower you to make the best decision for your homeownership journey.