How a Conventional Mortgage or Loan Works
A conventional mortgage or conventional loan is any type of home buyer’s loan that is not offered or secured by a government entity. Instead, conventional mortgages are available through private lenders, such as banks, credit unions, and mortgage companies. However, some conventional mortgages can be guaranteed by two government-sponsored enterprises; the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Key Takeaways
- A conventional mortgage or conventional loan is a home buyer’s loan that is not offered or secured by a government entity.
- It is available through or guaranteed by a private lender or the two government-sponsored enterprises-Fannie Mae and Freddie Mac.
- Potential borrowers need to complete an official mortgage application, supply required documents, credit history, and current credit score.
- Conventional loan interest rates tend to be higher than those of government-backed mortgages, such as FHA loans.
Understanding Conventional Mortgages and Loans
Conventional mortgages typically have a fixed rate of interest, which means that the interest rate does not change throughout the life of the loan. Conventional mortgages or loans are not guaranteed by the federal government and as a result, typically have stricter lending requirements by banks and creditors.
There are a few government agencies that secure mortgages for banks, such as the Federal Housing Administration (FHA) which offers low down payments and no closing costs. Two other agencies are the U.S. Department of Veterans Affairs (VA) and the USDA Rural Housing Service, neither of which require a downpayment. However, there are requirements that borrowers must meet to qualify for these programs.
Conventional vs. Conforming
Conventional loans are often erroneously referred to as conforming mortgages or loans. While there is overlap, the two are distinct categories. A conforming mortgage is one whose underlying terms and conditions meet the funding criteria of Fannie Mae and Freddie Mac. Chief among those is a dollar limit, set annually by the Federal Housing Finance Agency (FHFA). In most of the continental U.S., a loan must not exceed $647,200 in 2022 (up from $548,250 in 2021).
So while all conforming loans are conventional, not all conventional loans qualify as conforming. A jumbo mortgage of $800,000, for example, is a conventional mortgage but not a conforming mortgage-because it surpasses the amount that would allow it to be backed by Fannie Mae or Freddie Mac.
In 2020, there were 8.3 million homeowners with FHA-insured mortgages. The secondary market for conventional mortgages is extremely large and liquid. Most conventional mortgages are packaged into pass-through mortgage-backed securities, which trade in a well-established forward market known as the mortgage to be announced (TBA) market. Many of these conventional pass-through securities are further securitized into collateralized mortgage obligations (CMOs).
In the years since the subprime mortgage meltdown in 2007, lenders have tightened the qualifications for loans-“no verification” and “no down payment” mortgages have gone with the wind, for example-but overall, most of the basic requirements haven’t changed. Potential borrowers need to complete an official mortgage application (and usually pay an application fee), then supply the lender with the necessary documents to perform an extensive check on their background, credit history, and current credit score.
Required Documentation
No property is ever 100% financed. In checking your assets and liabilities, a lender is looking to see not only if you can afford your monthly mortgage payments, which usually shouldn’t exceed 28% of your gross income. The lender is also looking to see if you can handle a down payment on the property (and if so, how much), along with other up-front costs, such as loan origination or underwriting fees, broker fees, and settlement or closing costs, all of which can significantly drive up the cost of a mortgage. Among the items required are: