What Is A Conventional Loan And Is It Right For You?

When shopping for a new home, one of the biggest financial decisions you’ll face is the type of mortgage to pursue. Plenty of options are available to choose from, but conventional loans are the most popular.

Conventional loans are by definition any loan not backed by a government agency, and they come with plenty of benefits, including – at least in some cases – a lower down payment requirement and greater accessibility than alternative loan options.

Let’s take a closer look at conventional loans, including how they work, the different types of conventional loans that are available and whether this type of loan might be right for you.

What Is A Conventional Home Loan?

A conventional loan is a traditional mortgage offered through a private lender. Conventional loans can be used to finance the purchase of a new home or to refinance an existing mortgage.

FHA loans and VA loans are nonconventional mortgages that are insured by the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA), respectively. Since conventional loans don’t have government backing, they often have stricter eligibility requirements.

When you apply for a conventional loan, you’ll have to meet certain requirements related to your down payment, credit score and debt-to-income ratio (DTI). While the requirements may be different for other types of loans and among different lenders, the process of applying and being approved for these loans is similar.

How A Conventional Loan Works

Most conventional loans are conforming loans, meaning they’re eligible for sale to the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac provide liquidity to the mortgage market. Conventional lenders that originate conforming loans can sell their loans to these entities once they’ve closed, giving them the cash flow they need to continue providing new mortgages.

To be considered conforming, a loan must conform to the loan limits set by the Federal Housing Finance Agency (FHFA), as well as Fannie Mae and Freddie Mac’s own guidelines, which include minimum credit scores and maximum DTIs.

However, conventional loans can also be nonconforming, which means they don’t meet these standards and can’t be sold to GSEs.

Conventional Loan Requirements

Like many mortgage applications, conventional loans come with requirements that borrowers must meet. Some of these requirements are set by the individual lender, while others are set by the FHFA and GSEs.

Here are the typical considerations for conventional loan approval:

• Credit score: The standard credit score requirement is 620 for a conventional loan. If you have a score above 620, you may qualify for a lower interest rate.
• Debt-to-income ratio (DTI): Your DTI is the percentage of your income that goes toward debt, including housing, student loans and credit card payments. DTI has the biggest impact on determining how large of a loan you’ll qualify for. You’ll need a backend DTI of 50% or less to potentially qualify for a conventional loan.
• Down payment: A down payment is the percentage of the home’s purchase price you pay upfront. The minimum down payment requirement is 3% for conventional loans. To avoid paying private mortgage insurance, you’ll need to put down at least 20%.
• Private mortgage insurance (PMI): PMI helps protect the lender in case you default – the lower your down payment, the more risk the lender takes on. You’re required to pay PMI until you reach 20% equity in your home.
• Loan limits: You’ll have to meet the conforming conventional loan limit set by the FHFA. In 2023, the baseline conforming loan limit is $726,200 for most of the U.S. For high-cost-of-living areas, like Alaska and Hawaii, the limit is $1,089,300.
• Proof of income and employment: Like with any mortgage application, you’ll have to provide proof of income through documents such as W-2s and bank statements.

As always, it’s important to review with your mortgage lender any additional lender-specific requirements. Doing this will increase your chances of approval.

Conventional Loan Rates

Mortgage interest rates are always changing based on the economic and interest rate environment. Looking at the average rates can give you a general idea of the type of mortgage rate you can expect.

But the actual rate you end up with will depend on several factors, including your overall financial situation. For example, your DTI, down payment and credit score impact your interest rate. Generally speaking, the less risky you are as a borrower, the more likely you are to get a better rate.

Your interest rate will also depend on the type of mortgage you have. If your credit score prevents you from securing an optimal interest rate with a conventional loan, you might consider a government-backed loan, which can give you access to a better interest rate. On the other hand, borrowers with good or excellent credit can usually save the most money with a conventional loan.

What Is A Conventional Loan Vs. An FHA Loan?

As noted earlier, an FHA loan is one that’s backed by the Federal Housing Administration (FHA). These loans are geared toward borrowers who might have trouble qualifying for a conventional loan, perhaps because of their credit score or annual income.

To qualify for an FHA loan, you’ll need a down payment of potentially as low as 3.5% as long as you have a credit score of 580 or above. If your credit score is lower than 580, you’re more likely to need a higher down payment. You can’t qualify for an FHA loan with a credit score of less than 500.

Keep in mind, however, that lenders will set their own credit score requirement at or above 500. For example, Rocket Mortgage^® requires a minimum credit score of 580 for FHA loans.

Unlike with a conventional loan, you must pay mortgage insurance on an FHA loan regardless of the size of your down payment. You’ll have to pay an upfront mortgage insurance premium (MIP) as well as an annual one. The upfront premium is payable at closing or can be financed into the loan amount.

If your down payment is 10% or more, the mortgage insurance can come off the loan after 11 years. Otherwise, it stays on for the life of the loan. To remove mortgage insurance on an FHA loan with a down payment of less than 10%, you’ll need to refinance into a conventional loan once you have 20% equity.

Conventional Mortgage Options

When you’re ready to buy a house, it’s best to explore your mortgage options just like you typically consider different houses when you go house hunting.

Here are some of the most common conventional mortgages to choose from:

• Conforming loans: Conforming loans adhere to Fannie Mae and Freddie Mac standards as well as limits put in place by the Federal Housing Finance Agency. These loans typically require minimal fees but may have stricter eligibility requirements than government-backed mortgage loans.
• Fixed-rate loans: Fixed-rate mortgages guarantee the same interest rate throughout the life of the loan. Most people sign up for a 15-year or 30-year loan term.
• Adjustable-rate loans (ARM): ARMs have an interest rate that adjusts to the market conditions, shifting either higher or lower.
• Jumbo loans: Jumbo loans are a common type of nonconforming loan that exceeds the conforming loan limit.

The right mortgage option is different for every home buyer. It’s best to speak with a loan expert who can recommend the best loan based on your financial situation and goals.

Conventional Loan Advantages And Disadvantages

Every big financial decision comes with benefits and challenges. To help you better understand if you should get a conventional loan, let’s highlight the advantages and disadvantages of one.

Conventional Loan Pros

Here are some of the positives of conventional loans:

• The ability to avoid mortgage insurance with a 20% down payment or drop it once you have 20% equity
• Flexible terms
• Fixed- and adjustable-rate options
• A lower down payment minimum than FHA loans
• Availability for many property types
• Higher borrowing limits than government-insured loans
• No upfront mortgage insurance fee requirement

Conventional Loan Cons

Here are some of the drawbacks to conventional loans:

• Higher credit score requirements than government-backed loans
• A higher down payment requirement than VA and USDA loans
• Interest rates that depend largely on DTI
• DTI limits that affect eligibility

Conventional Loan FAQs

Looking for more on conventional loans and how they work? Check out the answers to our frequently asked questions.

Why should I consider a conventional loan?

Conventional mortgages are the most popular mortgage option for several reasons. They’re especially suitable for buyers in good financial standing because they allow such buyers to get a bigger loan than they would likely get with a government-backed mortgage. A conventional mortgage can also be used for a variety of properties, including second homes, vacation homes and rental properties.

What credit score is needed for a conventional loan?

To qualify for a conventional loan, you’ll need a credit score of 620 or higher in most cases. Every mortgage lender sets their own requirements, though, so some lenders may require a higher or lower score. If a conventional loan is right for you, take the time to compare lenders or wait until you’ve increased your credit score.

What if I don’t qualify for a conventional loan?

Several options are available if you don’t qualify for a conventional loan. One is an FHA loan, which typically comes with a more relaxed credit score and annual income requirement. Learn more about the FHA credit score and down payment requirements.

The Bottom Line

A conventional loan isn’t for everyone, but it offers higher borrowing limits than most other loans, along with an opportunity to avoid paying mortgage insurance or make a low down payment if a borrower has a strong credit score and a solid income relative to their outstanding debts.

If you’re ready to apply for a conventional loan, get started on your application today and see what you may qualify for.