Is a Conventional Loan a Good Option for Homebuyers?

A conventional loan is one of the most common types of mortgages used by homebuyers in the US. But is it truly the best option? As with any major financial decision, the answer depends on your unique situation. In this comprehensive guide, we’ll break down everything you need to know about conventional loans so you can decide if it’s the right choice for your home purchase.

What is a Conventional Loan?

A conventional loan is a mortgage issued by private lenders like banks, credit unions, or other non-government financial institutions. The loan is not backed by any government agency. Conventional loans must meet the underwriting guidelines set by Fannie Mae and Freddie Mac, which are government-sponsored enterprises.

The main features of a conventional loan include:

• Originated and funded by private lenders
• Must meet standards set by Fannie Mae and Freddie Mac
• Typically requires a minimum credit score of 620
• Down payment is usually at least 3-5%
• Maximum loan amount follows conforming loan limits set by Fannie and Freddie
• Requires private mortgage insurance (PMI) if down payment is less than 20%

Conventional loans come in two main types

Conforming loans – These loans meet all requirements set by Fannie and Freddie and can be purchased by the agencies. Loan limits for 2022 are up to $647,200 depending on location.

Non-conforming or jumbo loans – The loan amount exceeds conforming limits so they are not eligible to be purchased. Requirements are usually stricter.

What are the Pros of Conventional Loans?

There are several advantages that make conventional loans a popular mortgage option:

• Lower interest rates – Conventional loans tend to have lower rates than government-backed mortgages like FHA and VA loans This makes them more affordable

• Flexible standards – Conventional loans have more flexible credit and income requirements than government loans, This makes qualification easier,

• Lower mortgage insurance – Conventional loans require private mortgage insurance (PMI) if less than 20% is put down. PMI rates are lower than FHA mortgage insurance premiums.

• No prepayment penalties – Conventional loans don’t charge any early repayment fees if you pay off your loan ahead of schedule. This provides flexibility.

• Variety of terms – Conventional loans come in a range of terms like 10, 15, 20, or 30 years. This allows you to find the right repayment timeline.

• No limit on loan amount – Jumbo conventional loans can be over $647,200 so they work for pricier homes. Government loans have lower limits.

• Easier to drop PMI – With conventional loans, PMI can be canceled more easily once you build 20% equity. FHA MIP is required for the full loan term.

What are the Cons of Conventional Loans?

However, conventional mortgages also come with some potential drawbacks to consider:

• Stricter eligibility – Conventional loans require good credit, income, and down payment funds. Government loans are more lenient.

• PMI required – If you put down less than 20%, private mortgage insurance is required, adding to costs.

• Higher upfront costs – Conventional loans can require higher down payments and closing costs than government loans.

• Complex process – There is a lot of documentation and underwriting required. The process can be tedious.

• Loan limits – Conforming loan amounts are capped so jumbo loans are needed for higher priced homes.

• Difficult to qualify without good credit – Minimum credit scores are around 620. Borrowers with scores below 580 will have a very hard time qualifying.

• Not for investment properties – Conventional loans are just for primary residences. Only government loans can be used for investments.

Who Is a Conventional Loan Best For?

In general, conventional loans are best suited for borrowers who:

• Have a minimum credit score of 620 or higher
• Have at least a 3-20% down payment saved
• Have a low debt-to-income ratio (DTI) below 43%
• Have a consistent income and employment history
• Are purchasing a primary residence, not investment property
• Qualify for loan amounts below conforming limits
• Want to avoid mortgage insurance (PMI) by putting 20% down

For borrowers with lower credit scores or income, bigger down payment funds, and those buying investment properties, an FHA or VA loan may be a better fit.

How Do Conventional Loan Rates Compare?

Conventional mortgage rates are typically lower than rates for government-backed FHA and VA loans. However, conventional rates can vary significantly depending on your specific qualifications.

Borrowers with high credit scores, low debt, sizable down payments, and strong financial profiles tend to receive the lowest conventional rates. Average 30-year fixed mortgage rates for conventional loans are around 4% to 7% APR depending on market conditions.

In comparison, rates for FHA loans average around 4.5% to 8% while VA loan rates are in the 3.5% to 7% range. So conventional loan rates are usually about 0.5 to 1 percentage point lower for well-qualified applicants.

Be sure to shop and compare quotes from multiple lenders to find the best possible rate. Rate differences of half a point can save tens of thousands over the loan’s term.

What Credit Score is Required for Conventional Loans?

The minimum credit score requirement for conventional loans is typically around 620. However, average scores for approved borrowers are much higher, in the range of 700 and above.

Here are general conventional loan credit score guidelines:

• Minimum score of 620-640 – Meets baseline requirements but likely means higher rates or costs
• 680-700 – Considered good credit and provides access to better loan terms
• 720+ – Excellent credit allows you to qualify for the lowest rates and costs
• 780+ – Top tier credit gives you prime borrower status for the ideal loan terms

The higher your score, the better mortgage rate and lower PMI you can obtain. People with scores below 580 will have little chance at a conventional loan. Improving your credit before applying is wise.

How Much Do You Need for a Down Payment?

Conventional mortgage down payment requirements are:

• 3% minimum for fixed-rate loans
• 5% minimum for adjustable-rate mortgages (ARMs)
• 20% to avoid PMI – Lesser amounts require private mortgage insurance

So you can get approved for a conventional loan with just 3-5% down. But putting less than 20% down means you’ll have to pay an additional PMI premium until you build 20% home equity.

While possible to put down 3-5%, the average conventional loan down payment is around 10% to 15%. Coming up with more down payment funds leads to better rates and terms.

The Bottom Line

Conventional loans offer homebuyers lower rates, flexible standards, and access to low down payment options. However, you need pristine credit and ample finances to qualify. Conventional mortgages are best suited for buyers with top tier credit and income who want to minimize costs.

Carefully compare your options including government-backed FHA and VA loans. Shop multiple lenders to find the most competitive rate and terms for your situation. Pre-approval early in the home buying process can provide an advantage.

In the right circumstances, a conventional loan can be an excellent choice. But make sure you understand the qualifications and costs before committing to give yourself the best chance at an affordable home loan.