Applying for a home loan can be confusing and nerve-wracking for anyone, especially first-time home buyers. You work hard and go through a gamut of emotions just to find your dream home, and then comes the part where you have to complete the financing process! One of the most basic concepts home buyers need to grasp is the different types of loans available to them. In this post, we’ll cover the basics about a conventional mortgage.
Part 1: What is a Conventional Mortgage?
When you apply for a home loan you have several of different products available to choose from, but the most common are conventional loans or government insured loans. Government insured loans, such as VA, FHA, AND USDA loans, are insured by agencies within the federal government. Conventional loans, on the other hand, are Underwritten to the guidelines of Fannie Mae (the federal national mortgage association or FNMA) or Freddie Mac (the federal home loan mortgage corporation, or FHLMC) who provide the backbone for the secondary mortgage market. Fannie Mae and Freddie Mac purchase loans from primary lenders to help them fill their coffers and make more home loans to consumers. Conventional loans, on the other hand, are insured through private companies.
Conventional mortgage loans meet Fannie Mae and Freddie Mac guidelines for the size of the loan and your personal financial situation. Conventional mortgages are attractive to most borrowers because they often feature more attractive terms than jumbo or government insured loans.
Conventional Mortgage Rates
Conventional home loans are available in both fixed or adjustable rate options. A “fixed-rate” mortgage refers to a product that offers an interest rate that won’t change for the life of your loan. This is a great option people who plan on living in their home for many years and want to know exactly what their monthly payments will be for the duration of the loan.
Conversely, adjustable-rate mortgages (ARMs) offer a lower Interest rate for a short term during the first few years of the term—usually from 3 to 10 years, after which the interest rate can change based on the underlying index and margin of the loan. Typically, the initial interest rate is lower than on a fixed rate loan, but there is the risk that the rate may climb after the introductory fixed period ends. An ARM may be a better option for people who know they will either sell the home or pay it off prior to point at which the rate can change.
30-Year Fixed-Rate Conventional Mortgages
This mortgage is one of the most popular with borrowers because the interest rate is locked in at the beginning and will never change over the course of the loan (30 years). But, while monthly payments will be lower over the life of the loan, since interest is spread out over a longer period of time, homeowners can expect to pay more in interest than they would on a shorter-term mortgage.
15- and 20-Year Fixed-Rate Mortgages
As the name implies, these mortgages offer shorter loan terms and in fact, consumers may choose a term as short as 5 years with a conventional loan if they are comfortable with the payments. Those that offer lower interest rates over the life of the 15 or 20-year loan will allow the homeowner to build equity faster and pay a smaller amount of interest due to the lower rate and shorter amortization compared to the longer 30-year term. This mortgage is not for everyone, however, because monthly payments will be higher. A loan with a shorter term may be a great option for those refinancing.
Crunch Some Numbers
For the experienced consumer, an on line mortgage calculator will provide an estimated house payment but most mortgage calculators, including ours, assume a few things:
- That you have excellent credit. Typically, this means a FICO credit score of 740 and above.
- That you’re buying a single-family home (as opposed to a multiple family dwelling) and it will be your primary residence (as opposed to a second home or investment property you will rent out).
- Average settlement costs, lender’s fees, mortgage insurance and other typical costs/fees will be used.
But for those new to the home financing process or even those who may be a little unfamiliar with the nuances of home financing, speaking with a qualified mortgage broker to zero in on the payment options that fit your unique scenario (not to mention where you are house hunting and what kind of home you want to pursue) is a much better option. A good loan officer will understand the regional nuances of home financing and the various additional housing costs—like taxes, insurance and HOA dues—that will affect your specific transaction to a much greater degree than a generic payment calculator.
What’s Expected for a Conventional Mortgage Down Payment?
Conventional loans and government loans require different down payment amounts. Typically speaking, you will be required to invest a minimum of 3% of the sales price as a down payment on conventional loans (assuming you’re financing a primary residence—down payments for second homes or investment properties will be higher), but the more you put down, the more favorable the terms will be on your conventional loan. Down payments of less than 20% will require private mortgage insurance, or PMI and consumers have several options for structuring the PMI to suit their individual needs and preferences.
WHAT ARE Conventional Mortgage QUALIFYING Requirements?
The home loan applicant, as well as the property they wish to finance must meet certain requirements in order to be eligible for conventional financing. Lenders will look at several aspects of your financial life to see if you qualify for a conventional loan.
- Your debt-to-income ratio. Debt to income ratio (or DTI for short) is expressed as a ratio comparing your monthly income with your monthly payments on debts like car loans, student loans, or credit cards. Standard debt-to-income ratios are 28/36 for conventional loans, but those ratios can be exceeded or even decreased depending on other aspects of a borrower’s fiscal profile. A borrower with exceptional credit scores and excellent reserves in the bank after closing may be allowed a higher debt to income ratio than a borrower with minimal reserves after closing and marginal credit history.
- Your credit history. Generally, a borrower will have to have a minimum credit score of 620 or more to obtain a conventional loan. But similar to down payment requirements, the rates and financing terms for borrowers with higher credit scores will be more attractive.
- Reserves after closing. Lenders want to know that, should you be laid off, you have a nest egg to draw from to make your monthly payments, so it’s always a good idea to make sure you have some money in the bank after closing on a home loan.
- The property you wish to purchase must also satisfy Fannie Mae and Freddie Mac requirements. Generally, Fannie and Freddie have fairly lenient requirements when it comes to your traditional single family home, but there are some property types that may be more difficult to finance with a conventional loan. If you find yourselves drawn to something that doesn’t fit the typical mold, like a “tiny home”, an older manufactured home, homes on leased land or homes that are extremely unique in design or functionality may not fit the Fannie/Freddie profile.
Part 2: What Mortgage Can I Afford
Many home buyers spend months searching for their dream home and, once they find it, then begin to go through the pre-approval process. This is actually the opposite of what you want to do. There is no sense finding your perfect house if you cannot afford said perfect house. Getting pre-approved will also allow you time to optimize your financial situation to obtain the best terms for your situation.
Your first step in getting a home loan should always be to determine what kind of mortgage you can realistically afford and get pre-approved first. This will negate any possible disappointment (read: heartbreak).
It’s important to note the difference between prequalification and a full credit approval.
Getting pre-qualified is a fairly quick and easy process. You supply some basic income and asset documentation to your mortgage broker who will review it in detail and give you a general concept of your buying power.
A full credit approval is much more detailed and involves completing a loan application, pulling a comprehensive credit report and providing all of the necessary financial documentation an underwriter will require to render a credit decision. With a full credit approval you can shop for homes with the full confidence that as long as the property and the total monthly costs of your payments fit within the parameters outlined by your mortgage broker, you will be approved for financing once you’ve found your dream home. In competitive housing markets, a full credit approval is typically “a must have” in order to submit an offer to purchase a home.
It’s also very important to note that while getting a home loan will help you cover a huge chunk of the purchase price, there are other expenses you will incur, including your closing costs, pre-paids, and reserves that will need to be paid at closing. These may be paid out of pocket by the buyer, or the buyer may negotiate with the seller to pay all or some of the additional costs above and beyond the down payment.
Consult your mortgage broker to get a firm estimate for the costs you can reasonably expect to incur at closing based on the type and price of home you are shopping for, but here are some the typical costs associated with buying a home:
- Home appraisal
- Home inspection
- Title insurance
- Escrow fees
- Loan processing and/or underwriting fees
- Property taxes
- Recording fees to the city or county
- Homeowners insurance policy paid for the first 12-months
- Pre-paid interest on the new home loan
- HOA transfer fees
Part 3: Jumbo Loans
You’ve probably heard the term “jumbo loan” but were confused by it. It has nothing to do with the size of house you’re buying and everything to do with the price. A jumbo loan is a mortgage loan that exceeds conforming loan limits established by regulation. The jumbo loan limit is $417,000 in most of the United States but can go as high as $625,500 in some high-cost areas of the country.
Because these loans do not conform to industry standards, they are a great way for qualified borrowers to purchase a high-priced or luxury home. Borrowers with a lower debt-to-income ratio, higher credit score, and the ability to put down a larger down payment may find a jumbo loan gets them into the house they desire.
Benefits of a Jumbo Loan
Higher Purchase Limits
As previously mentioned, conforming loan limits in most of the country are $417,000. Jumbo mortgages can exceed these limits and get home buyers into luxury properties.
In recent years, jumbo loan rates have reached historic lows, which is very attractive to people who are borrowing large amounts. On top of low rates, interest on these loans (up to $1 million) may be tax deductible. If you’re interested in obtaining a jumbo loan, check with your accountant about the possibly of deducting your interest.
Second Mortgage Potential
If you have a loan amount a little over the conforming limit you may be able to use a non-jumbo conforming loan up to your county loan limit plus a second mortgage for the difference.
Who Will Qualify for a Jumbo Loan?
As you’ve probably already guessed, jumbo lenders will take a very careful look at the financial life of prospective jumbo borrowers to see if they are a risk for such a big loan. Lenders will look at things like:
- Credit history – These conventional loans will require borrowers to have an excellent FICO score, generally 700 or higher. (Programs allowing lower scores are available but are not as common.)
- Down payment – There is no private mortgage insurance (PMI) option with a jumbo loan, so the required down payment will be larger, usually 20 percent. Recently a few jumbo lenders have re-introduced “self insured” jumbo loans that will only require a 10% down payment, but the threshold for qualifying for these loans will be higher.
- Property appraisal – The property appraisal must support the purchase price for the home.