Mortgage Q&A Friday: “What is a conventional mortgage loan?”
A “conventional mortgage” simply refers to any mortgage loan that is not insured or guaranteed by the federal government.
Additionally, these types of loans may be conforming or non-conforming, with the former meeting the standards set forth by government-sponsored enterprises Fannie Mae and Freddie Mac.
Be careful not to confuse conventional with conforming, as the two terms are very different. However, neither are considered government loans, despite the fact that Fannie and Freddie are now in government control.
One major factor that determines whether a mortgage is conforming or not is the loan amount – loans over the conforming loan limit are considered jumbo mortgages and will come with a higher mortgage rate as a result. Still, both types of loans are considered conventional.
Additionally, conforming loans have a minimum credit score requirement of 620 and tend to have a max loan-to-value ratio (LTV) of 97%, whereas non-conforming conventional loans may allow lower credit scores and higher LTVs.
Fannie Mae’s Homepath is a conforming loan program that allows LTVs of up to 97%.
These days, conventional mortgages (whether conforming or not) typically have higher down payment and credit score requirements than government loans, and if the LTV exceeds 80 percent on a conventional loan, private mortgage insurance is required by the mortgage lender.
However, conventional mortgages provide more flexibility because they may be kept on the original lender’s books, meaning banks can set their own underwriting guidelines and risk appetite.
Now let’s turn our attention to mortgage loans that are backed by the federal government, referred to as “government loans,” or “govie loans” for short.
The most popular of the government loans is the FHA loan, which is a mortgage backed by the Federal Housing Administration (FHA), an arm of the Department of Housing and Urban Development’s (HUD) Office of Housing.
FHA loans allow for down payments as low as 3.5 percent, but mortgage insurance is also required, even if the LTV is below 80%. The FHA surged in popularity after the mortgage crisis all but wiped out subprime lending thanks to its low down payment and lenient credit score requirements.
In fact, many suggest that FHA lending essentially replaced subprime lending, though during the boom, it was quite the opposite. Nobody was interested in government loans because private lenders had the most attractive (yet risky) loan programs.
Another common and widely used government loan is the VA loan, which is backed by the Department of Veteran Affairs. As the name implies, it is reserved for military and their families, unlike the FHA, which any individual can use.
Lastly, there is the USDA home loan program, which provides 100 percent financing on purchase mortgages to borrowers in rural neighborhoods throughout the country. In that sense, it has a limited reach as well, making FHA loans the king of the govie loans.
For the record, most mortgage lenders originate both conventional mortgage loans and government loans, though the government-share has increased markedly since the mortgage crisis got underway.
However, as time goes by and things normalize, expect conventional mortgages to regain market share. This is especially true now that the FHA is increasing mortgage insurance premiums to shore up capital and avoid a government bailout.