The Pros and Cons of Conventional Loans
Buying a home is one of the most significant financial decisions most people will make in their lives. With home prices steadily rising across the country, financing that dream home can be a challenge for many prospective homeowners. That’s where mortgages come in – they allow you to borrow money to purchase a home you otherwise may not be able to afford upfront.
When it comes to mortgage options, conventional loans are one of the most common and popular choices for homebuyers. But are conventional mortgages the right fit for you and your financial situation? Here, we’ll break down the key pros and cons of conventional loans so you can make an informed decision when choosing a mortgage.
What are Conventional Loans?
Conventional loans are mortgages that conform to established guidelines for loan amounts, down payments, credit scores, and debt-to-income ratios. These loans are not insured or guaranteed by the federal government – instead, they are underwritten by private lenders such as banks, credit unions, mortgage companies, and other financial institutions.
The two main types of conventional loans are conforming and non-conforming loans. Conforming loans meet the loan limits set by Fannie Mae and Freddie Mac and usually have more favorable interest rates. Non-conforming loans exceed those limits and come with slightly higher rates.
Pros of Conventional Loans
1. Lower Interest Rates
The main appeal of conventional mortgages is that they typically come with lower interest rates compared to government-backed loans. This means lower monthly payments and tens of thousands of dollars in interest savings over the life of the loan. Conventional rates are competitive thanks to private securitization rather than government insurance.
2. Lower Down Payment Requirements
Many conventional loans only require a down payment of 3-20% of the purchase price. This smaller down payment makes it easier for borrowers to qualify while still allowing them to keep more savings. With FHA loans, down payments can be as high as 3.5-10%.
3. Wider Range of Eligible Properties
Conventional loans can be used to finance single-family homes, townhomes, condos and even multi-family properties with 2-4 units. Some government loan programs place restrictions on the types of homes you can purchase. Conventional loans provide more flexibility.
4. No Mortgage Insurance Requirement
If you make a down payment of 20% or more, you won’t be required to pay private mortgage insurance (PMI) on a conventional loan. This can save you hundreds of dollars per year. With an FHA loan, you are required to pay mortgage insurance no matter your down payment size.
5. Higher Loan Limits
In high cost real estate markets, conventional loans allow for higher loan amounts above what the FHA will insure. The baseline conforming loan limit in 2023 is $726,200 but it goes higher in pricier zip codes. This makes financing easier.
Cons of Conventional Loans
1. Stricter Credit Score Requirements
To qualify for the best rates and terms, you’ll need a strong credit score – typically 680 or higher. Applicants with scores in the fair to good range may have difficulty qualifying or pay higher rates. Government loans can offer more leniency for lower scores.
2. Higher Upfront Costs
The down payment requirements may be lower than FHA loans, but conventional loans can incur larger upfront costs in fees. Expect to pay around 2-5% of the loan amount in origination/underwriting, application, appraisal and other lender fees at closing.
3. Tighter Debt-to-Income Ratios
Your total monthly debt such as credit cards, auto loans and student loans cannot exceed 43% of your gross income with conventional loans. For government-backed loans, you may qualify with a ratio into the mid to high 40s.
4. Requirements for PMI Removal
If your down payment is under 20%, you’ll pay PMI each month until you reach 20% equity. With FHA loans, PMI drops off once you hit 78% loan-to-value regardless of down payment percentage. Conventional loans have stricter requirements to remove PMI.
5. No First Time Homebuyer Programs
Government loans like FHA and USDA offer special loans and grants for first time buyers. Conventional loans do not offer these types of targeted products. Down payment assistance can be harder to find.
Is a Conventional Loan Right for You?
Conventional loans offer competitive interest rates and provide more financing power in high-cost markets. But make sure you can meet the stricter credit, income and down payment requirements before applying. Also factor in the higher upfront fees and down payment requirements compared to government loan alternatives. Do the math to determine the monthly and long-term costs between loan options.
While conventional lending standards have loosened up in recent years, they still remain tighter than government-backed loans. Work to improve your credit score and expand your savings for a down payment to boost your chances of approval. Get pre-qualified by multiple lenders to find your best available interest rate. With the right research and preparation, a conventional loan can be an affordable path to homeownership.
Conclusion
Purchasing a new home is a big commitment. Conventional mortgages provide a balanced option combining competitive interest rates with more flexibility than government loans. To determine if a conventional loan is your best choice, compare total costs including fees, insurance requirements, and loan limits across all your available financing options. Look closely at the loan terms to find one that aligns with your current financial standing and long-term home financing goals. With an adjustable rate mortgage lender, you gain lower initial payments but accept the risk of higher future rates. Weigh the pros and cons carefully for your situation.
