Conventional Loans 101
Updated January 2017
Are you ready to purchase a home? If so, you probably have many questions about the financing that is available to you. One of the most popular options is the conventional loan. This loan is the most popular choice for those applicants with decent credit and an average debt-to-income ratio because it does not have a lot of fees and most importantly, the private mortgage insurance can be cancelled as you gain equity in your home.
Conventional loans are not just used for the purchase of your primary home; they can also be used to purchase a second home or investment property. Generally they are a fixed rate loan, but they are also available as adjustable rate mortgages. They are available in a variety of terms including 15, 20, and 30-year terms and have programs that require as little as 3 percent down for the down payment.
What is PMI?
Private mortgage insurance, or PMI, is what you will have to pay if you put less than 20 percent of the price of the house down. For example, if the home is $250,000, you need to put down $50,000 to be at 20 percent. If you put less than that $50,000 down, you will have to pay private mortgage insurance, which is how the bank is backed up if you were to default on the loan. This is done because the lower the amount of equity you have in the home, the more likely it is that you will default. Rather than declining your request for the loan, the lender issues mortgage insurance, which you pay the premium for every month. This is done until your home reaches lower than an 80 percent loan-to-value ratio, at which point it can be canceled.
The General Requirements
Every lender will be different when it comes to their requirements for a conventional loan. In most cases, a credit score of at least 680 is necessary in order to qualify. Some lenders who are willing to take a certain level of risk, will allow a lower credit score, but you will pay for it in other areas. For instance, you may have a higher interest rate than someone with a higher credit score or you will have to pay a fee, such as an origination fee in order to make up for the risk level of your loan. Most areas will also be restricted to a loan amount of $417,000 or lower, with the exception of certain high cost areas, which will allow a higher maximum loan amount.
After your credit score, your debt-to-income ratio is the second most important thing that will make or break your financing deal. The lender will look at two things: your front end and back end ratio. The front end ratio is tacitly your mortgage, interest, taxes, and insurance (including MIP) payments. The back end ratio is the front end ratio plus your other monthly obligations, such as any installment loans, credit card payments, and student loans. In general, banks want your front end ratio to be 28 percent and the back end to be no more than 38 percent, but some will go higher as long as you have compensating factors, such as a large amount of assets, employment duration, or a high credit score. You need to show the bank that you are responsible with your money and are able to make the payments for the money you will owe them.
If you are looking to get a conventional loan, take the time to look at your financial picture. Do you have good credit or do you have too much outstanding balance that is bringing your score down? Do you have enough money to put 20 percent down or are you comfortable paying MIP? These are the things you need to consider. If you have not been at your job for a long time or you do not have a lot of assets, combined with a poor credit score, it is time to start reevaluating and making things right before you apply.