Conventional loans are by far the most popular choice among home buyers. Conventional loans are those underwritten to standards set forth by Fannie Mae and Freddie Mac. When a loan is approved using these guidelines it is then eligible for sale in the secondary markets. Selling a loan allows the lender to continue making mortgages. Today, nearly two out of every three home loans made are conventional mortgages. Individual lenders originate and approve conventional mortgages, Fannie and Freddie are not involved.
Basic Guidelines for Conventional Loan Approval
The primary purpose of Fannie and Freddie is to provide liquidity in the mortgage marketplace. This liquidity is achieved upon the sale of the mortgage. Most every conventional mortgage is sold directly to Fannie Mae or Freddie Mac. Conventional loans can also be used to finance a non-owner occupied property such as a rental property, vacation home or investment property. Conventional loans ask for a down payment of at least 5.0 percent, although there are special conventional programs designed for first time buyers that ask for a down payment of just 3.0 percent.
With a down payment of less than 20 percent however, private mortgage insurance, or PMI, is required. PMI is an insurance policy that protects the lender in the case of default. If a default does occur, the lender is compensated for the difference between 80 percent of the value of the home and the down payment. If the down payment is 5.0 percent, the compensation would then be 15 percent.
Lenders are required to determine a borrower’s ability to repay a new mortgage. This is first done by calculating qualifying monthly income. Borrowers will be asked to supply copies of the most recent pay check stubs covering a 30 day period. The pay check stubs should show both a monthly amount as well as a year-to-date total. Because conventional guidelines ask for verification of at least two years of employment, the last two years of W2 forms will be needed.
For those that are self-employed or receive more than 25 percent of monthly income from sources other than an employer, the last two years of federal income tax returns will be required. In addition, the most recent profit and loss statement will be included in the file. The lender will then average both the income on the tax returns as well as the profit and loss statement.
As part of the affordability review, monthly debt is also reviewed. Qualifying debt includes those payments listed on a credit report, both installment and revolving. This debt is used when comparing debt to qualifying income to arrive at a percentage, or debt ratio. There are two separate ratios used with conventional loans, a housing ratio and a total debt ratio.
The housing ratio compares the total monthly payment which includes an amount for principal and interest, taxes and insurance. The secondary ratio is the total debt ratio which includes the housing payment plus other installment and revolving debt payments. Conventional debt ratio requirements vary widely with conventional loans and can vary based upon the amount of down payment. A common debt ratio requirement for housing can be 28-33 percent and the total ratio at 38-45 percent. These are guidelines only and the lender has the authority to approve loans with higher ratios, up to 50 percent of qualifying income, given other positive factors included and highlighted in the loan file.
The minimum credit score for most conventional loans is 620. There are three credit scores, one each from Equifax, Experian and TransUnion. Of the three scores, the lender uses the middle score, ignoring the highest and lowest scores. This minimum credit score can vary based upon the amount of down payment.
A conventional loan can be used to finance a single family home as well as a 2-4 unit property, such as a duplex or four-unit property as long as the applicant intends to occupy one of the attached units. Conventional loans can be used to finance a primary residence, secondary or vacation home or a rental or investment property.
The value of the property must be supported by a property appraisal performed by a licensed residential property appraiser. The appraisal must include recordings of at least three sales of similar properties in the area that have sold within the previous 12 months and within one mile of the property being financed. Conventional loans can also be used to finance a condominium unit.
The types of conventional loans is vast. The most popular form of financing using a conventional loan is the standard 30 year fixed rate loan. The second most popular is the 15 year loan with other loan terms available including 10, 20 and 25 year terms.
Conventional mortgages are also offered as adjustable rate loans either in the form of an ARM which can adjust every six or twelve months or a hybrid which has an initial fixed rate term such as three or five years before switching to a loan that can adjust every six or twelve months.