Go Spokane Real Estate

The Conventional Home Loan

A conventional home loan is a mortgage that is not guaranteed or insured by the federal government. Normally when people refer to a conventional loan they also mean a conforming loan. A conforming conventional loan will conform to the terms and conditions set forth by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are government sponsored enterprises that buy mortgages on the secondary market.

The government sponsored enterprises are not the only players on the secondary market for this type of loan but they are by far the biggest. Because of this, loans that conform to their standards are easier to trade, therefore will have lower interest rates.

Advantages to a Conventional Loan

Conventional loans are a very good option for well qualified buyers. They will likely have lower interest rates than government backed loans such as FHA and VA. Because they do not have a funding fee, the initial loan costs may be lower too.

They will probably require a little higher credit score, and still higher with less than 20% down due to mortgage insurance. Conventional loans will also have a more conservative debt to income ratio.

Maximum Loan Amount

Maximum loan amount of a conforming conventional mortgage in Spokane County for a single family home is $510,400. For a duplex or 2 unit residence the limit is $653,550. For a 3 unit residence the limit is $789,950 and a 4 unit it is $981,700. These loan limits are the same for owner occupied or investment properties.

If you need to borrow more than that, you may apply for a jumbo loan. A jumbo loan is a nonconforming conventional loan for more than the conforming amount. The interest rate will be higher than a conforming loan because it is not as easy to sell on the secondary mortgage market.

Debt to Income Ratio

How much you can borrow with a conforming conventional loan depends on what your debt to income ratio is. For a conforming loan you want your debt to income ratio to be no higher than 28/36. The debt to income ratio is expressed as 28/36 because there are two important numbers to consider when discussing your debt to income ratio.

The first number is your total housing expenses divided by your gross monthly income. Total housing expenses means the total of this new liability that you will be taking on. This will include principle and interest payment, as well as property taxes, homeowners insurance, mortgage insurance, and any homeowner's association dues. This total must not exceed 28% of your gross monthly income. Your gross monthly income is your total monthly income before taxes.

The second number is total monthly recurring debt divided by gross monthly income. Total recurring debt includes all the housing expenses as discussed above as well as auto loans, student loans, credit card payments, and any other monthly recurring debt. This only includes debt, not living expenses like food and utilities. The total on these expenses may not exceed 36% of your gross monthly income.

You may notice that the debt to income ratios to qualify for conventional loans are a little more conservative than the ones for the government backed loans.

Credit Requirements

Minimum credit score for a conforming loan with 20% down is 620 but this will vary from lender to lender. It will be difficult to find a conventional home loan with a low credit score and the interest rate will likely be higher than the government backed loans. With higher credit scores the borrower will qualify for lower interest rates. Less than 20% down or higher than 80% loan to value ratio will require Private Mortgage Insurance (PMI).

Lenders will get credit reports from all three credit reporting services. They will most likely take the middle credit score to qualify a borrower. If there are co-borrowers on the loan, they will take the middle score of both borrowers, and use the lower score of the two.

Down Payment Requirements

There are conventional home loans available for as little as 3% down, which is a 97% loan to value ratio. Lower loan to value ratios generally mean better loan terms with lower interest.

Non owner occupied property requires a higher down payment and the loan will also likely have a higher interest rate. Lenders have found that borrowers are less likely to default on their primary residence.

Conforming conventional loans do not allow for gifted down payments, meaning that a relative may not give the buyer the money for the down payment. Bank accounts will be scrutinized for at least two months prior to the acceptance of the offer until closing. All bank deposits need to be accounted for.

Mortgage Insurance

Mortgage insurance is designed to protect the lender against losses if a borrower defaults on their loan and the foreclosure sale of the property does not net enough to cover the loan.

Conventional loans made on home purchases with less than 20% down payment require Private Mortgage Insurance (PMI). Conventional refinances made with less than 20% equity or greater than 80% loan to value ratio also require mortgage insurance.

Lower down payments require mortgage insurance for two reasons. Lenders have found that borrowers are less likely to default on a loan when they have a higher vested interest. Also with lower than 80% loan to value, it would be easier to net enough on a foreclosure sale to cover the loan amount.

The cost of mortgage insurance will vary quite a bit. The mortgage insurance cost with a 15% down payment will be significantly less than a 5% down payment. The cost of mortgage insurance will also vary depending on credit scores.

The mortgage insurance will likely require a higher credit score than the loan itself. It would not be uncommon for the loan to require a minimum credit score of 680 but the mortgage insurance to require a 720.

Closing Costs

There are closing costs associated with conventional home loans. This is the money paid by the buyer at closing in addition to the down payment. Closing costs include: loan origination fees, interest rate buy down points, prepaid interest, appraisal, title insurance, escrow fees, property taxes and prepaid homeowner’s insurance.

Some closing costs are fixed, some depend on the amount of the loan, and some are proportional to the value of the property. Some closing costs even depend on when you close. You will receive a "Good Faith" estimate of closing cost but it will probably be a little different than your actual costs, though it should be quite close. A closing date moved up or back just a day or two will change your closing costs.

You can approximate an additional 3% to 4% on top of the borrowed amount for closing costs on most loans. Closing costs are discussed in greater detail in the article titled Closing Costs.

Types of Property

Conventional home loans are for residential real property. They can be used for houses, condominiums, town homes, and even rural property with a home on it. They can even be used to buy a manufactured home on land. This property can be used as a primary residence, a vacation home, or an investment property.

You can use a conventional home loan to purchase a multi family residence up to four units. In other words, you can buy a duplex, tri-plex or a four-plex.

You may not buy a five or more unit apartment building or any other type of commercial property with this type of loan. Additionally conventional loans may not be used for raw land or manufactured homes on leased land.

Adjustable Rate Mortgage

Most conventional loans are fixed rate loans. With a fixed rate loan the interest rate does not change. Your principal and interest payment stay the same throughout the life of the loan. An adjustable rate mortgage (ARM) will have an interest rate that changes throughout the term of the loan. An adjustable rate loan can still be a conforming loan.

Initially this interest rate with an ARM will be lower than comparable fixed rate loans therefore will have a lower monthly payment. This low interest rate remains fixed at that lower rate for a period of time but not the life of the loan. It is common for an adjustable rate mortgage to remain fixed for a period of time. To denote the period of time the loan has a fixed rate, these loans are referred to as 3-year, 5-year, or 7-year ARMs.

This lower payment will most likely change after the initial fixed period because the interest rate is adjustable. The lender cannot just arbitrarily raise the interest rate to whatever they want. It is usually attached to the Constant Maturity Treasury Index, or the London Interbank Offered Rate Index. The loan agreement will also have limits on how often and how much the interest rate may change, as well as a cap on how high it can go.

Initially the payments on an adjustable rate mortgage are lower, but over the life of the loan you will pay more. If you were only going to keep your home for a few years, an ARM may be a better choice. If the interest rates were high, financing with an ARM to lower your payments with plans to refinance down the road may work to your advantage.

written by:Todd Hays