Definition
A conventional loan is a type of mortgage loan that is not insured or guaranteed by the federal government. Instead, it’s backed by private lenders, and its insurance is usually paid by the borrower. These types of loans may have fixed or variable interest rates and are often stricter in their underwriting procedures compared to government-backed loans.
Key Takeaways
- A Conventional Loan is a type of mortgage loan that is not guaranteed or insured by any government agency. This includes the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), and the United States Department of Agriculture (USDA).
- Conventional Loans often require a higher credit score and a larger down payment than government-insured loans. However, they typically come with lower interest rates and fewer fees, making them more cost-effective in the long run if you can meet their requirements.
- There are two types of conventional loans: conforming and non-conforming. Conforming loans follow the terms and conditions set by government-sponsored organizations Fannie Mae and Freddie Mac, while non-conforming loans are those that don’t meet these guidelines, often referred to as jumbo loans.
Importance
Conventional Loan is a critical finance term because it represents one of the most common types of mortgage loans in the financial market. This loan is synonymous with traditional lending mechanisms where the loan is not guaranteed or insured by any government entity but is instead offered by private lenders such as banks, credit unions, or mortgage companies.
Its importance also lies in its flexible terms, interest rates, loan amounts, and repayment periods, which often adhere to the standards set by Freddie Mac and Fannie Mae. Furthermore, the borrower’s credit score, income level, and down payment capacity significantly influence the terms of a conventional loan, making it central to personal finance management and real estate purchases.
It promotes the reduction of risk for lenders while upholding purchasing power for qualified borrowers. Therefore, understanding conventional loans can provide an individual with a robust perspective on their mortgage options.
Explanation
Conventional loans fulfill a crucial role in the pursuit of homeownership and real estate investments by serving as the most common type of mortgage loan used by home buyers. They are offered by private lenders (banks, credit unions, mortgage companies) without any government backing, making them different from options like Federal Housing Administration (FHA) loans.
In essence, these loans are designed to facilitate the purchase of residential property by providing the necessary financing to those who meet the standard credit and income requirements set by lenders. The primary use of conventional loans is the purchase of permanent residences, vacation homes, or investment properties.
Individuals may also use this type of loan when they wish to borrow money against the equity in their home, which is known as cash-out refinancing. They can take out a conventional loan for a fixed term, typically 15 to 30 years, with interest rates that can be either fixed or variable.
Unlike some government-backed loans, conventional loans accept varying levels of down payments and often come with fewer restrictions, making them a flexible and versatile home financing option for a wide range of prospective borrowers.
Examples of Conventional Loan
Home Purchase: John is interested in buying a new house which is priced at $300,
He doesn’t have the cash for the entire amount and so he chooses to apply for a conventional mortgage loan. He goes to the bank, meets all their credit and income requirements, and gets approved for the loan. He put 20% down payment, which means he avoids paying for private mortgage insurance (PMI) and the rest of the amount is financed through the loan which he repays over a period of 30 years.
Small Business Loan: Maria wants to start her own bakery. She has a solid business plan and some savings but she needs an extra $50,000 to buy equipment and secure a location. Maria applies for a conventional loan from her local bank with her business plan. The bank reviews her credit score, business plan, and financials and approves her for the loan.
Auto Loan: Steve wants to buy a new car, which is priced at $25,
Steve doesn’t want to deplete his savings, so he decides to finance the car and makes a 10% down payment. He then secures a conventional auto loan from his credit union to cover the rest of the cost. The loan has a specific term (e.g. 60 months) and a fixed interest rate. Steve makes monthly payments until the loan is paid off.
FAQs on Conventional Loan
What is a conventional Loan?
A conventional loan is a type of mortgage loan that is not insured or guaranteed by the government. Instead, the loan is backed by private lenders, and its insurance is usually paid by the borrower.
What are the advantages of a conventional loan?
Conventional loans can be used to buy a primary home, second home, or rental property. They are available in a variety of terms and may come with either fixed or adjustable interest rates. If you can make a down payment of 20%, you may be able to avoid paying for private mortgage insurance (PMI).
What is the difference between a conventional loan and an FHA loan?
Conventional loans are not backed by the government, whereas Federal Housing Administration (FHA) loans are. FHA loans typically have lower credit score requirements, making them an excellent option for first-time home buyers or those with less-than-stellar credit. However, borrowers must pay a mortgage insurance premium with FHA loans, which is not required with conventional loans.
What are the eligibility criteria for a conventional loan?
Eligibility for a conventional loan depends on several factors, including your credit score, income, debt-to-income ratio, and the size of your down payment. Generally, you’ll need a credit score of at least 620 and a down payment of at least 3%. However, a larger down payment can offer you better terms and rates.
What is the maximum loan limit for a conventional loan?
Conventional loan limits are set by Federal Housing Finance Agency (FHFA). As of 2021, the maximum loan limit for a conventional loan in most areas of the U.S. is $548,250 for a single-family home. However, in high-cost areas, the limit can be as high as $822,375.
Related Entrepreneurship Terms
- Fixed-Rate Mortgage
- Private Mortgage Insurance (PMI)
- Loan-to-Value Ratio (LTV)
- Down Payment
- Credit Score
Sources for More Information
- Investopedia: An extensive online resource for understanding and improving knowledge about finance and investment terms including Conventional Loans.
- Bankrate: An online aggregator of financial rate information, also providing in-depth articles about various finance related topics like Conventional Loans.
- Consumer Financial Protection Bureau: A U.S. government agency that provides detailed information and helps consumers understand financial terminology and concepts, including Conventional Loans.
- NerdWallet: Offers in-depth insights, advice, tools, and guides for financial products and terms, including Conventional Loans.
