What Is a Conventional Loan?

Conventional Loans Explained

Image shows a few small houses. Text reads: "Types of conventional loans for homebuyers: conventional portfolio loans: held directly by mortgage lenders. amortized conventional loans: prize the term of the loan and loan-to-value ratio. sub-prime conventional loans: for borrowers with poor credit, offers high interest rates and fees. adjustable conventional loans: interest rate is adjusted periodically to keep pace with the economy"

Melissa Ling / The Balance  

A conventional loan is a mortgage loan that a homebuyer receives from a private non-government lender. There are many types of conventional loans available. Since they come from private sources, they vary in terms of borrower eligibility, interest rates, term length, loan limits, down payment threshold, and more.

If you are in the market to buy a home, you can find conventional mortgage loan offerings through banks or mortgage brokers. You'll have many options to choose from, so before taking steps to qualify, prepare yourself by learning about the many types of conventional loans and how they differ from those offered by government programs.

Definition and Examples of Conventional Loans

Conventional loans are any type of mortgage loan that is not offered or insured by a government entity as part of a specific program. Private lenders can set the loan terms, including eligibility or qualification criteria, interest rates, down payment thresholds, payment schedule, and more. Mortgage loans that are regulated by the government, on the other hand, conform to strict guidelines surrounding borrower eligibility, interest rates, and loan limits. Conventional loans may or may not follow government-sponsored entity (GSE) guidelines, and they can further be categorized into two types: conforming and non-conforming.

  • Alternate names: Conventional mortgage loans; Non-government loans
  • Acronym: Non-GSE loans

Conforming loans—those that conform to GSE guidelines—are limited to $647,200 in most counties or up to $970,800 in high-cost counties (in 2022). This number is generally adjusted annually by the Federal Housing Finance Agency. In addition, the minimum credit score for a good interest rate is typically higher than those required for government loans.

Loans that exceed the limits set by the GSE guidelines are considered agency loans and are sometimes referred to as non-conforming or jumbo loans.

How Conventional Loans Work

Mortgage brokers carry a vast array of products, including conventional loans. A bank can make a conventional loan, too, but a bank's product line is generally limited and particular to only that bank. A mortgage broker can broker loans through any number of banks.

Many of the exotic types of loans vanished after the mortgage meltdown of 2007, but conventional loans remained. In fact, they regained a prominent position in real estate markets. Conventional loans enjoy a reputation for being safe, and there is a variety from which to choose.

To get a conventional mortgage loan, you'll need to apply at your bank, credit union, or mortgage broker. The application process will include a thorough credit check and any other requirements set by the particular lender, such as cosigner information and mortgage insurance.

If you are approved, your loan will dictate the terms of the down payment, as well as all future payments, at the interest rate and for the term length.

Conventional Loans vs. Government Loans

The main difference between a conventional loan and other mortgage types is that a conventional loan isn't made by or insured by a government entity. They're also sometimes referred to as non-GSE loans.

Conventional loans aren't particularly generous or creative regarding credit score flaws, loan-to-value ratios, or down payments. There's generally not a lot of wiggle room here when it comes to qualifying.

Government loans include Fair Housing Administration (FHA) and Veterans Association (VA) loans. The government insures FHA loans and backs VA loans. Down-payment requirements are much more buyer-friendly. The minimum down payment for an FHA loan is 3.5%. The minimum down payment can be zero for VA loans to qualifying veterans. The U.S. Department of Agriculture offers USDA loans if you want to buy rural property and are eligible.

Conventional loans Government loans
Private lenders and insurers Lender or insurer is a government entity
Usually require higher down payments Down payment requirements are low to accommodate certain homebuyers
Buyers with low credit may not qualify or may have higher interest rates Available to borrowers with low credit

Types of Conventional Loans

There are several types of conventional loans you might come across if you're in the market for a home.

Conventional 'Portfolio' Loans

These are a subset of conventional loans held directly by mortgage lenders. They're not sold to investors like other conventional loans are. Therefore, lenders can set their guidelines for these mortgages, which can sometimes make it a little easier for borrowers to qualify.

Sub-Prime Conventional Loans

Like other industries, mortgage lenders have been known to offer a special class of loans to borrowers with lower credit scores. The government sets guidelines for marketing these "sub-prime" loans, but that's the end of any government involvement. These, too, are conventional loans, and the interest rates and associated fees are often quite high.

Amortized Conventional Loans

Homebuyers can take out an amortized conventional loan from a bank, a savings and loan, a credit union, or a mortgage broker that funds its loans or brokers them. Two important factors are the term of the loan and the loan-to-value ratio. Some examples of terms and LTVs you might see are:

  • 97% LTV with a common 30-year term (or 20, 15, or 10)
  • 95% LTV with a common 30-year term (or 20, 15, or 10)
  • 90% LTV with a common 30-year term (or 20, 15, or 10)
  • 85% LTV with a common 30-year term (or 20, 15, or 10)
  • 80% LTV with a common 30-year term (or 20, 15, or 10)

The loan-to-value ratio indicates how much the loan represents the property's value. A $200,000 mortgage against a property that appraises for $250,000 results in an LTV of 80%: the $200,000 mortgage divided by the $250,000 value.

The LTV can be less than 80%, but lenders require that borrowers pay for private mortgage insurance when the LTV is greater than 80%. Some conventional loan products allow the lender to pay for private mortgage insurance, but this is rare.

A fully amortized conventional loan is a mortgage in which the amount of principal and interest paid every month changes over time, with more interest being paid than principle initially. For example, your monthly payments might be $1,266.71. Your lender could split it so that $329.21 went towards the principle and $937.50 toward interest. Every month, the ratio of principal to interest would change, with more being applied to principal and less to interest until eventually, you're paying more on the principal than on interest.

A loan's term can be longer or shorter, depending on the borrower's qualifications. For example, a borrower might qualify for a rare 40-year term, which would significantly lower the payments. Conversely, a 20-year loan would raise the payments.

It's important to understand how term length affects payments. A $200,000 loan at 6% interest with a 20-year term would result in payments of $1,432.86 per month, whereas a $200,000 loan at 6% interest with a 30-year term would result in a payment of $1,199.10 per month. A $200,000 loan at 6% interest with a 40-year term would result in a payment of $1,100.43 per month.

Adjustable Conventional Loans

Payments on an adjustable-rate conventional loan (also called an adjustable-rate mortgage, or ARM) can fluctuate because the interest rate is adjusted periodically to keep pace with the economy.

Some loans are fixed for a certain period; they turn into adjustable-rate loans when it is over. For example, a 3/1 30-year ARM is fixed for three years. It then begins to adjust for the remaining 27 years. A 5/1 ARM is fixed for the first five years. A 7/1 ARM is fixed for seven years before it begins to adjust.

Features of an Adjustable Conventional Loan

Many borrowers shy away from adjustable rate conventional loans. Instead, they prefer to stick with traditional amortized loans, so there are no surprises concerning mortgage payments due down the road. But an adjustable-rate mortgage might be just the ticket to help with the early years of payments for borrowers whose incomes are expected to increase.

The initial interest rate is typically lower than the rate for a fixed-rate loan, and there's usually a maximum, known as a cap rate, on how much the loan can adjust over its lifetime. The interest rate is determined by adding a margin rate to the index rate. Adjustment periods can be monthly, quarterly, every six months, or yearly.

Key Takeaways

  • Mortgage loans offered by private sources are called "conventional loans" or "non-GSE loans" and come in many forms.
  • Loans offered by the Fair Housing Administration (FHA) or secured by the Veterans Association (VA) are two examples of government loans.
  • The loan-to-value ratio measures the amount a borrower needs to finance a home against its appraised value, affecting some loan terms.
  • Interest rates for conventional loans can be fixed, adjustable, or convertible in some cases.