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 type of mortgage loan that a homebuyer receives from a private non-government lender. There are many types of conventional loans available, and 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 their own 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 follow these government sponsored entity (GSE) guidelines, or not, and so 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 $483, 350 in most counties, or up to $726,525 in high-cost counties, as of 2021. This number can be adjusted annually. A 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 loans. Some up to $2 million are called "jumbo loans," and the interest rates are typically higher here, too.

How Conventional Loans Work

Mortgage brokers carry a vast array of products, including those tired and boring old 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 were still there. 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 with 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 types of mortgages 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—not a non-government sponsored entity.

Conventional loans aren't particularly generous or creative when it comes to 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. They are what they are.

Government loans include Fair Housing Administration (FHA) and Veterans Association (VA) loans. An FHA loan is insured by the government, and a VA loan is backed by the government. 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. If you want to buy rural property, the U.S. Department of Agriculture offers USDA loans for eligible homebuyers.

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

Conventional "Portfolio" Loans

These are a subset of conventional loans that are held directly by mortgage lenders. They're not sold to investors as 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 iffy or even poor credit. The government sets guidelines for the marketing of these "sub-prime" loans, but that's the beginning and 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:

  • 97 percent LTV with a common 30-year term (or 20, 15, or 10)
  • 95 percent LTV with a common 30-year term (or 20, 15, or 10)
  • 90 percent LTV with a common 30-year term (or 20, 15, or 10)
  • 85 percent LTV with a common 30-year term (or 20, 15, or 10)
  • 80 percent 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 percent: the $200,000 mortgage divided by the $250,000 value.

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

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

For example, that $200,000 loan at 6 percent payable over 20 years would result in payments of $1,432.86 per month, whereas a $200,000 loan at 6 percent payable over 30 years would result in a payment of $1,199.10 per month. A $200,000 loan at 6 percent payable over 40 years would result in a payment of $1,100.43 per month.

A fully amortized conventional loan is a mortgage in which the same amount of principal and interest is paid every month from the beginning of the loan to the end. The last payment pays off the loan in full. There is no balloon payment.

Adjustable Conventional Loans

Payments on an adjustable-rate conventional loan means can fluctuate because the interest rate is adjusted periodically to keep pace with the economy.

Some loans are fixed for a certain period, then they turn into adjustable-rate loans. For example, a 3/1 30-year ARM is fixed for three years. Then it 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. 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 can be 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 every year.

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, and can affect some loan terms.
  • Interest rates for conventional loans can be fixed, adjustable, or convertible in some cases.