Conventional Loan

A conventional loan is a mortgage that is not insured by the federal government. This type of loan was the first kind of established mortgage loan made by various local lenders. The lenders kept these loans within their investment portfolio until they were either paid-off or foreclosed on. This practice was not in the best financial interest of the lender, because when interest rates went up, the lender would receive below-market interest on the loans they held. Also, the funds could not be used to create loans for other borrowers. The introduction of the secondary market in the late 1930’s allowed lenders to get together and sell their loan portfolios. Thus they could use the funds to make loans to other borrowers. Although many lenders today keep their loans within their portfolios, many sell them to the secondary market.

There are many advantages for the borrower of a conventional loan:

  • More underwriting flexibility when the loan stays in the lenders investment portfolio. There are no secondary market guidelines to meet.
  • Loan fees can be better negotiated or even eliminated by the lender.
  • Collateral other than the property being mortgaged can be used.
  • You might be able to finance personal property with this type of real estate loan
  • Appraisals only have to meet the lender’s guidelines if the loan is held within their financial portfolio or the guidelines of the secondary market if the loan is sold. The appraisal standards of the Federal Housing Administration FHA and those of the Veterans Administration VA are quite strict.
  • The difficulty of obtaining Private Mortgage Insurance (PMI) can be avoided if the lender self-insures the loan. In this case the interest rate of the loan would increase because the lender is taking on a higher risk.
  • The lender may be willing to fund a portion of the closing costs in exchange for a higher loan interest rate.
  • The borrower may receive more innovative financing options when the lender holds the loan within a portfolio.

Conventional loans may also have some disadvantages for the borrower:

  • A larger down payment is usually required with a conventional loan.
  • A lender can set his own interest rates and they can exceed those of FHA or VA loans
  • Individual lenders can set their own origination fee and any other fees, thus they could be higher than those set by other programs.
  • The lender could specify certain clauses within a mortgage contract. These could include alienation (due-on-sale), prepayment penalty, or acceleration clauses.
  • If a loan has a greater than 80% loan-to-value ratio (LTV) then the lender will require the purchase of Private Mortgage Insurance.
  • Nonrefundable application or processing fees may be required by the lender.
  • Innovative financing options may not be made available to the borrower.

A Conventional mortgage allows that the rules regarding what the lender can and can’t do to be determined by the loan and its’ final destination. If loans are being sold to the secondary market, then there are only one set of rules to be adhered to. For instance if a borrower want Private Mortgage Insurance, different rules will apply. Today, a majority of conventional loan are sold to the secondary market, thus these guidelines have become the general standard for these types of loans.

FHA vs. Conventional Loans
FHA Loans have several advantages over conventional loans, including lower down payments and more relaxed credit-qualifying guidelines. The federal government created FHA loan programs to encourage homeownership throughout the country. The FHA can help people to obtain a loan with little or no down payment. The FHA does not supply the loan; it simply insures the loan to limit the risk to the lender.

Benefits of a FHA mortgage:

  • A 3% down payment, as opposed to a 5% down payment on traditional loans
  • Low monthly mortgage insurance
  • Low closing costs, which are regulated by HUD
  • No credit score requirements
  • Qualify for a loan two years after a bankruptcy
  • Qualify for a loan three years after a foreclosure

The FHA loan guidelines are more relaxed than conventional loan guidelines; this includes less strict regulations about past bankruptcies and/or foreclosures, job requirements, use of alternative credit, and debt-to-income ratios. The FHA ensures that their interest rates remain competitive with the interest rates of conventional loans. FHA loans were originally created to help first-time buyers; people who are not first-time buyers may qualify, however, the FHA does not allow anyone to have more than one FHA-insured loan at a time. The borrower is required to pay an insurance premium upfront, but this premium can be financed into the loan amount directly. The borrower must also pay a monthly premium, which is .5% of the total loan amount divided equally over 12 months. Unlike a conventional loan, the FHA requires a termite report and clearance, as well as a few other property condition standards, to qualify for a loan.