When you think of the word “conventional,” I know it brings to mind images of things that are considered “normal” or “standard” in our culture. That kind of thinking has caused a great deal of confusion among mortgage-seekers for a very long time because a Conventional mortgage isn’t the default choice for many buyers. For example, military families will often do much better with a VA loan, first time buyers may find their credit will only support an FHA loan and folks in rural America can often get amazing deals through the USDA.
Conventional mortgages are often called “conforming” loans because that’s exactly what they are — loans that conform to specific guidelines. The guidelines in question come from the Federal National Mortgage Association (Fannie Mae), one of two entities that guarantees and purchases these loans on the secondary market (the other is Freddie Mac, also a government-sponsored company).
Although the guidelines for Conventional mortgages are issued in a formal document, they’re open to interpretation by lenders, who often add mortgage overlays to further limit the pool of eligible buyers. Lenders don’t do this because they’re mean or they’re conspiring against the American people — it’s all about risk avoidance. In short: they don’t want to get your house back, so they’re going to ensure you’re ready to buy. And there’s no program where this is clearer than with a Conventional mortgage.
Who Should Get a Conventional Mortgage?
As I stated above, Conventional mortgages aren’t the best option for everyone, although that’s what a lot of sources would have you believe. In fact, there’s a fairly narrow description of buyers who will benefit most from the Conventional mortgage. That’s why if you sit down with your local loan officer to discuss your mortgage options, he might not even bring them up.
In general, an ideal candidate is:
Well-established in their career. In general, banks want to see that you’ve been working in the same career field for an extended period of time to ensure that you’re going to be able to pay the mortgage in the future. Many banks look for at least two years of continuous employment or two filed tax returns for self-employment or business ownership. However, I’d not be shocked if a bank wanted to see more documentation to reduce their risk if your career field was one that was still experiencing employment contraction.
An experienced homeowner. Although you can qualify for a conventional mortgage without having owned a home before, the additional punch that a mortgage adds to your credit file can help push your score high enough to make qualifying a slam dunk. Fannie Mae guidelines allow for the use of alternative credit, but you’ll have to be squeaky clean otherwise before you even try this move, and even then it’s a process.
A dedicated saver. I know how hard it is to put back a nickle these days, but a Conventional loan is for those kids who can pinch pennies. Often, a bank issuing a Conventional loan will want to see that you have some back up funds so you can continue to pay your mortgage even during a rough patch. On top of that, you’ll also need cash funds to pay your own down payment and any closing costs that exceed the allowed three percent of your future home’s value.
These are the kinds of people who qualify easily for Conventional mortgages and do really well with them. In exchange for the relatively low risk of foreclosure these borrowers pose, they get a significantly reduced rate on mortgage insurance, lowering their overall mortgage payment. Hooray for them!
Getting Ready To Go Conventional
If you want to be one of those Conventional mortgage holders, you’re going to have to do your homework, you’re going to have to really make an effort and you’re going to have to pay very close attention to your financial life for a while. You can do it, anybody can, given a long enough time frame, but it demands sacrifice and commitment. Understand that qualifying for a Conventional mortgage can take time, so be patient as you work on these things:
Your Credit. Conventional loans have some of the strictest credit requirements of any mortgage program. You have to be free of late pays, collections, judgments and bankruptcy before you’ll be considered a good candidate. Usually if there’s a collection item uncovered during your application process, your lender will require that you pay it at or before closing. Do yourself a favor and get a free credit report, check it for accuracy, dispute anything you don’t recognize and make a plan for paying off any bad debt.
If you had to dispute more than one or two things, it may pay to subscribe to your credit report through Fair Isaac’s MyFICO. Normally, I’d not make a specific recommendation like that, but because this is the company that literally designed the FICO scoring process, this is the place to be for the most accurate scoring. I actually used them before our home purchase and their tool helped me increase my score significantly.
Saving Money. Budgeting and saving isn’t easy these days, I know. However, if you want to qualify for a Conventional mortgage, you’ll need to show that you have the money in your bank account to close and that it didn’t just fall from the sky. Start saving today, make a plan and stick to it. Every month you hit your goal is a month that you’re closer to your homeownership goals. Remember, you can’t have a seller pay more than three percent of the home’s value in closing costs, so you’ll need funds to close on top of that down payment and it all has to be verifiable the day you apply.
Gift funds are an exception to this rule, but I strongly caution against using them unless you have a lot of time and very flexible parents. Gift funds are difficult to handle, legally and within the confines of a mortgage application, and add additional pain and suffering to the process. Not only will your money need to be verified, your gift funds will be, too. Use them if you must, but realize you may need extra time to close if your parents aren’t on the ball about getting paperwork to the bank.
Establishing Reserves. Your loan product and situation will dictate whether or not you are required to provide reserve funds. With my recent purchase, we were required to have them. In fact, since we were both downsizing and buying a home while owning another home that had yet to be put on the market, the bank wanted proof of six months of reserves for us — it was a shocker. However, we learned something else that day: reserves don’t necessarily have to be cash.
In fact, if your loan requires reserves, look to your investments in stocks, bonds, money market accounts, CDs or trusts, as well as fully vested retirement accounts or insurance policies. Our recent home purchase was the first time we realize the power of my husband’s long-established retirement account habit. He had managed to sock away enough money to cover our steep reserve requirements, much to the shock and amazement of our Realtor.
Eliminating Debt. Debt isn’t your friend, even if it got you through college. When you go to get a Conventional loan, how much debt you have is going to make a huge difference to whether or not you’re approved. The current Eligibility Matrix will allow underwriters to go up to a 45 percent debt to income ratio, however, that 45 percent comes with strings attached — you have to have stellar credit, significant reserves or both.
Consider paying off your car and credit cards during the year you’ll be applying for a mortgage. You want those trade lines to show on your credit report, but with a zero balance, for the biggest impact. With a debt to income ratio of less than 36 percent, a 680 can secure a lower mortgage down payment requirement, barring any bank overlays. It’ll take a 700 or better for the guidelines to allow you to have debt ratio toward the top end once your home closes.
Employment Stability. This isn’t specified in the guidelines, but I happen to know that most banks include employment factors in their overlays. Most will be looking for stable jobs over the long-term, so if you’re temping, substituting or are in some other way part of the “gig economy,” it’s time to find a way to show the bank that you’re for real. Securing full time employment is ideal, but if you’re self-employed and can prove your income is stable or increasing, that’s good, too.
Either type of employment should be in place for at least two years and you should expect a great deal of paperwork to add to the pile if you’re trying to get a Conventional loan while self-employed. If your spouse is employed in a more standard way, consider using their income alone to qualify for the new mortgage — it’ll save you a billion headaches. Make sure to ask your Realtor how this will affect your legal claim on the property before you commit, though. Not all states automatically give spousal stakes in real estate purchases.
Your Home Wishlist. Last, but not least, you really need to know what you want when you dive into a Conventional mortgage. Unlike FHAs, VAs and USDAs, most Conventional programs will loan on just about anything that’s not a smouldering husk of a building. That means that you absolutely need some organized way to approach listings before you even start shopping.
Don’t daydream up an ideal home that no house can be (mine still doesn’t have a fireplace!), but have an idea of what you want. Do you want a house in a particular location or with particular features? Save yourself a huge headache by visiting Open Houses and driving through neighborhoods that you’ll be able to afford before you’re ready to apply for a loan.
The Bottom Line: Conventional Loans Require Planning and Effort, But They Can Be Worth It All
If you’ve decided that a Conventional loan is right for your home purchase, be prepared to dig in for the long term to make it possible. There was a day not that long ago when they were much easier to get, but now it’s a trick — you really have to prove your worth because of a lot of folks who didn’t. I’m sorry about that, but it’s the reality we have now.
However, for the average person, a Conventional loan can offer significant savings over the long term, especially when it comes to mortgage insurance. Unlike an FHA that charges almost twice as much in mortgage insurance premiums and may require that you keep that mortgage insurance for the life of your loan, a Conventional loan has minimal mortgage insurance that will drop when your home reaches a 78 percent loan to value ratio.
Conventional loans are the kind you want to retire with, if you can. They’re the kind of loans people pay off, not the sort that tend to be refinanced to shed ugly features. There’s nothing wrong with an FHA loan for a homebuyer who plans to sell in five or ten years, but it won’t carry you to the end of the road — a Conventional can.