What is a conventional loan and how does it work?

The most common type of mortgage is the conventional loan. So, if you’re house hunting or considering a mortgage refinance, you’ll want to understand what it is and how it works.

A conventional loan isn’t a single type of home loan, rather it’s a catch-all term for mortgages that aren’t government-backed. It includes mortgages with fixed or adjustable interest rates and repayment terms that typically fall between 15 and 30 years. Jumbo loans and commercial loans are also considered conventional mortgages.

No matter what type of property you’re buying, there’s a conventional loan that will suit your needs. But there are tradeoffs with conventional loans and they aren’t as easy to qualify for as mortgages that are backed by the government.

Below, CNBC Select details how conventional mortgages work and the benefits and drawbacks compared to other loan types.

A conventional loan is a type of mortgage that’s not backed by the government. So mortgages backed by the U.S. Department of Veterans Affairs (VA loans) or the Federal Housing Administration (FHA loans) are not conventional loans.

In general, conventional loans have more strict eligibility requirements than government-backed mortgages, the borrower often needs a higher credit score, a larger down payment and a lower debt-to-income ratio (DTI). However, conventional loans are available through nearly every type of private mortgage lender, including banks, credit unions, online lenders and mortgage brokers. This makes it easier to comparison shop for a conventional loan. Some lenders, like Better, don’t charge origination fees and others, like Rocket Mortgage, may be more forgiving if you have a lower credit score.

The two main categories of conventional loans are, conforming loans and non-conforming loans.

A conforming loan is a mortgage that meets, or conforms, to the standards set by the Federal Housing Finance Agency (FHFA). One of the main guidelines a conforming loan must meet is the conforming loan size limit. These limits are set each year and vary depending on the type of property and the area where the property is located. For 2023, the single-family home loan limit is $726,200 for low-cost areas, and goes up to $1,089,300 in high-cost areas.

Any loan that doesn’t meet the FHFA’s standards is considered a nonconforming loan. One of the most common types of nonconforming loans are jumbo loans. A jumbo loan is what you’ll need if the amount you need to borrow exceeds the conforming loan limits for your area. For most places, a mortgage with a balance over $726,200 is a jumbo loan.

The eligibility requirements for conventional loans are as varied as the many types of conventional mortgages that are available. Although, there are general minimum standards and maximum limits to conventional loan requirements.

Credit score

The minimum credit score required for conventional loans is typically 620, but can vary by the lender and loan. Even if you can get a mortgage with bad credit, you’ll want to raise your credit score as much as possible before taking out a home loan. Having a higher credit score allows you to qualify for a larger variety of loans and helps you secure a lower interest rate.

Down payment

Your down payment could be as little as 3% with Freddie Mac Home Possible® or Fannie Mae HomeReady® loans. However, many conventional loans require larger down payments, especially if you’re taking out a jumbo loan, a loan for a multi-family property or purchasing a vacation home.

Debt-to-income ratio (DTI)

Lenders typically prefer a DTI of 43% or less, although there are exceptions to this. Regardless of what DTI a lender allows, experts recommend keeping your monthly mortgage payment under 30% of your gross monthly income.

Private mortgage insurance (PMI)

With conventional loans, you’re usually required to pay private mortgage insurance (PMI) if your down payment is less than 20% of the purchase price. However, it’s easier to get rid of the mortgage insurance on a conventional loan compared to FHA loans. PMI can typically be waived once your loan-to-value ratio drops to 80% or less, which means your mortgage balance is less than 80% of the home’s appraised value. This is accomplished as you pay down your loan balance and the home increases in value.

Loan amount

There are no loan size limits for conventional loans. But if the amount you need to borrow exceeds the conforming loan limits set by the Federal Housing Finance Agency (FHFA), then you’ll need a jumbo loan. Jumbo loans require a larger down payment and typically have more stringent approval guidelines.

In many ways, conventional loans are more simple and more flexible than FHA loans or VA loans. They typically have fewer fees because you don’t have to pay the upfront mortgage insurance premium that’s required with FHA loans or the funding fee that comes with a VA loan. And getting rid of PMI is easier with a conventional loan.

There are drawbacks to conventional loans, the main one being that you’ll typically need stronger finances to qualify. Conventional loans usually have larger down payment requirements and you’ll need a higher credit score compared to government-backed mortgages. This is why they aren’t always the best home loan option for first-time homebuyers.

Pros of conventional loans

• Easier to get rid of mortgage insurance
• Fewer fees
• More flexible loan options
• High loan limits

Cons of conventional loans

• Larger down payment requirements
• Higher credit score minimums
• Stricter approval standards

Conventional loans are a popular type of mortgage for many reasons. This type of loan can be used to finance a range of properties and typically has fewer restrictions compared to government-backed loans. There can also be fewer fees on a conventional loan. This makes it an appealing option for borrowers who meet the rigorous approval standards.

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