A conventional mortgage loan is a type of financing offered by private lenders. Also called a conforming conventional loan, the mortgage meets the requirements for government-backed loans like Fannie Mae and Freddie Mac mortgages. Borrowers must meet specific financial criteria. Unlike government-backed mortgages, living in the property is not a requirement.
A conventional loan can be a viable financing option to expand a real estate investment portfolio. Conventional home loans are attractive to investors due to their flexibility and favorable terms. However, navigating the world of conventional mortgages can be overwhelming, especially if you are new to real estate investing.
Finding the right financing for an investment property is key to being a successful real estate investor. But with so many types of loans out there—FHA loans, VA loans, and hard money loans—knowing the best type of financing to choose is challenging.
This is a comprehensive guide to conventional loans and how they can work for your investment strategy. Additionally, you’ll learn how conventional mortgages compare with other types of loans available to investors.
Conventional Loan Requirements
Approval for conventional loan programs with commercial banks, credit unions, or loan and savings associations depends on meeting the lender’s requirements. During the loan application process, the mortgage lender checks your credit score, income, and current debt liabilities. Additionally, the down payment and loan size also affect your eligibility.
Here are the various aspects of a conventional loan explained in more detail.
You must meet the minimum down payment requirements when applying for a conventional loan. The down payment size depends on the type of mortgage you want.
Here is what you can typically expect to pay upfront when purchasing a property:
- First-time buyers can apply for a 3% conventional loan with an up-front payment of 3% of the loan amount.
- A multiunit investment property typically requires a down payment of 15%; however, some lenders require 30%.
- Homeowners selling their existing home and buying a new one need at least a 5% down payment.
- Buying a second home requires a down payment of at least 10%.
- The minimum down payment amount for an adjustable-rate mortgage is usually at least 5%.
When refinancing a conventional loan, you must have enough home equity to secure the mortgage. For example, refinancing the mortgage requires at least 5% equity. However, if you are doing a cash-out refinance, at least 20% home equity is necessary.
Mortgage lenders require a minimum credit score of at least 620 to qualify for a conventional mortgage. However, having a poor credit history means you must meet more stringent criteria to be approved. These could include a larger down payment or higher income. According to FICO, a higher credit score of 660 is necessary to get interest rates around the national average.
A higher credit score of at least 740 is ideal for securing the best interest rate. For example, a higher credit score can mean a difference in interest rates of 1% to 1.5%. This could mean a difference in the monthly mortgage payment of $330, amounting to nearly $119,000 over the loan term.
You may qualify for a subprime loan if you have a below-average credit score or a poor credit report. But subprime loans have a higher interest rate and cost more in the long term.
Therefore, it makes sense to improve your credit history if you have a lower credit score than 660.
Private mortgage insurance (PMI)
PMI is usually necessary if your down payment is less than 20% of the conventional loan amount. Mortgage lenders require private mortgage insurance in case you default on monthly mortgage payments. The mortgage insurance premiums depend on loan types, credit reports, and the down payment size.
Here are a few ways to pay private mortgage insurance premiums:
- Include them in your monthly payment.
- Pay an up-front mortgage insurance fee in closing costs.
- Pay a slightly higher interest rate.
Monthly mortgage insurance doesn’t last the entire loan term. When you reach 20% home equity, you can request a home appraisal to recalculate the mortgage insurance premium. And when you reach 22% equity in your home, you no longer need mortgage insurance.
Debt-to-income ratio (DTI)
The mortgage loan officer will also consider your debt-to-income ratio before approving a conventional mortgage. Your DTI is the percentage of your monthly income required to pay off debts. Typically, you must have a debt-to-income ratio of 50% or lower.
Here is the formula to calculate your DTI:
[Total of minimum monthly payments ÷ gross monthly income] x 100 = DTI ratio (%)
When calculating your DTI, your minimum monthly payments should include credit cards, auto loans, and housing costs.
Conventional mortgages require a property appraisal to ensure the purchase price reflects fair market value. The appraisal focuses on the value and condition of the property. A conventional mortgage is usually approved If the appraiser determines the property’s market value is equal to or more than the purchase price.
The appraisal must meet the requirements to conform to Fannie Mae and Freddie Mac guidelines. Therefore, the appraiser will generally check the following:
- Comparable sales of similar properties in the neighborhood
- The general condition of the home
- The condition of the roof, foundation, and landscaping
- The size of the property
- Number of rooms, bathrooms, bedrooms, and closets
- The quality of upgrades or remodeling
- The condition of the attic and basement
Suppose the appraiser discovers evidence of termites, mold, roof leaks, or hazards. In that case, they will flag these adverse conditions for further inspection by a qualified expert.
Appraisals based on Fannie Mae and Freddie Mac guidelines differ from those for VA or FHA loans. However, most FHA or VA appraisals are valid for conforming conventional loans.
Conforming loan limits
Conforming loans are subject to limits set by Freddie Mac and Fannie Mae. The loan limits change annually and depend on the area of the country where you plan to buy real estate.
According to Fannie Mae, the conforming loan limit in 2023 is $726,200. However, in high-cost areas of the country, including Hawaii and Alaska, loan limits can be as high as $1,089,299.
The conforming loan limit can be higher for real estate investors, depending on the number of units in the investment property. Therefore, a conventional loan can be as much as $1,396,800 for a four-unit property.
The Federal Housing Administration (FHA) sets the loan limits for the country. You can check out the loan limits in your area on the Federal Housing Finance Agency website.
The mortgage lender must ensure you can afford the monthly payment on the conventional loan. Therefore, you must show a stable employment record and income documentation for the previous two years. The lender will consider your monthly debt payments in ratio to your income to determine (known as debt-to-income ratio) if you qualify for a home loan.
Conventional Loan Rates
The interest rate for a conventional loan depends on several factors. The Federal Open Market Committee (FOMC) determines the federal funds rate. Based on this rate, money lenders offer a range of mortgage interest rates based on the mortgage type, loan repayment period, down payment, and credit score.
According to Freddie Mac, the average interest rate for a 30-year home loan was between 6.48% and 6.69% for the first half of 2023. This is significantly higher from 2021, when the average interest rate was 2.65%.
To find current interest rates for FHA loans, conventional loans, and VA loans, check out BiggerPockets’ loan page. Here, you can compare various loan types from multiple lenders to find the best deal to purchase an investment home.
How to calculate a conventional mortgage
To calculate the monthly payment on a conventional loan, you need to know the mortgage principal (loan amount minus the down payment), interest rate, and loan term. And additional costs like mortgage insurance, HOA fees, down payment, homeowners insurance, and property taxes affect monthly mortgage payments.
Calculating your monthly payment by hand can be complicated, especially considering PMI and annual taxes.
The easiest way to know if you can afford a conventional loan is to use BiggerPockets’ Mortgage Calculator.
How Does a Conventional Loan Differ From Other Mortgage Loan Options?
Conforming conventional loans have certain advantages over other types of home loans. By comparing loans offered by government-sponsored enterprises, you can decide on the best option for your next investment.
FHA vs. conventional loan
Government loans backed by the Federal Housing Administration have less stringent requirements than conventional loans. For example, homebuyers with lower credit scores can apply for a home loan. In this case, the minimum credit score affects the down payment amount.
- Credit score 500-579: The minimum down payment is 10% of the purchase price.
- Credit score 580-plus: FHA loans require a minimum down payment of 3.5%.
There are a few important caveats. First, you must take out FHA mortgage insurance if the down payment is less than 10%. And the mortgage insurance is for the loan term, regardless of how much equity you build.
Second, the home must be your primary residence. However, FHA loan interest rates are typically lower than conventional loans.
But getting rid of mortgage insurance is easier on a conventional loan compared to an FHA loan. You can stop paying mortgage insurance premiums when you have at least 20% equity. However, higher credit score requirements exist to qualify for a conventional loan.
VA loan vs. conventional loan
VA loans have several benefits over conforming loans for veterans, active-duty personnel, and their surviving spouses. For example, you don’t need a down payment or private mortgage insurance.
Of course, VA loans are not available to everyone. And there are restrictions on the type of property you can buy.
Here are a few things to consider:
- Conventional loan requirements are similar to VA loans.
- A VA loan is only for purchasing a primary residence.
- You cannot use a VA loan to purchase a second home or vacation home unless you live there for more than six months of the year as a second primary residence.
- You must pay a funding fee—between 1.25% and 3.3%, depending on how much money you can pay upfront.
Your credit score, down payment, and property purchase price can affect the loan cost. However, a VA loan allows you to save on mortgage insurance and get more competitive interest rates.
Suppose you are considering purchasing an investment home that isn’t your main residence. In that case, a conventional loan is the best option.
Jumbo vs. conventional loan
Jumbo loans are popular with real estate investors because of their flexible financing options. Unlike a conventional mortgage, there is no limit to the amount you can borrow.
However, jumbo loans have more stringent criteria than conventional loan requirements. This is because they don’t meet the same guidelines as government-backed loans—and therefore are riskier for the lender.
Here are a few differences between jumbo loans and conventional loans:
- The down payment is usually 20% or more.
- They require higher credit scores and high cash reserves.
- Your DTI must be lower than a conventional mortgage.
- Your loan-to-value ratio must be over 80%.
- Higher closing costs compared to conforming loans.
Most real estate investors choose a jumbo loan to finance high-value property investments if they have an excellent credit score and a high income.
USDA loan vs. conventional loan
Loans backed by government agencies like USDA loans have certain benefits. The major difference between USDA loans and conventional loans is availability. USDA loans are only available in certain rural areas, and eligibility is based on income levels. Therefore, not all homebuyers can apply for a USDA loan.
However, these loans offer significant benefits in certain circumstances compared to taking out a conventional mortgage.
Here are a few factors to consider about the pros and cons of USDA loans:
- You can lock in a lower interest rate compared to conventional loans.
- No money to pay upfront.
- Your household’s income cannot exceed 115% of the median income for your area.
- Your debt-to-income ratio should be below 50%.
- You typically need credit scores above 640 to qualify, compared to 620 for a conventional loan.
- The property must conform to the USDA’s definition of a “rural area.”
A USDA loan may be a good option if you have a low to moderate income, cannot afford the down payment, and want to live in a rural location.
Is a Conventional Loan Good for Investors?
Conventional loans are a good financing option for real estate investors. This type of loan offers a range of benefits and flexibility. They have lower fees than FHA loans, low down payment options, and faster closing times. Additionally, you can avoid PMI payments if you pay at least 20% upfront. Furthermore, the loans suit various real estate investments like buying rental properties, vacation homes, or second homes.
Consider applying for a conventional loan if you want long-term financing solutions to purchase real estate.
Conventional Loan FAQs
Here are common questions real estate investors and homebuyers ask about conventional loans.
Do conventional loans require PMI?
A conventional loan only requires private mortgage insurance if your up-front payment is less than 20% of the loan principal. However, subject to certain conditions, you can request to cancel mortgage insurance when you have at least 20% equity in your home.
Are conventional loans assumable?
Most conventional loans are nonassumable. This restriction is because the mortgage terms and conditions typically have a “due-on-sale” clause. This clause means you must pay the remaining loan amount when selling the property.
An exception is when you have a conventional adjustable-rate mortgage. Fannie Mae allows conventional loans to be assumable if the borrower agrees to switch to a fixed-rate mortgage.
Can you get a conventional loan on a mobile home?
Securing a conventional loan to purchase a mobile home is usually impossible. There are several reasons for this.
First, mobile home values depreciate rapidly. Second, location restrictions and a lack of permanent foundations make them riskier investments. Third, the mobile home generally is not on land the borrower owns.
The situation with manufactured homes is different, and some eligible homes qualify for conventional loans and loans backed by government agencies. However, the manufactured home must meet specific criteria. For example, it must be permanently fixed to the land, and the borrower must own the land.
Can you buy a foreclosed home with a conventional loan?
Conventional loans are available for purchasing a foreclosed home. To qualify, the lender must be sure that the home is in livable condition, and you must meet the standard eligibility requirements. Like most property purchases, a mortgage preapproval increases your chances of the seller accepting your offer.
You can also use government-backed loans like FHA loans, VA loans, and FHA 203(k) loans to buy a foreclosed home. However, the standard restrictions of these government loans still apply.
What are amortized conventional loans?
An amortized conventional loan refers to the monthly interest and principal payments. At the loan’s start, most of the monthly payments go toward interest. However, as you get nearer the end of the term, your entire payment goes mostly toward paying the principal.
Can I use a conventional loan to buy an investment home or a second home?
Conventional loans are popular financing options for real estate investors. Unlike FHA loans, you can use the loan to buy a vacation home, investment real estate, or a second home. However, lenders typically require an up-front payment of at least 30% if the asset is for an investment portfolio. You also need at least six months of cash to cover monthly mortgage obligations.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.