May 7th, 2014 2:31 PM by Gregg Mower
What is a Conventional Loan you ask? Well in the lending industry it is a home loan that is underwritten to the Federal National Mortgage Association’s (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) guidelines. You may have heard of them referred to as Fannie Mae and Freddie Mac loans. These organizations provide liquidity in the mortgage markets in that they securitize home loans and free up capital for lenders so they can lend more money. I know that was a mouthful of technical babble but the bottom line is that FNMA and FHLMC will buy contracts from lenders that collect payments from home owners (loan servicers) at a lower rate than the lenders are collecting from the borrowers. For example, if you have a conventional loan for $100,000 and are making payments at 4% the lender you are making the payments to probably securitized your loan with either FNMA or FHLMC. This means that you pay 4% on the $100,000 and the lender (to keep it simple) sold the principle of your loan to either agency and they make monthly payments to them. So if your payment is $478 at 4% the lender will pay FNMA or FHLMC at say 3.5% $449 and the lender keeps the $29 difference as a servicing fee.
This is how lenders make money and can keep lending money. Because this system exists and is backed by the government it makes Conventional Loans more attractive to investors and rates are generally lower with these types of loans. The rules that govern these loans are also tighter than any other type of loan. The reason the rules are tight is to protect FNMA and FHLMC from losses. Conventional loans will require that a borrower have good credit with scores no lower than 680. Convectional loans will require that the borrower’s funds to close come from the borrower’s own savings in most cases. Conventional loans will require mortgage insurance on Loan to values greater than 80%. Conventional loans will allow for gifts but only after the main borrower’s put at least 5% of their own funds into the transaction. By keeping the rules tight for Conventional loans it will allow investors in FNMA and FHLMC securities to have a more secure investment.
When lenders talk about underwriting your loan they are referring to assigning risk to your loan. Risk is risk of foreclosure and lenders don’t want to have to deal with the losses associated with foreclosure. So the tighter an underwriter looks at a borrower’s credit, income, and the amount of cash the borrower has put into the transaction the less risk of foreclosure there is for the lender and inevitably the investors in FNMA and FHLMC securities.
Your Loan Officer will refer to the FNMA and FHLMC guidelines many times when qualifying you for a conventional loan. The underwriting process is not an exact science but over the years the data has suggested areas of higher risk in a borrower’s credit file, so your Loan Officer might ask you for more documentation on your financial situation to make your loan more palatable or saleable. Mortgage Insurance will be required when a borrower does not put 20% or more down in a transaction. Again this is to lessen the risk to FNMA and FHLMC. Mortgage Insurance is not for the borrower it is for the lender. Although the borrower has to pay for mortgage insurance it is basically to protect the lender from losses. A borrower should view mortgage insurance as a payment on the amount they did not put down to achieve a 20% down payment. Mortgage insurance comes from a different company than the lender, it is from a privately owned company thus we call it private mortgage insurance. The private mortgage insurance company also has their own underwriting guidelines so that is why you will see even tighter guidelines on the higher Loan to Value loans.
In conclusion, be prepared to be scrutinized more on a transaction you put very little money down on. But on the other side the more money you put down when you buy a home the less risk there is to the lender, as they figure you won’t walk away from a large investment. Conventional Loans are a great vehicle to use when you purchase a home with a large down payment as you will not be required to get the additional expense of Mortgage insurance whereas with a FHA loan you will have Mortgage Insurance no matter how much money you put into the transaction. However, if you have less than good credit this loan will probably not be for you as the risk to the lender will be too high.