You’re a first-time homebuyer who is confused by the mortgage industry’s jargon.
If you’re in the market for a mortgage, it’s a good idea to have a dictionary on hand. And the first step in doing that is deciding whether you’re looking for a conforming mortgage or a nonconforming loan.
You should be aware of the distinction between the two before meeting with a loan officer to discuss your mortgage choices.
Mortgage Loans: Conforming vs. Nonconforming
Loans for purchasing a home can be split into two basic categories: conforming and non-conforming.
Loans that “comply” with Fannie Mae (the Federal National Mortgage Association) or Freddie Mac (the Federal Home Loan Mortgage Corporation) guidelines are backed by those two government-sponsored enterprises (the Federal Home Loan Mortgage Corporation or FHLMC). This is significant because it allows your lender to sell your loan to a government-sponsored enterprise like Fannie Mae or Freddie Mac.
This business model appeals to banks and mortgage lenders since they are relieved of the responsibility of loan servicing. They can then reinvest their meager profits or lend them out to another business. They profit not from interest accrual but rather from upfront and closing charges.
Fannie Mae and Freddie Mac supply lenders with a list of permissible lending rules in an effort to standardize the loans they purchase. There are several different lending schemes available to accommodate various clientele.
Those with stellar credit histories, for instance, may be offered access to low-interest, no- or low-down-payment mortgages. Poor credit borrowers can only get loans with higher interest rates and larger down payments.
However, not every potential customer will qualify for one of their financing packages. Nonconforming loans, such as Federal Housing Administration (FHA) or Veterans Affairs (VA) loans, may better suit some borrowers’ needs.
Mortgages that conform
- Appropriate for the secondary market. Loans meet the requirements set out by Fannie Mae or Freddie Mac, allowing the lender to quickly resell them once completion.
- Higher Standards: These loans are made to borrowers with fair credit and income documentation who are eligible to be purchased and resold by private enterprises.
- Usually Cheaper: All else being equal, the borrower will save money on interest and fees by choosing a conforming loan that is eligible for one of these lending programs.
- Common: Conventional mortgage loans in the United States are typically conforming loans. In 2022, the maximum loan amount for a conforming mortgage is $647,200, while in high-cost locations, that number can rise to $970,800.
- Lenders can either put nonconforming loans up for sale on the secondary market or maintain them on their books if the loan doesn’t meet certain standards.
- Narrow market Nonconforming loans are designed for certain groups of people, such as first-time homeowners with poor credit or members of the armed forces.
- Nonconforming loans typically have higher interest rates and origination costs, making them more expensive.
- Due to the lack of regulation from Fannie Mae and Freddie Mac, lenders are free to make more substantial loans.
Which loan kind is appropriate for you is determined by both you and your requirements.
Borrowers in the medium income range with decent credit should prioritize getting a conforming loan.
These loans are priced according to market forces and are intended for more creditworthy clients. Government aid does not go into funding them.
Because the lenders are confident of receiving their principal and interest payments in full, they do not charge higher interest rates than they would for riskier products such as Federal Housing Administration loans. Yet this also implies that not all borrowers will be able to secure a conforming loan.
Conforming Mortgage Eligibility Requirements
The following are the minimum requirements for obtaining a conforming mortgage loan:
- Most conforming lending programs have a minimum FICO score requirement between 620 and 650. A credit score of 740 or above is often required to qualify for the best rates and lowest down payment options.
- The “front-end ratio” for a conforming loan cannot exceed 28% of the borrower’s gross annual income. To put it another way, your total monthly mortgage payment (including principle, interest, taxes, insurance, and HOA dues) can’t be more than 28 percent of your gross monthly income. Additional restrictions include a “back-end ratio maximum” of 36% of monthly income for all “back-end” debt payments. Car payments, school loan payments, and credit card minimums are all examples of such financial obligations.
- Conforming loan limits in the United States generally do not exceed $647,200 for the loan’s principal and interest. A conforming loan’s maximum loan amount is $484,350; however, in high cost of living locations, that amount might be as high as $970,800. To find out what the conforming loan maximum is in your location, visit the website of the Federal Housing Finance Agency.
- Some conforming loan programs, like Fannie Mae’s HomeReady program, have a modest minimum down payment requirement of 3 percent. For the other hand, the down payment on a conforming loan is typically between 5% and 20%, and sometimes even more for riskier applicants.
- Conforming loans are limited to single-family homes and multifamily dwellings with no more than four units. This covers both primary and secondary houses, as well as rental units.
Conforming vs. Conventional Loans
Conforming loans are commonly misunderstood as conventional loans. There is a connection between both, but they are not the same. Conventional mortgage loans are those that are issued by banks and other private lenders.
These loans consist of both Fannie Mae and Freddie Mac conforming loans and lender-held loans. Government-backed loans, such as those from the Federal Housing Administration, the Veterans Administration, and the United States Department of Agriculture (USDA), are not considered conventional loans.
The Benefits of Conforming Mortgages
If you’re a good credit risk, you’re a good candidate for a conforming mortgage, which offers many advantages.
- Economically viable costs. Moneylenders will compete for your company. As long as you qualify for a conforming loan program, they have considerable freedom to negotiate interest rates and costs with you. This facilitates cost-cutting efforts by allowing for more straightforward rate comparisons and charge negotiations.
- PMI that may be detached. If you borrow more than 80% of the home’s worth as a mortgage, PMI premiums will be added to your monthly payments (PMI). It will be removed from your monthly payment if and when your loan debt drops below 80% of the property’s value.
- There is hope for a little initial investment. You may be able to get a loan with a 3% down payment if you have a strong credit history and can provide proof of consistent income.
- Accessibility and Consistency in Quality If you need a conforming loan, you can contact any traditional mortgage lender in the country and they will likely use the same Fannie Mae or Freddie Mac guidelines. As a result, it’s less of a hassle to look around for the most favorable conditions and interest rate.
Drawbacks of Conforming Mortgages
If all borrowers could get approved for a conforming loan, there would be no reason to discriminate between the two. You could not qualify for conforming loans, depending on your credit history and other factors.
- Rigidity. Conforming loans, by definition, must be eligible for purchase by Fannie Mae or Freddie Mac. One of these specific lending schemes must accept you.
- Loan Caps. Borrowers with impeccable credit and abundant income might still be denied a conforming loan if they need more money than they can afford.
- Minimum Credit Requirements. There is no point for would-be homeowners with poor credit to apply for conventional mortgages.
- Investment Caps. Borrowers can only have a small number of mortgages listed on their credit reports and still qualify for most conforming lending programs. The typical cap is four. That limits the total amount of conforming loans a real estate investor may employ before having to turn to alternative financing, such as private lenders that hold their loans in separate accounts.
Each and every mortgage loan that does not qualify for a Fannie Mae or Freddie Mac lending program is considered “nonconforming.” It covers a diverse group of loans aimed towards certain customers.
Nonconforming Mortgage Types
Although the number of nonconforming loan options is theoretically infinite, they may be roughly divided into four categories.
- Jumbo Loans. Large loans that exceed the size restrictions for conforming loans are known as “jumbo loans” Jumbo loans are for borrowers with high incomes who wish to purchase or refinance pricey houses. Even with great credit, you will likely pay more for a jumbo loan than for a conforming loan of the same amount.
- The Federal Housing Administration (FHA) loan is another frequent nonconforming mortgage. FHA loans are meant for first-time homeowners with lower incomes and less-than-perfect credit, but they come with additional restrictions and fees.
- VA Loans. The Department of Veterans Affairs offers discounted VA loans to active-duty military personnel, veterans, and their spouses. They have a renowned 0% down payment option.
- USDA Loans. USDA loans are the last popular nonconforming lending product and are meant for rural properties. They also offer a 0% down payment option.
Nonconforming Mortgage Eligibility Requirements
Nonconforming mortgages have varying standards for qualification.
- Required Credit Score: Typically, but not always, a score in the 700s is needed for a jumbo mortgage. A credit score of 580 is required for the 3.5% down payment on an FHA loan, however a score of 500 is acceptable. There is no required credit score for a VA loan. It’s common knowledge that a credit score of 640 or above is needed to qualify for a USDA loan.
- Debt-to-Income Ratio (DTI) Floor Some jumbo loan providers, including Rocket Mortgage, provide greater DTI ceilings for borrowers than those for conventional loans (up to 45%). The FHA limits both the front and back DTIs to 31% and 43%, respectively. For VA loans, the maximum back-end ratio that a lender will allow is 41%. The maximum loan-to-value (LTV) ratio for a USDA loan is 41%, while the maximum front-end ratio is 29%.
- Size Restrictions: Jumbo loans, VA loans, and USDA loans all have no size limits. For 2022, the Federal Housing Administration (FHA) has established a maximum loan limit of $970,800 for borrowers who are purchasing a primary residence, with a minimum limit of $420,680 depending on the local housing market. The FHA loan limit for your area may be found on the HUD website.
- Standard requirements for a down payment on a jumbo loan are at least 10%, and often 20% or more. FHA loans allow for a 3.5% down payment for people with credit scores over 580, and a 10% down payment for those with scores between 500 and 579. Borrowers who qualify for a VA or USDA loan don’t have to put any money down.
- Nonconforming loans, like conventional loans, can fund properties with as many as four dwelling units. However, only main residences can be purchased with an FHA, VA, or USDA loan.
The Benefits of Nonconforming Mortgages
For many people, nonconforming loans are not just the best option for purchasing a house, but the only alternative available.
- Major Financing Available. A jumbo loan is the only option for high-income borrowers who want to purchase a property that costs more than the maximum allowed by conventional financing.
- Loan Leniency. Even if a borrower has poor credit, they may still qualify for a nonconforming loan, which allows them to purchase a property.
- Modularity in DTI. Nonconforming loans are the only option for borrowers with excellent credit whose DTI ratios are too high to qualify for a conventional loan.
- Possibility of Paying Less Up Front Millions of people in the United States may now afford homes because the Federal Housing Administration requires only a 3.5% down payment from even those with poor credit. The zero-percent-down option of VA and USDA loans is unique.
Drawbacks of Nonconforming Mortgages
The disadvantages of these loans vary from one scheme to the next.
- Life-of-Loan FHA Loans Require Mortgage Insurance. The need that borrowers keep paying the mortgage insurance premium (MIP) for the duration of their loan is one of the biggest drawbacks of FHA financing. As a result, the cost of homeownership continues to rise even when the amount is reduced to below 80% of the home’s value.
- Expenses rise. Higher interest rates are associated with jumbo and FHA loans since the lenders take on greater risk when providing these types of loans. Potentially higher mortgage rates and other charges may be incurred.
- Best Loans Have Strict Requirements. If the conditions of a VA loan or a USDA loan appear too good to be true, that’s because the government is subsidizing them for a select group of borrowers. Which is fantastic if you’re a veteran or a resident in a rural area, but not available to everyone else.
- Reduced Availability and Standardization Nonconforming loans are still widely available, although there may be fewer mortgage lenders willing to make them.
- There’s just more bureaucracy and hassle. When applying for a federally backed loan like an FHA, VA, or USDA loan, be prepared for the bureaucratic red tape, lengthy wait times, and other hassles that come hand in hand with dealing with the federal government. The loan might potentially fail due to the strict underwriting requirements. Since this is cumbersome for the borrower, sellers are less inclined to accept bids backed by government-issued loans.
It’s going to be lot easier to talk to loan officers if you already know the difference between a conforming loan and a nonconforming loan. Discuss your borrowing needs with them, and be sure to ask for the names of particular loan programs when they provide you with a quote.
Borrowers with great credit might, for instance, compare rates for the 3% down payment loan programs HomeReady from Fannie Mae and Home Possible from Freddie Mac. This facilitates the process of comparing loan rates offered by many lenders that offer the same product.
Don’t be scared off by how things work. Find the best loan program for your specific situation by taking your time to familiarize yourself with the language used.