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Conventional Loans: How to Finance a Home Purchase

You’ve decided you’re ready to purchase your first home. Congratulations! Homeownership is a key part of the American Dream. So, what’s next?

The next step is finding the right financing for your home purchase. There are many different types of loans available, but one of the most popular is the conventional mortgage loan.

In this article, we will discuss what conventional loans are, how to qualify for one, and some of the benefits of using this type of loan to finance your home purchase.

What Is a Conventional Mortgage Loan?

A conventional loan is a type of loan that is not guaranteed or insured by the government. These loans are typically issued by private lenders, banks, or credit unions.

Conventional loans can be either fixed-rate or adjustable-rate mortgages (ARMs). Fixed-rate mortgages have an interest rate that remains the same for the life of the loan, while ARMs have interest rates that can adjust periodically. To decide which conventional loan rate is best for you, it’s important to understand the types of conventional loans and their features.

Fixed-Rate vs Adjustable-Rate Mortgages: Weighing Your Options

With a fixed-rate conventional loan, you will be paying the same interest rate throughout the entire loan term. This makes it easier for you to create a budget for housing costs. However, because the interest rate is locked in, you may not be able to take advantage of lower rates if they become available during the life of your loan.

An adjustable-rate conventional loan, on the other hand, has an interest rate that can change over time. These loans typically start with a lower interest rate than fixed-rate loans, which can save you money in the short term. However, your payments could increase if rates go up during the life of your loan.

To determine which option is ideal for your situation, it’s important to consider your financial goals and plans for the future. If you plan on staying in your home for many years, a fixed-rate mortgage may be the better choice. But if you’re not sure how long you’ll stay or think there’s a chance you may move in the near future, an adjustable-rate mortgage could be a good option.

Conventional Loan Requirements

In order to qualify, there are certain conventional loan requirements that you need to meet.

DTI Ratio

The first thing that lenders look at is your debt-to-income (DTI) ratio. This is the amount of debt that you have compared to your income. To qualify for a conventional loan, most lenders require that your DTI ratio should be no more than 28% of your gross monthly income (before taxes) to service your mortgage. However, some lenders would allow higher than that, given certain circumstances.

To know what your DTI ratio is, you can calculate it simply by taking the total amount of your monthly debts (including the proposed mortgage payment) and dividing it by the gross income that you also receive each month. For example, if you make $50,000 per year and your existing monthly debts are $14,000, then your DTI would be…

$14,000/12 = $1,166.67 – total monthly debts

$50,000/12 = $4,166.67 – gross monthly income

$1,166.67/$4,166.67 = .28 or 28% – DTI  ratio

If you’re not sure what your DTI is, there are many online calculators that can help you figure it out.

Keep in mind that the lower your DTI ratio is, the better. A lower DTI indicates to lenders that you’re a good candidate for a loan because it shows that you have enough income to cover your debts.

Credit Score

Your credit score is another important factor that lenders will consider when determining whether or not to give you a loan. A good credit score will show the lender that you’re responsible when it comes to borrowing money. It gives a positive impression that you’re likely to make payments on time.

The conventional loan credit score that is generally considered acceptable is 620 or higher. However, some lenders may require a higher credit score if you’re applying for a larger loan amount.

If you’re not sure what your credit score is, you can check it for free on websites, like Credit Karma or Credit Sesame. You should also check your credit report at least once per year to make sure there are no mistakes on it.

Improving your credit score before applying for a conventional mortgage loan can help you get a better interest rate and increase your chances of getting approved. Some of the things that you can do are paying all of your bills on time, maintaining a good credit history, and keeping your credit card balances low.

Down Payment

Customarily, lenders would require you to have a down payment of at least 20% of the purchase price. Some lenders may allow you to put down an amount that is lower than this, but it usually requires you to pay for private mortgage insurance (PMI).

If it’s your first time buying a home, it can be perplexing to establish how much of a down payment you can afford. Fortunately, there are many online calculators that can help you figure it out. You can also speak with a financial advisor who can help you create a budget and set savings goals for your home purchase.

Saving up for a conventional loan down payment may take some time, but it’s worth it in the long run. Not only will it help you get lower interest rates, but it will also help you avoid having to pay for PMI.

Proof of Employment and Income

As lenders would try to protect their interest in the loan, they also set certain conventional loan income requirements. In a way, they would need to verify that you have a steady income. So, when you apply for a conventional mortgage loan, you’ll likely need to provide proof of employment and income.

The most common way to do this is by providing lenders with your most recent pay stubs and some Internal Revenue Service (IRS) forms. If you’re self-employed, you may need to provide additional documentation, such as tax returns or financial statements.

Stable Housing History

A conventional loan is a good option if you have a stable housing history. Lenders like to see that you have lived in the same place for at least two years because it shows them that you’re a reliable borrower who is less likely to default on the loan.

If you’ve moved around frequently or don’t have a long rental history, then you may need to wait until you’ve lived in your current home for at least two years before applying for a conventional mortgage loan.

If you meet all conventional loan requirements, you’ll likely be approved for the loan. However, even if you don’t meet all the conventional loan qualifications, there are still other options available to help you finance your home purchase, such as a Federal Housing Administration (FHA) loan and any other government-backed loan, which generally have more flexible qualification standards.

Conventional Loans vs FHA Loans: Understanding the Key Differences

 

Now that you know the conventional loan requirements, it’s time to compare conventional loans with FHA loans. Both conventional and FHA loans are popular choices for financing a home purchase. But there are some key differences between the two loan types that you should be aware of before applying.

The main difference between conventional and FHA loans is that conventional loans are not backed by the government, while FHA loans are. This means that if you default on your loan, the lender can’t go to the government to recoup its losses like it could with an FHA loan.

Another difference is that conventional loans typically have higher credit score requirements than FHA loans. So, if your credit score is lower than 620, you may have a better chance of getting approved for an FHA loan.

Lastly, conventional loans typically have higher down payment requirements than FHA loans. As we mentioned earlier, conventional loans typically require a down payment of 20% (or more), while FHA loans allow for a down payment as low as just 3.5% of the purchase price.

3 Benefits of Using Conventional Loans to Finance Your Home Purchase

While government-backed loans have more lenient qualification standards, conventional loans offer several key benefits that make them a great choice for financing your home purchase.

1. Lower Interest Rates

One of the biggest advantages of conventional loans is that they typically have lower interest rates than government-backed loans. This can save you a significant amount of money over the life of your loan, especially if you are taking out one with a long repayment term.

For example, a $250,000 conventional loan with a 30-year repayment term and an interest rate of just 3%, instead of 5%, would save you tens of thousands of dollars that you can use for other important things in life.

2. No PMI Requirements

Unlike FHA loans and other types of government-backed mortgages, conventional loans don’t require borrowers to pay for PMI. While this type of insurance protects the lender in case you default on your loan, it also adds to your monthly payment. So, if you’re looking to keep your monthly payments as low as possible, a conventional loan is the way to go.

3. Shorter Loan Terms

While most conventional loan terms are for 30 years, you can also find 15-year conventional loans. This shorter repayment term means that you can pay off your home much faster than with a 30-year conventional loan.

Of course, this also means that your monthly payments will be higher since you’re paying off the loan in half the time. But if you can afford the higher payments, a 15-year conventional loan can save you a lot of money in interest over the life of the loan.

Tips on Getting the Best Deal on a Conventional Loan

Just like with any other type of loan, you’ll want to shop around and compare conventional loans from multiple lenders before deciding on one. This will help ensure that you get the best deal possible on your home loan.

And again, you should consult with a financial advisor or housing counselor to make sure that you are ready and able to take on a conventional loan before you apply.

Apart from the financial experts, your real estate agent could also be a great resource when it comes to finding conventional loans. Many agents have worked with conventional lenders in the past and can help you find one that offers the best terms for your situation.

Final Thoughts

Financing is a crucial part when buying a home. Thus, you should make sure you understand all the ins and outs of the type of loan you’re getting.

We hope this article has helped you understand conventional loans and how they work. Good luck with your home purchase!

For more interesting real estate tips and information, please check out the other posts on our site!

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