When you’re in the market for a new home, one of the most important decisions you’ll make is how to finance the purchase. There are many different types of home loans available, and it can be difficult to know which one is right for you.
In this guide, we’ll explore your options when taking out a conventional home loan. We’ll discuss the pros and cons of each option, so you can make an informed decision about which one is best for you.
Conventional Loan Definition
A conventional home loan is the most popular type of mortgage available today that is not backed by the government. Generally, they are classified into two categories: conforming and non-conforming.
A conventional conforming loan meets the guidelines set by Fannie Mae and Freddie Mac, while a non-conforming loan does not. However, most mortgage products offered by lenders classify as “conventional”.
There are several benefits to taking out a conventional loan. For one, you can usually get a lower interest rate than with other types of loans. There’s also more flexibility when it comes to the terms.
All in all, a conventional loan would be the first option that will be offered to you when financing a home purchase.
5 Types of Conventional Loans for a Home Purchase
Learning the different types of conventional home loans available to you can make the decision-making process easier and quicker when taking out a mortgage. So, what are they?
1. Fixed-Rate Mortgage
This type of mortgage loan has a consistent interest rate for its entire term, which is typically 15 or 30 years. The monthly payments will stay the same throughout the life of the loan, making it easier to budget for.
Pros
The main benefit of a fixed-rate mortgage is that you’ll always know how much your monthly payment will be. This can make it easier to plan for other expenses in your budget.
Cons
One downside of taking out this type of loan is that, if interest rates go down, you won’t be able to take advantage of them unless you refinance your loan.
If you’re planning on staying in your home for a long time and want stability with your monthly payments, then a fixed-rate mortgage might be right for you.
2. Adjustable-Rate Mortgage
Unlike the fixed-rate mortgage, an adjustable-rate mortgage (ARM) has interest rates that can change over time. The initial interest rate is usually lower than with a fixed-rate mortgage, but it can go up or down depending on market conditions.
Pros
The biggest advantage of an ARM is that you’ll have lower monthly payments during the initial period of the loan. This can give you some breathing room in your budget if you’re tight on cash.
Cons
If interest rates go up, your monthly payments will increase, which could make it difficult to afford your mortgage. There’s also the potential for negative amortization, which means you could end up owing more money than what you originally borrowed.
So, if you don’t think you can handle the uncertainty of an adjustable-rate mortgage, it’s best to steer clear. An ARM might be a good option if you’re planning on selling your home before the interest rate adjusts. It could also work well if you expect your income to increase over time so that you can afford the higher payments down the road.
3. DSCR Loan
A debt-service coverage ratio (DSCR) loan is a type of conventional loan that is typically used by investors to finance properties. Usually, it is an option considered by those who want to purchase rental properties, such as short-term vacation rentals.
The loan amount is based on the property’s DSCR, which is the ratio of net operating income to debt payments. DSCR loans can also be either fixed-rate or adjustable-rate.
Pros
Getting a DSCR loan will offer you a lower interest rate since the loan amount is based on the property’s income. This means that the lender views the loan as being less risky.
Cons
With a DSCR loan, your monthly payments could go up if the property’s income decreases. This could make it difficult to make your mortgage payments on time.
To learn more about this type of loan, you can visit this page, https://mortgage.shop/dscr-loan-and-mortgage-program/.
4. Bank Statement Loan
A bank statement loan is typically used by self-employed borrowers. The lender will use your bank statements to verify your income instead of relying on tax returns.
Pros
One obvious advantage of this type of loan is that it makes it easier for you to qualify for a mortgage even if you are not working for a company. It can also be a good option if you have irregular income or are paid in cash. There’s also more flexibility when it comes to the term of the loan. So, if you’re looking for a conventional home loan with more favorable terms, this is the way to go.
Cons
Bank statement loans usually have higher interest rates than other types of loans. This means that you’ll end up paying more in interest over the life of the loan.
5. Full Documentation Loan
A full documentation loan is the most common type of conventional home loan. As the name implies, this type of loan requires that you provide full documentation to verify your income and employment. This includes tax returns, W-forms, and pay stubs.
Pros
A full documentation loan also offers favorable terms, such as lower interest rates and, sometimes, even higher loan amounts.
Cons
One downside of a full documentation loan is that it can be difficult to qualify for if you’re self-employed or have irregular income. It can also be time-consuming to gather all of the required documents.
But if you qualify for this type of loan, it’s definitely worth considering!
Now that you know the different types of conventional home loans, we’ll proceed to how you qualify for them.
Conventional Loan Requirements
In order to qualify for a conventional home loan, there are certain requirements that you need to meet.
Credit Score of 620 and Up
For most conventional loans, you’ll need a credit score of 620 or higher. If your credit score is below this, you might still be able to qualify if you have a large down payment or can prove that your income is high enough to offset the loan.
Also, there are ways to improve your current credit score, such as by paying your bills on time, maintaining a good credit history, and using a credit monitoring service.
Maximum DTI Ratio of 43%
Another metric that lenders would look at when assessing you for a loan is your debt-to-income ratio. This is the percentage of your monthly income that goes towards paying off debts, such as student loans, credit cards, and car loans.
For conventional home loans, the maximum DTI ratio is typically 43%. This means that your monthly mortgage payments should not exceed 43% of your monthly income.
To calculate your DTI ratio, you can use this formula: Monthly Debt Payments ÷ Monthly Gross Income = DTI Ratio
For example, if your monthly debt payments are $800 and your monthly gross income is $3,000, your DTI ratio would be 26.67%. This would make you highly eligible for a conventional home loan.
LTV Ratio of No More Than 80%
Like the DTI ratio, your lender would also try to assess your loan-to-value (LTV) ratio. This is the ratio of your loan amount to the appraised value or sales price of the home, whichever is less. For conventional loans, the maximum LTV ratio is typically 80%.
So, how do you know if you have a good LTV ratio?
Basically, the lower your LTV ratio is, the better. A low LTV ratio means that you have a smaller loan amount and/or a higher appraised value or sales price. This makes you a less-risky borrower and, therefore, more likely to qualify for a conventional home loan.
To calculate your LTV ratio, you can use this formula: Loan Amount ÷ Appraised Value = LTV Ratio
For example, if you’re taking out a $100,000 loan on a home that has been appraised at $200,000, your LTV ratio would be 50%. This is an excellent LTV ratio and would make it very likely for you to qualify for a conventional home loan.
Stable Source of Income
Lenders will also protect their interests when providing loans, and one way they do this is to ensure you have a stable source of income. This means that you have a job with a steady income stream.
If you’re self-employed, you’ll need to provide additional documentation to verify your income. This might include tax returns, financial statements, and other records. Overall, having a stable source of income is important because it shows lenders that you’re able to make regular loan payments.
Minimum Down Payment
While many people believe that 20% is the suggested down payment for a mortgage, some lenders would actually allow you to have lower down payments, sometimes as low as 3%.
Of course, the more money you’re able to put down as a down payment, the lower your monthly mortgage payments will be. But if you don’t have a lot of money saved up, there are still options available to you.
For example, some lenders offer conventional loans with low down payments if you’re a first-time homebuyer or haven’t owned a home in the past several years. There are also programs that can help you come up with the money for a down payment, such as grants and loans from state housing agencies.
Conventional loan requirements can vary depending on the lender and the type of loan you are applying for. To know exactly what will be required from you, you should speak with the lender about it during the application process.
The Importance of Applying the 28/36 Rule When Taking Out a Mortgage
When taking out a conventional mortgage loan, the 28/36 rule can be a very useful tool to determine how much you can afford. This rule states that your monthly mortgage payments should not exceed 28% of your gross monthly income, and your total debt (including your mortgage) should not exceed 36% of your gross monthly income.
For example, let’s say you have a gross monthly income of $5,000. Based on the 28/36 rule, your maximum monthly mortgage payment should be $1,400 ($5,000 x 0.28). And, your maximum total debt including your mortgage should be $1,800 ($5,000 x 0.36).
If you can stay within these limits, it’s likely that you’ll be able to afford a conventional home loan. It also ensures that you won’t be burdened financially when you pay up your mortgage month after month.
Conclusion
Phew! That was a lot of information on conventional home loans. But now, you should already have a good understanding of the different types of conventional loans as well as the requirements for qualification. So, sit back and relax—you’ve got this!
For more tips on loans and buying a house, please check out our other posts!
OTS News on Social Media