What is a conventional loan?
A Conventional Loan is a loan that isn’t guaranteed by the government, as with FHA, USDA or VA loans. This type of loan follows the guidelines of Government Sponsored Enterprises such as Freddie Mac or Fannie Mae. These entities are the largest purchasers of loans and represent the most common mortgages available. The underwriting guidelines and loan amount limits are set forth very clearly by the GSE’s. Conforming is sometimes used interchangeably with Conventional, but Conforming relates to the maximum size of the loan that the GSE’s allow. A non-conforming loan is a loan that is above the maximum loan limit (i.e. Jumbo), or does not follow their precise guidelines (i.e. bank portfolio loan).
What are conventional loan requirements?
Credit scores will likely be the first, and most important, qualification item a borrower will encounter. Many lenders require a minimum of 620 FICO score in order to move forward with a loan application. Secondly, debt-to-income ratios are important. A borrower must have adequate monthly income to support the housing expenses – mortgage payment, real estate taxes, homeowner’s insurance, and association dues, if applicable. Generally, this amount should be approximately 28% of the monthly gross income. There is another ratio that is calculated by taking the housing expense and adding all other monthly debts, such as auto, student, and credit card debt. Generally, the total overall debt shouldn’t exceed 36% of the monthly gross income.
What are the typical interest rates for conventional loans?
In general, interest rates are determined by the value of mortgage backed securities (MBS), which determine the interest rates that lenders offer on a given day. Interest rates change every day – sometimes more frequently, if there are market indicators calling for changes up or down. Borrowers should contact their lenders for the most current and accurate rates.

Some elements that can affect an interest rate quote for a borrower are:

  • Credit scores
  • Loan type
  • Property type
  • Occupancy (owner occupied, investment, second home)
  • Down payment amount
  • Purpose of loan (purchase, refinance, cash-out refinance)
What types of properties are eligible for conventional loans?

Conventional Loans can be used to finance:

  • condos
  • modular homes
  • 1-4 family residences
  • manufactured homes
  • planned unit developments
  • primary residences
  • investment property
  • second homes
What is the maximum amount I can borrow with a conventional loan?
This number varies by county, but can range anywhere from $417,000 to $729,000, and also depends on the property type. For example, Multi-unit properties allow for higher loan amounts, as do certain counties that are designated high-cost areas. The vast majority of properties fall into the maximum loan amount of $417,000.
Are conventional loans assumable?
For the most part, conventional loans aren’t assumable.
What are the typical closing costs associated with a conventional loan and how are they paid?

These costs vary anywhere from 3 – 9%. Closing costs are generally comprised of lender fees, title services, loan discount fees, and misc. fees such as appraisal, credit report, attorney, or other services required for the loan which can vary by state. Closing costs are charged to and paid by the borrower, but in certain circumstances, assistance in paying these costs can be obtained in some of the following ways:

  • A Seller of a home may agree to give the buyer a credit, which can be used to pay for all or part of the cost.
  • A lender may agree to pay for all or part.
  • In the case of a refinance, there are circumstances where the closing costs may be rolled into the new loan.
  • Some states and local municipalities offer closing cost assistance on purchase transactions.
Do conventional loans require an escrow?
If a borrower puts less than 20% down, an escrow is required. Taxes and insurance are collected and placed into the escrow accounts each month. When these items come due, the lender will make the payment. Borrowers with a down payment of 20% or more can choose whether or not they wish to escrow.
What is an ARM/Adjustable Rate Mortgage?
Adjustable rate mortgages (ARMs) differ from fixed rate mortgages (the more traditional mortgage) in that the rate of the loan changes over the life of the loan. What does this mean to you? That means that the rate of interest you are paying when you start (let’s say 4.25%) doesn’t remain the same for the life of the loan. It could go up (to 4.50%, for example) or down (to 4.00%). That means that your monthly payments may also go up or down.
Is an ARM more risky than a traditional fixed rate loan?

Yes, but like all risk, there are benefits paid for taking this risk. For one, the starting interest rate will be lower when you first take the loan. This can be a saving grace if you’re already stretched thin (financially speaking) when making a new home purchase. If a rate adjustment does occur, it can happen after you’ve had time to absorb all of the new home expenses (furniture, moving costs, landscaping, repair, etc.)

Also, for the last 5 years, people with ARMs have won financially over those with fixed rate loans. Since the rates have stayed low, the ARMs have either stayed the same or adjusted downwards, so those with ARMs have paid less interest than their fixed-rate peers.

On the negative side, the rate will adjust, so if interest rates climb, you may end up paying more interest than if you had locked in the rate with a fixed mortgage.

Does that mean with an ARM, my rate can go through the roof?

Probably not. Most ARMs have two different types of rate caps: a yearly cap and a lifetime cap. The yearly cap limits the amount that the rate can increase in a given year. The lifetime cap limits the amount the rate can increase across the full lifetime of the loan.

So, if you have a rate of 4.25% with a yearly cap of 2% and a lifetime cap of 9%, even if the rates skyrocket into the double digits (unlikely), the maximum rate you will have for the 1st year will be 6.25%. Over the lifetime of the loan, your rate will max out at 9%. While this may seem high, realize that it’s a worst case scenario. It’s more likely that your rate will go up one or two percentage points in the next decade.

A lender told me I could get a rate of 1.125%. How can they offer a rate this low?
This rate is known as a “teaser” rate and is generally only in effect for the first 6 months of the loan. Then the rate progressively jumps to the real ARM rate of the specified loan. Some people have told me, “I’ve seen my loan documentation and it shows this low rate and nothing higher.” That’s because the low rate WILL be your start rate and that is the only known rate at the time you sign your loan docs. The real rate that the loan will adjust to is calculated from a loan index plus the loan margin.
Loan index? Margin? What are those?

The rates of all adjustable rate mortgages are determined by using a mortgage index. In the stock market, the Dow Jones Average provides a stock index that gives a general overview of how the market is performing. In the mortgage industry, there are several indexes that average mortgage interest rates. These indexes are used by lenders to determine the rates of adjustable mortgages. Popular indexes include the index of U.S. Treasury Bills, LIBOR, COFI, and COSI. Indexes are not controlled by the lender.

A margin (also called a spread) is the percentage over the index that will determine your rate. For example, if your loan has a margin of 1% and the current LIBOR is 3.95%, then when your loan adjusts, it will adjust to 4.95%. The lower your margin, the lower your overall rate. Margins are generally in the 2-4% range.

So are those low interest rate (1%, 1.125%, 1.5%, etc.) loans a good deal?

For most situations, they aren’t. When your mortgage adjusts, usually within 6 months to a year, your monthly payment can jump quite a bit (because the rate will adjust to sometimes 2-4% higher than the start). The margins on these loans tend to be higher since the lender has to make up the money lost in the beginning of the loan when the money was lent at below market rates.

However, there are situations when these low starter rate programs can be good. Some lenders offer attractive margins and suitable rate caps that for certain types of situations they can be useful (where the absolute minimum monthly payment is needed in the beginning). For most situations, though, these loans are more expensive then traditional ARMs.

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