A conventional loan is not government-backed and follows guidelines set by Fannie Mae and Freddie Mac. It requires 3-20% down, a 620+ credit score, and offers PMI that drops off at 80% equity. Conventional loans are the most common mortgage type and offer the best long-term value for buyers with good credit because PMI eventually goes away.
How Conventional Loans Work: Fannie Mae and Freddie Mac
Conventional loans are created by private lenders and sold to government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. These GSEs buy most conventional mortgages, package them as mortgage-backed securities, and sell them to investors. This system keeps mortgage rates competitive and ensures there is a steady supply of funding available for homebuyers.
Because conventional loans are not backed by the government, lenders take on more risk. That is why they require higher credit scores and down payments than FHA loans. But the trade-off is that PMI drops off automatically once you reach 80% equity, making conventional loans cheaper over the long term for borrowers with strong credit.
Conventional Loan Requirements
- Credit score: Minimum 620, but 660+ gets you better rates. Best rates at 740+.
- Down payment: 3% through HomeReady/HomeOne programs, typically 5-20%. Under 20% requires PMI.
- Debt-to-income ratio: Typically up to 45%, can go to 50% with strong compensating factors.
- Loan limits: $766,550 for conforming loans in most areas. Higher limits in high-cost markets.
- Reserves: Some lenders require 2-6 months of mortgage payments in reserves after closing.
PMI Rules: How It Works and How It Drops Off
Private mortgage insurance (PMI) is required when you put down less than 20% on a conventional loan. The cost varies from 0.3% to 1.5% of the loan amount per year, depending on your credit score and down payment. On a $350K loan with a 5% down payment and 720 credit score, PMI would cost about $130 per month.
The key advantage of PMI on conventional loans is that it drops off automatically once your loan-to-value ratio reaches 78% of the original value. You can also request early cancellation at 80% LTV. This is the biggest difference from FHA, where MIP stays for the life of the loan on most loans with less than 10% down.
Conforming vs Jumbo Loans
Conventional loans come in two types:
- Conforming loans: Meet Fannie Mae/Freddie Mac limits and guidelines. Current limit is $766,550 in most areas. Lower rates and easier approval.
- Jumbo loans: Exceed conforming limits. Require 700+ credit, 10-20% down, and have slightly higher rates. Used for luxury properties.
When Conventional Is Best
Conventional loans are ideal when you have a credit score of 660+ and at least 3-5% saved for a down payment. The PMI drops off, saving you hundreds per month starting around year 6-7. If you plan to stay in the home 7+ years, conventional almost always beats FHA in total cost. The trade-off is slightly stricter qualification, but the long-term savings are substantial.
Conventional vs FHA Decision
Run both scenarios before deciding. A buyer with 700 credit and 5% down on a $300K home might pay $1,950 in PMI per year on conventional, but that drops off. FHA's MIP stays forever. Over 10 years, conventional could save $12K-$18K. But for a buyer with 620 credit and limited savings, FHA's lower barriers may be the right choice.
