MortgageLoans.net

Conventional Loans Explained

A conventional loan is a mortgage that is not insured or guaranteed by a federal government agency. Conforming conventional loans meet the purchasing criteria of Fannie Mae and Freddie Mac, including adherence to loan limits, credit score minimums, and documentation standards. They offer flexible terms and competitive pricing for borrowers with solid credit profiles.

Key Takeaways

  • Conventional loans are not government-backed and are governed by Fannie Mae and Freddie Mac guidelines. Loans meeting all GSE criteria are classified as conforming.
  • The minimum credit score is generally 620, but loan-level price adjustments (LLPAs) create significant cost differences between score tiers, making conventional loans most cost-effective at 680 and above.
  • Down payments range from 3% (through specific programs like HomeReady and Home Possible) to 20% or more. Putting down 20% eliminates the requirement for private mortgage insurance.
  • PMI is required when the down payment is less than 20% and can be cancelled when the LTV reaches 80%, unlike FHA mortgage insurance which may persist for the life of the loan.
  • Back-end DTI ratios up to 50% may be approved through automated underwriting with strong compensating factors, though 45% is a more common standard threshold.
  • Conventional loans are available for primary residences, second homes, and investment properties across multiple property types and loan terms (15, 20, and 30-year fixed, plus ARM options).
  • Borrowers should compare total loan costs across conventional, FHA, VA, and USDA programs rather than selecting based on a single factor such as rate or down payment.

How It Works

How the Conventional Loan Origination Process Works

Conventional loan origination begins with a borrower application (Uniform Residential Loan Application, or URLA/Form 1003) submitted to a lender. The lender collects income documentation, asset statements, employment verification, and credit authorization, then orders a tri-merge credit report. The complete file is submitted to either Fannie Mae’s Desktop Underwriter (DU) or Freddie Mac’s Loan Product Advisor (LPA) for automated underwriting. The automated system evaluates the borrower’s credit, income, assets, and property information against the GSE’s guidelines and issues a recommendation: Approve/Eligible, Refer (requires manual review), or Caution/Ineligible.

An Approve/Eligible finding means the loan meets the GSE’s automated criteria and the underwriter can proceed with verifying the documentation to confirm the data matches what was submitted. A Refer finding indicates that the automated system could not approve the loan and it must be manually underwritten, which involves a human underwriter evaluating the complete file against the GSE’s manual underwriting guidelines. Manual underwriting typically requires stronger compensating factors and may have lower DTI limits.

Once the underwriter issues conditional approval, the borrower must satisfy all conditions (additional documentation, letters of explanation, appraisal review) before final approval and clear-to-close. The appraisal is ordered independently to confirm the property’s market value supports the loan amount, and the appraiser evaluates the property against conventional appraisal standards.

How Loan-Level Price Adjustments (LLPAs) Affect Cost

LLPAs are the mechanism through which Fannie Mae and Freddie Mac risk-adjust the pricing of conventional loans. The GSEs publish LLPA matrices that assign fee percentages based on combinations of credit score, LTV ratio, loan purpose (purchase vs. refinance), property type (primary vs. investment), and other risk factors. These adjustments are cumulative: a borrower may face separate LLPAs for credit score/LTV, property type, cash-out refinance status, and subordinate financing.

For example, a borrower with a 700 credit score purchasing a primary residence at 90% LTV might face a base LLPA of 1.25%, while the same borrower at 75% LTV faces 0.375% . If that borrower is instead purchasing an investment property, an additional property-type LLPA is layered on. Lenders translate the cumulative LLPAs into either a higher interest rate or upfront points at closing, and borrowers can choose to pay points or accept the rate adjustment.

Understanding the LLPA structure is essential for comparing conventional loan offers between lenders and for evaluating whether a conventional loan or a government-backed alternative is more cost-effective at a given credit score and down payment level.

How PMI Cancellation Works

Under the Homeowners Protection Act (HPA), borrowers with conventional loans can pursue PMI removal through two paths. The borrower-initiated cancellation occurs when the borrower requests removal after reaching an 80% LTV based on either the original purchase price or the original appraised value (whichever is lower). The lender may require that the borrower be current on payments, have a good payment history (no 30-day lates in the prior 12 months and no 60-day lates in the prior 24 months), and confirm through an appraisal that the property value has not declined .

Automatic termination occurs when the LTV reaches 78% based on the original amortization schedule, regardless of whether the borrower requests it. At this point, the servicer must terminate PMI if the borrower is current. There is also a final termination date: the midpoint of the amortization term (year 15 on a 30-year loan), at which point PMI must be removed regardless of LTV.

Borrowers who believe their property has appreciated significantly may pursue early cancellation by ordering a new appraisal. If the new value demonstrates an LTV at or below 80% (or 75% for loans less than two years old, under some servicer guidelines), PMI may be removed ahead of the original amortization schedule .

How Conventional Loans Compare to Government Programs

The choice between a conventional loan and a government-backed option depends on the borrower’s specific financial profile. Conventional loans offer advantages in PMI cancellation, no upfront funding or guarantee fees (unlike FHA’s UFMIP or VA’s funding fee), and generally better pricing for borrowers with high credit scores. Government programs offer advantages in lower down payments (VA: 0%, USDA: 0%, FHA: 3.5%), more flexible credit requirements, and non-score-based mortgage insurance pricing (FHA).

A useful comparison exercise involves running parallel loan estimates for the same property under conventional and government programs, comparing total monthly payment (including mortgage insurance), total closing costs, and projected costs over the expected holding period. The lowest-rate loan is not always the lowest-cost loan when mortgage insurance duration and upfront fees are factored in.

Related topics include fha loans explained, jumbo loans explained, fha vs conventional loans: a complete comparison, fixed-rate vs adjustable-rate mortgages (arm), down payment requirements by loan type, and pmi and mortgage insurance explained.

Key Factors

Factors relevant to Conventional Loans Explained
Factor Description Typical Range
Credit Score Determines program eligibility and heavily influences pricing through LLPAs. Higher scores unlock lower rates and reduced mortgage insurance costs. 620 minimum (agency floor). 680+ for competitive pricing. 740+ for best available LLPA tiers. 760+ for top-tier pricing.
Down Payment / LTV Affects PMI requirements, LLPA pricing, and available interest rates. Higher down payments reduce lender risk and borrower costs. 3% minimum (specific programs). 5% standard minimum. 10-15% reduces PMI significantly. 20% eliminates PMI requirement.
Debt-to-Income Ratio (DTI) Measures total monthly debt obligations relative to gross monthly income. Both front-end (housing only) and back-end (all debts) are evaluated. Back-end DTI up to 45% standard. Up to 50% possible through DU/LPA with compensating factors . Manual underwriting: 36-45%.
Loan Amount vs. Conforming Limit Loans at or below the conforming limit qualify for GSE purchase. Loans exceeding the limit are classified as jumbo and follow different guidelines. Baseline limit: $766,550 (2024). High-cost areas: up to $1,149,825 . Varies by county and unit count.
Property Type and Occupancy Primary residence, second home, and investment property each have different eligibility rules, down payment minimums, and LLPA structures. Primary residence: 3-5% minimum down. Second home: 10% minimum. Investment: 15-25% minimum depending on unit count .

Examples

First-Time Buyer Using 5% Down Conventional Loan

Scenario: A first-time buyer with a 740 credit score purchases a $350,000 primary residence with 5% down ($17,500). The loan amount is $332,500 at 95% LTV. The borrower has a gross monthly income of $7,200 and total monthly debts of $450 (auto loan and student loan).
Outcome: The borrower qualifies with a back-end DTI of approximately 40% (including estimated PITI and PMI). At 740 with 95% LTV, the LLPAs are moderate. PMI at this score and LTV tier runs approximately $85-$120 per month . The total monthly payment including principal, interest, taxes, insurance, and PMI is approximately $2,450. PMI can be cancelled once the LTV reaches 80% through a combination of payments and potential appreciation.

Borrower Comparing Conventional vs. FHA at 660 Credit Score

Scenario: A buyer with a 660 credit score is purchasing a $275,000 home with 5% down. The buyer compares a conventional loan at 95% LTV with an FHA loan at 96.5% LTV. Both lenders provide loan estimates.
Outcome: The conventional loan carries elevated LLPAs at the 660/95% tier, resulting in an interest rate approximately 0.75-1.00% higher than a 740-score borrower would receive, plus PMI of approximately $180-$220/month . The FHA loan has an upfront MIP of 1.75% ($4,688 financed into the loan) and annual MIP of 0.55% ($130/month) , but the base interest rate is lower because FHA does not apply score-based pricing adjustments. In this scenario, the FHA loan likely has a lower total monthly payment despite the additional MIP, though FHA MIP cannot be cancelled as readily as conventional PMI. The borrower must weigh short-term savings against long-term mortgage insurance costs.

Investor Purchasing a Duplex with Conventional Financing

Scenario: An investor with a 720 credit score and $150,000 in liquid assets purchases a duplex for $400,000 as an investment property. The investor puts 25% down ($100,000) with a $300,000 loan amount at 75% LTV.
Outcome: At 25% down on an investment property, no PMI is required. The investor-property LLPA adds approximately 1.50-3.00% to pricing compared to a primary residence at the same score and LTV . The interest rate is approximately 0.50-0.75% higher than an equivalent primary residence loan. Rental income from the non-owner-occupied unit can be used to offset the mortgage payment for DTI purposes, typically at 75% of the market rent to account for vacancy (Fannie Mae standard) .

Common Mistakes to Avoid

  • Assuming conventional loans always require 20% down

    Conventional loans are available with as little as 3% down through programs such as Fannie Mae HomeReady and Freddie Mac Home Possible, and 5% down through standard conventional options. While 20% down eliminates PMI and provides the best pricing, borrowers with less available cash should not dismiss conventional financing without comparing the full cost against government alternatives.

  • Ignoring LLPAs when comparing interest rates between lenders

    Two lenders can quote the same nominal interest rate but have different LLPA structures. One lender may absorb certain LLPAs into their margin while another charges them as upfront points. Borrowers should compare the Annual Percentage Rate (APR) and the total cost over the expected holding period, not just the note rate, to identify the genuinely lowest-cost offer.

  • Choosing conventional over FHA without running a total-cost comparison

    At credit scores below approximately 700, the LLPA pricing on conventional loans can make the total cost higher than an FHA loan despite the perception that conventional is always cheaper. FHA mortgage insurance is not credit-score-dependent, which can benefit lower-score borrowers. The break-even analysis depends on the holding period, the score-specific PMI and LLPA costs, and how soon PMI can be cancelled on the conventional option.

  • Failing to request PMI cancellation when eligible

    PMI on conventional loans can be cancelled at 80% LTV, but automatic termination does not occur until 78% based on the original amortization schedule. Borrowers who have made extra payments, seen property appreciation, or both should proactively request cancellation rather than waiting for the automatic termination. Every month of unnecessary PMI adds cost that could be avoided.

Documents You May Need

  • Most recent two years of W-2 forms (or 1099s for independent contractors)
  • Most recent two years of federal tax returns (all pages and schedules)
  • Most recent 30 days of pay stubs
  • Most recent two months of bank and asset statements (all pages)
  • Government-issued photo identification
  • Signed Uniform Residential Loan Application (Form 1003)

Frequently Asked Questions

What is the difference between a conforming and non-conforming conventional loan?
A conforming conventional loan meets all of Fannie Mae's or Freddie Mac's purchasing criteria, including adherence to the loan amount limits set by the FHFA. A non-conforming conventional loan exceeds these limits or otherwise falls outside GSE parameters. Jumbo loans are the most common non-conforming type and are held in portfolio or sold to private investors with different underwriting standards.
How much does PMI cost on a conventional loan?
PMI costs vary based on credit score, LTV ratio, coverage percentage, and payment structure. Monthly PMI premiums typically range from 0.20% to over 1.50% of the loan amount annually. A borrower with a 760 score at 90% LTV might pay approximately $50-$80/month on a $300,000 loan, while a 660-score borrower at 95% LTV could pay $180-$250/month or more on the same loan amount .
Can I use a conventional loan for an investment property?
Yes. Conventional loans can be used for investment properties, but the requirements are stricter: minimum down payment of 15% for single-unit and 25% for two-to-four-unit investment properties, higher interest rates due to additional LLPAs, and typically stronger reserve requirements (six or more months of PITI in liquid assets) . Credit score minimums may also be higher under lender overlays.
When can I cancel PMI on a conventional loan?
You can request PMI cancellation when your LTV reaches 80% based on the original property value. PMI is automatically terminated at 78% LTV based on the original amortization schedule. If your home has appreciated, you may request early cancellation with a new appraisal demonstrating the current LTV is at or below 80% (with some servicers requiring 75% for loans seasoned less than two years). You must be current on payments and have a satisfactory payment history.
What credit score do I need for the best conventional loan rates?
The highest LLPA pricing tier (lowest fees) generally applies to borrowers with credit scores of 760 and above. Scores between 740 and 759 receive very similar pricing. Below 740, LLPAs increase progressively, with the steepest cost increases occurring below 700. While 620 is the minimum for most conventional programs, borrowers below 680 should compare conventional costs against FHA to determine which program offers lower total costs.
Last updated: Reviewed by:

Related Topics