What is a Conventional Mortgage and Why Would You Get One?
Shopping for a mortgage can be a long and confusing process. With so many different products to choose from and from so many different lenders, the options can be overwhelming. One type of mortgage is a conventional mortgage, which differs from an FHA or VA loan. Here is an overview of conventional mortgages: what they are and why you might want one.
WHAT IS A CONVENTIONAL MORTGAGE?
A conventional mortgage is a mortgage that is not guaranteed or insured by the federal government. This makes them more risky for lenders. As a result, conventional mortgages generally require you to have a much higher credit score and put down a much larger down payment in order to qualify for them. Conversely, however, with a conventional loan, you can also cancel your mortgage insurance once the principal loan balance drops to 78% of the home’s value. Here are four ways a conventional mortgage is different from other types of mortgages and why you might want one.
1. Higher down payment
Traditionally, conventional mortgages have required a 20% down payment, although this is changing somewhat. Because conventional mortgages are not backed or insured by the federal government, lenders take a higher risk. As a result, they want to ensure that buyers are already heavily invested in the property from the start and have more to lose if they default on the loan. Conversely, however, putting down a large down payment means buyers will pay less for the home overall. The smaller the principal loan amount, the less interest they end up paying over the life of the loan, which lowers the total cost of the home. In addition, since borrowers with a conventional mortgage can drop their mortgage insurance once their loan balance drops below 78% of the home’s value, making a 20% down payment means they don’t have to carry mortgage insurance for long. Today, however, lenders can offer a mortgage for as little as 3% down, depending on the borrower’s credit history and other factors.
2. Higher out-of-pocket costs at closing
Because FHA and VA loans are aimed at helping lower-income or new home buyers buy a home, they often roll many of the closing costs such as origination fees, mortgage insurance and appraisal fees into the loan. While this may help new homeowners up front, they also pay for it on the back end. Everything that gets rolled into your loan also gets interest attached to it, so over time a few thousand dollars in closing fees can end up costing significantly more. The more you pay in interest over the life of a loan, the less of a return you will see on your investment. Keep in mind that a house is more than just a place to live, it also represents a significant investment. Conventional loans may require more down and more in up-front costs, but every dollar that you pay upfront saves you in interest down the road.
3. Higher credit requirements
Because conventional mortgages are considered moderately high-risk loans, home buyers generally need to have a much higher credit score to even qualify for a loan and an even higher one to get a good rate. While it may seem that having to put down such a large down payment and pay higher closing costs may make conventional mortgages less attractive than other types of mortgages, the truth is they actually save home buyers a great deal of money. Not only can paying a healthier chunk of the cost of the home up front save them in interest, but it can also allow them to pay the home off much faster or walk away with a larger percentage of the sale price. As a general rule, borrowers need to have a credit score of at least 620 to obtain a conventional loan and a score of at least 740 to get a good rate.
4. NO Private mortgage insurance (PMI) requirement
FHA and VA loans are guaranteed and insured by the federal government, but it is homebuyers that actually pay for that insurance. Home buyers with conventional loans can drop their mortgage insurance once their principal balance drops below 78% of the purchase price of the home. If they make a 20% down payment, that will happen very quickly. Considering that PMI can run anywhere from .5% to 1% of the purchase price of the home, it can be quite costly. With a VA or FHA loan, home buyers are required to pay PMI payments for the entire life of the loan. Every dollar that they spend on PMI is also one less dollar they have to contribute towards paying off the principal balance on their home. In short, home buyers with conventional loans generally save around $100 a month on average by not having to pay for PMI.
HOW DO CONVENTIONAL MORTGAGES HELP SAVE HOME BUYERS MONEY?
One thing to keep in mind about all mortgages is that the interest compounds over time. This means that every month the interest that has accumulated during that month gets added to the principal and is the first thing that gets paid out of every mortgage payment. The majority of the first several years of mortgage payments goes predominantly towards interest at first. The smaller the principal balance gets, however, the less interest that accrues each month on the loan. Unfortunately, because the majority of every mortgage payment is going towards interest at first rather than principal, it takes a long time to whittle away at the balance. Once the principal starts to shrink, however, it generates less in interest each month. The less interest that accrues, the more of the monthly payment that gets applied to the balance after the interest has been paid and the more rapidly the principal balance begins to shrink. By the end of the loan, the majority of the mortgage payment is going towards the principal, with only a small amount going towards interest.
A conventional mortgage allows home buyers to start off with a balance that is 17% lower than buyers with an FHA or VA loan. This amounts to significant savings over time. For instance, if a home buyer takes out a conventional loan of $300,000 and makes a 20% down payment, then they would receive a loan of 240,000. At 3.6% interest over the course of 20 years, they would end up paying $152,813 in interest or a total of $452,813 for a $300,000 home. With appreciation, however, they may well still walk away with a tidy profit, even though they paid nearly 50% more for the home than the original purchase price.
If they get an FHA or VA loan and only put 3.5% down, however, then even at the same interest rate, they will still end up paying significantly more. In addition to having a higher principal balance, they will also have to pay for mortgage insurance for the entire life of the loan. When all is said and done, home buyers taking out an FHA loan at the same interest rate with a 3.5% down payment will end up paying $495,790 for the same home, or nearly $43,000 more than the buyers with the conventional loan.