Do Conventional Mortgages still make sense?

My collaboration with the folks from Money Geek continues.

The team does great research and conducts surveys to offer helpful and educational content to readers. They approached me to participate, and this is the second article we worked on together.

The core content was provided by Christopher Boston.

Christopher (Croix) Boston was the Head of Loans content at MoneyGeek, with over five years of experience researching higher education, mortgage and personal loans.

Boston has a bachelor's degree from the Seattle Pacific University. They pride themselves in using their skills and experience to create quality content that helps people save and spend efficiently.

In our collaboration we addressed some specific issues I added. Yuo find them under my picture.

Further down Christopher will provide the general info you should know when considering conventional mortgage loans.

Conventional loan market share (versus government-backed loans) has ranged from about 55% to approximately 80% in recent years. What do you believe drives changes in the popularity of these loans?

People think conventional loans, especially government-secured loans, are safer than other loan instruments. In my experience, that is not the case, and true safety comes from treating the loans correctly and not overburdening any assets with too much debt.

Per the NAHB, in 2019, reliance on non-conventional financing was heaviest in Texas, Oklahoma, Louisiana and Arkansas at 48.5 percent. It was significantly lower in New York, New Jersey and Pennsylvania at 15.8 percent. Why might that be the case?

We don’t get much financial education in school, college, or university, and even someone who goes for an MBA is learning statistical analysis and still does not really know how a home loan works. I suspect that in the states with higher rates, there are organizations that make easy-to-understand offers to customers. There might also be a political component, as the laws and rules can either support or hamper the use of financial instruments.

What do you believe is the most pervasive myth about conventional mortgage financing?

There are many, but one of the ones I often come across is the belief that each month, a certain amount of the payment pays down the house (asset), and some goes to interest, which occurs for 30 years (typically). People are often shocked to see how little they have actually reduced the original loan amount after 7–10. Most assume that after 15 years, the house should be half-paid. Most people are shocked when I tell them that almost all of the interest in the amortization table gets paid to the bank first, and only then will the principal really make a significant impact. In that context, after explaining it, it suddenly also makes sense why some extra payments a year or a little extra principle per month have such a huge impact on the overall duration of payments. Some calculations show that a little extra can reduce a traditional mortgage from 30 years to about 12 years.

Per NCRC, Fannie Mae and Freddie Mac make conventional loans “that mimic FHA lending.” But lenders are “offering LMI (low median income) and minority borrowers the higher-cost government-insured alternatives." Are conventional 97 mortgages under-utilized?

Probably, but I caution against generalizations. Anybody in the business of needing a loan should find an independent expert and go through all options, calculate the variables and impact, not just on the monthly payment but overall costs. I wish people would pay closer attention to the amortization tables and really compare different loans to see how a little change can make a big difference.

Mortgages are long-term loans that help you buy a home by spreading the cost over many years. There are different types of mortgages to choose from, and a popular option for aspiring homeowners is the conventional loan. Unlike government-backed mortgages, these are not insured by the federal government, offering flexibility in terms like interest rates and down payments. If you're thinking about getting a mortgage, it's crucial to understand the ins and outs of conventional loans — such as requirements, how to apply and the pros and cons — to make an informed decision.

What Is a Conventional Loan?

A conventional loan is a type of mortgage you can get from private lenders like banks or mortgage companies. Unlike government-backed loans, the federal government does not back these loans, which often makes them more flexible in terms of interest rates and down payments. You'll find various loan lengths to choose from, with 15, 20 or 30 years being the most common. Depending on your preference and financial situation, you can also decide between a fixed-rate mortgage, where the interest remains constant over time, or an adjustable-rate mortgage, which can fluctuate after an initial fixed period.

When diving into conventional loans, you'll encounter two main categories:

• Conforming Loans: These abide by the rules set by government-sponsored entities Fannie Mae and Freddie Mac. For 2023, the Federal Housing Finance Agency has set the conforming loan limit at $726,200 for most states. For high-cost areas like Alaska and Hawaii, the limit is $1,089,300. These loans usually offer lower interest rates and are a good fit for many borrowers.
• Non-Conforming Loans: These loans don't meet the conforming loan guidelines, often due to loan amounts surpassing the established limits. While they offer more flexibility, the interest rates are generally higher.

Understanding the nuances of a conventional loan helps you make an informed decision about your mortgage. Whether conforming or non-conforming, the right loan type depends on your financial goals and circumstances.

Conventional Loans vs. Government-Backed Loans

Government-backed loans, such as FHA, VA and USDA loans, are mortgages insured by the federal government. This insurance encourages lenders to offer loans to borrowers who might not be eligible for a conventional home loan. Let's dive deeper into their differences.

• Comparison Area
• Conventional Loans
• Government-Backed Loans

These loans have unique features tailored for different financial situations. Understanding their differences can guide you in selecting the loan that best matches your needs.

Types of Conventional Loans

When it comes to securing a mortgage, it pays to know your options. Conventional loans come in various types, each with unique features and benefits. Picking the right one for your financial situation can lead to long-term advantages. Let's break down the different types to give you a clearer picture.

Understanding the types of conventional loans helps you pick the one that's right for you. From conforming loans for standard cases to specialized options like jumbo and portfolio loans, there's a conventional loan that will likely meet your unique needs.

Pros and Cons of Conventional Loans

A conventional mortgage can offer advantages like lower interest rates and fewer hoops to jump through. However, you might also face higher down payment requirements or stricter credit standards. Focusing only on the perks might make you overlook the hurdles, leading to a mortgage that's not the best fit for you. In the same way, concentrating solely on the drawbacks could deter you from a loan that serves your needs well. The key is to balance both sides to make an informed decision.

Pros of Conventional Loans

After diving deep into the intricacies of different types of conventional loans, let's explore what makes them attractive. Knowing these benefits can help you determine whether a conventional home loan best matches your needs.

• More Mortgage Options: You have a variety of choices like fixed-rate, adjustable-rate and jumbo loans, to name just a few. You can also choose between several loan lengths to tailor your mortgage to your unique financial situation.
• More Financing and Property Types: With a conventional loan, your lender won't restrict you to owner-occupied residences. You can also finance second homes and investment properties.
• Low Down Payment Requirement: Conventional loans offer a low down payment requirement of 3% for first-time home buyers, which is lower than the FHA requirement and the more typical 5% down for non-first-time buyers.
• Ability to Cancel Private Mortgage Insurance (PMI): With a 20% down payment, you can avoid PMI, a cost often added to other loan types.
• Fewer Documentation Requirements: The paperwork tends to be less rigorous than government-backed loans, making the application process more streamlined.
• Higher Loan Limits: Conventional loans generally offer higher limits than government-backed options for those looking to borrow a larger sum, especially via jumbo loans.

Knowing these advantages puts you in a better position to assess whether a conventional home loan meets your needs. The array of mortgage options, flexibility and fewer requirements make it an attractive path for many borrowers.

Cons of Conventional Loans

As with any financial decision, conventional loans present some drawbacks you should be aware of. Let's get into the negatives.

• Higher Credit Score Requirements: A conventional loan typically demands a higher credit score than other loan types. A lower score could mean higher interest rates or disqualification.
• Closing Costs: Closing costs, which can include everything from appraisal to origination charges, are usually between 2% to 5% of the loan amount. Although some of these are negotiable, they will still increase your homebuying expenses.
• Rigidity in Rates: If you take out a conventional loan and market conditions are less favorable, you could find yourself committed to a higher interest rate, which can impact both your monthly payments and your long-term financial plans.

Awareness of these drawbacks ensures you're not mindlessly entering into a conventional loan. While they offer flexibility and options, the higher initial costs and credit requirements can be a hurdle for some borrowers. Choose wisely!

Who Should Consider a Conventional Loan

In the journey to homeownership, understanding your options can make all the difference. While conventional loans have their perks, they aren't the one-size-fits-all solution for every prospective homeowner. By diving into specific scenarios, we'll unpack how a conventional loan can either be a boon or a bust, depending on your situation.

Mia's Smart Mortgage Move

Let's consider Mia, a professional in her late 30s with a stable job and good credit. She's saved a decent down payment over the years and dreams of buying a condo in a bustling city. Since Mia has a credit score above 700 and has managed to save up more than 20% for a down payment, she's a prime candidate for a conventional loan. Here's why:

• No Need for PMI: With her solid down payment, Mia avoids the extra costs associated with Private Mortgage Insurance, a requirement if the down payment is less than 20%.
• Lower Interest Rates: Thanks to her strong credit score, Mia benefits from a more competitive interest rate, which could save her thousands over the life of the loan.
• Flexibility in Property Types: Unlike certain government-backed loans that come with owner-occupancy requirements, a conventional loan gives Mia the freedom to consider this property as an investment down the line.

In Mia's case, opting for a conventional loan unlocked a pathway to homeownership that suited her financial situation. It just goes to show that understanding your options and aligning them with your personal circumstances can be the key to making a wise decision.

Jack's Mortgage Misstep

Consider Jack, a recent college graduate in his early 20s. He's just landed his first job and has student loans to pay off. He's eager to invest in a home rather than continue renting, but his financial profile is more complex. A conventional loan might not be his best bet. Here's why:

• Student Loan Debt: Jack's debt-to-income ratio is skewed due to his student loans, which could make qualifying for a conventional loan more challenging.
• Short Credit History: Being new to the workforce, Jack has a limited credit history. While not necessarily bad, it's not as robust as lenders generally like to see for a conventional loan.
• Small Down Payment: Jack has saved some money, but it's not enough to cover a 20% down payment. If he went with a conventional mortgage, he would have to pay for PMI for several years.

While a conventional loan may offer attractive benefits, it might not be the right fit for everyone. In Jack's case, an FHA loan may be a better option. It could give him the stepping stone to start his homeownership journey without overstretching his finances.

Patricia's Wise Retirement Decision

Patricia is a 65-year-old retiree who's lived in the same home for the past 35 years. Now that she's retired, she wants to downsize and move to a smaller, more manageable property. While she has a decent retirement fund, her monthly income is limited. Given her situation, a conventional may not be her best option for the following reasons:

• Limited Monthly Income: Patricia's primary source of money is her retirement fund and Social Security benefits. The regular monthly payments might stretch her finances thin.
• Asset-Rich but Cash-Poor: Patricia has significant home equity but limited liquidity. A conventional loan would require her to make monthly mortgage payments, which isn't ideal for her financial situation.
• Stricter Approval Requirements: Given her age and limited income, Patricia might find the loan approval process for a conventional mortgage to be more challenging.

A reverse mortgage may be a more fitting option in Patricia's case. It allows homeowners aged 62 and above to convert a portion of their home equity into cash, which they can use to purchase a more modest home. Most importantly, a reverse mortgage doesn't require monthly mortgage payments, making it easier on Patricia's limited income.

How to Secure a Conventional Loan

Knowing the steps to secure a conventional loan in advance can be a real game-changer. For one, it helps you better manage your time and resources. You'll know exactly what documents to prepare and the key decisions you must make. Secondly, it can reduce stress. Mortgages can get complicated but breaking it down into digestible steps simplifies the process. It can even help you secure a better loan deal, as you'll be more equipped to navigate terms and negotiations.

Assess Your Financial Profile

Before even approaching a lender, closely examine your financial situation. Scrutinize your credit score, debt-to-income ratio and current financial commitments. Knowing these numbers upfront gives you a better understanding of what loan terms you may qualify for and helps you set realistic expectations.

Research Lenders

Don't settle for the first lender that crosses your path. Each one might offer slightly different interest rates and terms. Shop around to find the one that fits your needs best.

Get Pre-Approved

A pre-approval letter can put you in a strong negotiating position. It shows sellers that a lender has already assessed your financial credentials and is willing to back your home purchase.

Submit Loan Application

After you've zeroed in on the home you want to buy, you'll need to formally apply for a mortgage. This entails submitting financial documents such as W-2s, tax returns and recent bank statements.

Home Appraisal

Your lender will request a home appraisal to determine if the property you're buying is a good investment. They'll want to make sure the home's value justifies the loan amount.

Secure Your Mortgage and Close the Deal

Finally, your lender will finalize the loan terms and prepare a closing disclosure. It lays out the specifics of your mortgage, including the final terms and costs. After signing it, you’ll get the keys to your new home.

Securing a conventional loan isn't an overnight process, but knowing the steps helps you stay ahead of the game, optimizing your time and potentially even saving money.

I would like to thank Chris, Roman, and the team at Money Geek for their collaboration and friendship.