What is the Downside of a Conventional Loan

While conventional loans offer many advantages, it's essential to consider both the pros and cons before deciding on this type of mortgage. Understanding the downsides of conventional loans can help borrowers make informed choices and evaluate whether this financing option is the right fit for their needs. In this article, we will explore the potential downsides of conventional loans, providing valuable insights to help you navigate the homebuying process.

What is a conventional loan?

Definition of a Conventional Loan

A conventional loan is a type of mortgage that no government agency backs, which distinguishes it from government-backed loans like VA, USDA, and FHA loans.

15 Potential Drawbacks of a Conventional Home Loan

Higher credit requirements: Conventional loans typically have higher credit score requirements than government-backed loans, such as FHA or VA loans. If your credit score is not high enough, you may not qualify for a conventional loan or be offered a higher interest rate. The minimum credit score for a conventional loan is 620. The minimum credit score for an FHA mortgage is 500 (with a 10% down payment) or 580 and up with a 3.5% down payment. USDA and VA loans do not have minimum credit score requirements. These agencies let the lenders establish the minimum credit score for their companies.
Down payment requirements: Conventional loans usually require a larger down payment than government-backed loans. Depending on the lender and the loan program, you may need to put down 5% to 20% of the home's purchase price. A few specialty programs (i.e., HomeReady, Home Possible, Conventional 97, and HomeOne) only require a 3% down payment. However, some home buyers may not meet the guidelines, so the minimum down payment is 5%. This article states that FHA's typical down payment is 3.5%. USDA and veteran loans are zero-down mortgages.
Private mortgage insurance (PMI): If you make a down payment of less than 20%, you will likely be required to pay for PMI, which protects the lender if you default on the loan. PMI can add a significant cost to your monthly mortgage payment. The private mortgage insurance cost is determined by the down payment (loan to value), credit score, loan type (i.e., adjustable rate vs. fixed rate), property type, and a few additional factors.

FHA also has a few factors that can affect the PMI cost, but no credit score adjustments exist. The USDA loans have a PMI rate regardless of credit score, and the VA does not have monthly mortgage insurance.
Limited options for low-income borrowers: Conventional loans may not be the best option for low-income borrowers who need assistance with a down payment or closing costs. Government-backed loans, such as FHA or USDA, can offer more flexible requirements and lower down payment options.
Limited flexibility for self-employed borrowers: Conventional loans can be more challenging to qualify for if you are self-employed, as lenders typically require two years of tax returns to verify your income. This can be challenging for those who have recently started their own business or have a fluctuating income.
Higher interest rates for lower credit scores: If your credit score is on the lower end of the spectrum, you may be offered a higher interest rate on a conventional loan. This can result in higher monthly payments and more interest paid over the life of the loan.
Limited options for borrowers with high debt-to-income ratios: Conventional loans may not be the best option for borrowers with high debt levels compared to their income. Lenders typically prefer borrowers with a debt-to-income ratio of 43% or lower and may require a higher credit score or a larger down payment for those with a higher ratio.
Potential for foreclosure: Like any mortgage, there is always a risk of foreclosure if you cannot make your monthly payments. With a conventional loan, the lender can foreclose on your home if you fall behind on payments.
Limited options for homebuyers with unique circumstances: Conventional loans may not be the best option for homebuyers with unique circumstances, such as those purchasing a second home or investment property. In these cases, alternative financing options may be more suitable.
Higher closing costs: Conventional loans may come with higher closing costs than government-backed loans, which can add to the home purchase cost.

FHA, USDA, and VA loans all require a funding fee. However, the funding fee may be financed.
Limited assistance programs: Unlike government-backed loans, conventional loans may not come with assistance programs to help borrowers with closing costs, down payments, or other expenses associated with buying a home.
Limited options for borrowers with non-traditional credit histories If you have a limited credit history or no credit history, it may be difficult to qualify for a conventional loan. Lenders typically rely on credit scores and reports to assess a borrower's creditworthiness, which can be challenging for those with non-traditional credit histories.
Limited options for borrowers with past bankruptcies or foreclosures: If you have a past bankruptcy or foreclosure on your record, it may be more challenging to qualify for a conventional loan. Lenders typically have strict guidelines for borrowers with past credit issues and may require a longer waiting period before they can qualify for a conventional loan. The FHA only requires a two-year waiting period post-bankruptcy.
Limited options for borrowers with limited assets: Conventional loans may require borrowers to have significant assets, such as savings or investments, to qualify. This can be challenging for borrowers who are just starting or have limited financial resources, known as cash reserves.
Seller concessions: The conventional loans scale the seller assistance percentage based on the down payment, and the FHA is a flat 6% of the sales price.

What are the benefits of a conventional loan?

Here are some potential benefits of a conventional loan:

Lower interest rates: Conventional loans may offer lower rates than government-backed loans, especially if you have a strong credit score and a solid financial history.
No upfront mortgage insurance: Unlike FHA loans, conventional loans do not require upfront mortgage insurance, which can save you money at closing.
More flexible loan terms: Conventional loans may offer more flexible loan terms, such as adjustable-rate mortgages, which can be beneficial if you plan to sell or refinance your home shortly.
No funding fee: Unlike VA loans, conventional loans do not require a funding fee, which can help you save money on the overall cost of your mortgage.
Higher loan limits: Conventional loans may offer higher loan limits than government-backed loans, which can be helpful if you need to borrow more money to purchase a home.
No occupancy restrictions: Conventional loans do not have occupancy restrictions, which means you can use them to purchase a primary residence, a vacation home, or an investment property.
No income limits: Unlike USDA loans, conventional loans do not have income limits, which means you may qualify even if you earn a high income.

Remember that a conventional loan's benefits may vary depending on your financial situation and loan program. Working with a reputable lender to explore your options and find a mortgage that meets your unique needs and goals is essential.

Conclusion

In summary, conventional loans come with their fair share of downsides, which should be carefully considered when exploring mortgage options. From stricter eligibility requirements to potentially higher interest rates and down payment requirements, it's crucial to weigh these factors against the benefits of conventional loans. Every borrower's situation is unique, so it's important to assess your financial circumstances, long-term goals, and preferences before making a decision. By consulting with mortgage professionals and conducting thorough research, you can make an informed choice that aligns with your homeownership aspirations. Remember, knowledge is power, and understanding the downsides of conventional loans empowers you to make confident decisions on your path to homeownership.

SOURCE: