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Topic 13.2: Conventional mortgages

Learning Objective

After successfully completing this topic, you will be able to describe the characteristics of conventional mortgages.

Neither Government Insured nor Guaranteed

A conventional mortgage is not insured (like FHA mortgages) or guaranteed (like VA mortgages). FHA mortgages and VA mortgages are called nonconventional mortgages. The lender of a conventional mortgage has the full risk of loss from default on the loan.

Down payment and Loan-To-Value ratio

Conventional mortgage lenders usually require larger down payments from borrowers, typically 20% of the purchase price or the appraisal, whichever is lower. If a borrower makes a down payment of 20%, the loan amount will be 80%. 80% would be called the loan-to-value (LTV) ratio.

For example:
Assume the purchase of a home priced at $200,000. If the borrower makes a down payment of 20%, that would be $40,000 ($200,000 x .20). The mortgage amount would be $160,000, or 80%.

Conventional Mortgage Loan Features

Private Mortgage Insurance (PMI) 

Conventional loans can be a maximum of 80% of the property’s value unless the borrower buys private mortgage insurance (PMI) to protect the lender against loss from default. In that case the borrower can borrow up to 98% of the property value. Borrowers who pay at least 20% down don’t pay for mortgage insurance. PMI can be canceled when the home equity reaches 20%.

Qualifying Ratios 

Formerly, convention lenders used two ratios to qualify applicants: the housing expense ratio and the total obligations ratio. That has changed, and today conventional lenders use a debt-to-income (DTI) ratio to decide whether a borrower is qualified. The debt in the formula is the total of the borrower’s monthly payments of mortgage payment (PITI), the private mortgage insurance (PMI), and other monthly installment debt. The income in the formula is the borrower’s monthly gross income.

Generally, the maximum debt-to-income ratio for conventional loans is 43% for high credit score borrowers. In some cases, lenders will allow a DTI ratio of up to 50% if the borrower has high credit scores and lots of cash reserves. See example below.

Example of Debt-to-Income Ratio
The borrower’s monthly debt payments are
Mortgage payment (PITI)                                           $ 1,345
Private mortgage insurance (PMI)                                   37
Credit card minimum payments                                     275
Student loan payments                                                      850
Total debt payments                                                    $ 2,507

Borrower’s monthly gross income is                   $ 7,145

What is the debt-to-income ratio?   
Answer: 35% ($2,507 ÷ $7,145).
The borrower will qualify for the loan.

Interest rate

Interest rates on conventional mortgage loans are negotiated between the borrower and the lender. Interest rates on conventional loans are typically a little higher than FHA or VA loans.

Assumption

Conventional mortgage loans are not assumable without the lender’s permission because of a due-on-sale clause in the mortgage loan documents.

Prepayment

Conventional mortgage loans may be paid off at any time without penalty.

Down payment and private mortgage insurance

If a borrower makes a 3 percent down payment, the lenders risk is higher than if the borrower made a down payment of 20 percent. Because of the additional risk, lenders require borrowers who pay less than 20 percent down to buy mortgage insurance. The insurance will pay the lenders if the borrower defaults on the loan.