What’s the Difference Between a Conforming Loan and a Nonconforming Home Loan?

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Before you buy a home, it’s important to choose a mortgage that gives you the best possible terms, based on your credit history, income, and the size of your down payment. Finding the right loan can save you tens of thousands of dollars over the lifetime of a mortgage. And generally, buyers are better off if they can find and qualify for a conforming loan.

A conforming loan meets a set of guidelines established by Fannie Mae and Freddie Mac, explains Joe Parsons, a branch manager at Caliber Home Loans in Dublin, Calif. Conforming loans typically have lower interest rates, which means lower monthly payments and less interest paid over the life of a mortgage.

What Do Fannie and Freddie Have to Do With It?

You’ve probably heard of Fannie Mae and Freddie Mac — these are government-sponsored enterprises initially created by Congress to bring affordability, stability, and liquidity to the home mortgage market, according to the Federal Housing Finance Agency (FHFA).

Fannie and Freddie create a secondary mortgage market by purchasing loans from lenders and holding them in their own portfolios or repackaging them into mortgage-backed securities that are sold to investors, says Don Hensel, the president of North Coast Financial, a private-money mortgage brokerage in Oceanside, Calif.

By purchasing loans, Fannie Mae and Freddie Mac help ensure that there’s a continuous supply of mortgages for home buyers. After selling loans to Fannie Mae and Freddie Mac, lenders are able to remove the loans from their own books. This frees up money for them to make new loans.

Conforming Loan Requirements

If a mortgage doesn’t meet the federal guidelines of a “conforming loan,” however, it can’t be sold to Freddie Mac or Fannie Mae – which makes it less appealing to a lender. Some of the main criteria used to determine whether or not a loan is conforming include (but are not limited to):

  • The size of the mortgage: A conforming loan can’t exceed the maximum value set by the FHFA, which is currently $417,000 nationally for single family homes, says Parsons. However, the conforming loan limit can be higher – up to $625,000 – in certain high-cost housing markets, such as counties in California, New York, Massachusetts, and Washington, D.C., among others. To qualify for a conforming loan, consumers must make sure the amount they borrow is less than the conforming loan limit for their community.
  • Loan-to-value ratio: This has to do with the size of your down payment relative to the price of the house. While a down payment equal to 20% or more of the home’s value is standard, first-time buyers can qualify for a conforming loan through Fannie Mae with as little as 3% down.
  • Credit score: Generally, to qualify for a conforming mortgage that meets Fannie Mae and Freddie Mac’s guidelines, you’ll need a FICO credit score of 620 or better. However, there are other government-insured mortgages (such as FHA loans, discussed below) available to borrowers with lower credit scores.
  • Debt-to-income ratio: This refers to how much of your monthly income is devoted to debt repayment. In a conforming loan, Fannie Mae wants your debt-to-income ratio to be no more than 36% (or up to 45% in some cases). So if your gross income is $5,000 a month, your total monthly debts — including car payments, student loans, credit card minimums, and your potential mortgage – cannot exceed $1,800 (or $2,250 using the 45% limit).

Jumbo Loans

Some borrowers must seek nonconforming loans, which typically have higher interest rates. Nonconforming mortgages may also require greater upfront fees and have more stringent insurance requirements.

When you borrow an amount greater than the conforming loan limit for your area, it is called a “jumbo” loan. The loan terms for jumbo mortgages vary widely from lender to lender, but they’re typically more expensive than conforming loans.

“A jumbo can still be a great loan, but it will be priced a little higher,” Hensel says. “That’s because lenders have more trouble selling these loans on the secondary market.”

Generally, the down payment for a jumbo loans is 20% or greater, Parsons says. In addition, lenders examine the borrower’s credit history and income with even more scrutiny.

“The standards for a conforming loans are more forgiving than for a jumbo loan,” Parsons adds. “The bank that is making that jumbo loan in all likelihood will keep it in their portfolio.”

Why Get a Nonconforming Loan?

Jumbo loans aren’t the only nonconforming mortgages out there. Mark Goldman, a loan officer with C2 Financial, says there are a variety of reasons borrowers must seek nonconforming loans, in addition to exceeding conforming loan limits. They include:

  • A low credit score. Non-conforming borrowers may have had a bankruptcies or foreclosures in their credit histories. The three major credit bureaus, Equifax, Experian, and TransUnion issue credit scores based on the perceived default risks that consumers represent. Each credit bureau is required to provide consumers with a free copy of their credit report once a year. You can find more information on AnnualCreditReport.com.
  • Poorly documented finances. To qualify for a conforming loan, you must be able to document proof of your income, your employment, and your assets.
  • A short employment history. Lenders are looking for conforming loan borrowers with steady incomes. A brief employment history or recent changes in job status could hurt your ability to qualify for a conforming loan.

FHA Loans

Goldman says people who can’t qualify for conforming loans may be able to obtain loans insured by the Federal Housing Administration (FHA). FHA-insured loans allow low- and middle-income borrowers to buy homes with down payments as low as 3.5%, he adds.

FHA loans generally have lower down payments and closing costs than conventional loans. Also, unlike conventional mortgages, an FHA loan allows you to use a financial gift from a family member, employer, or charitable organization for your down payment.

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