Conforming Loan

A conforming loan is a mortgage that meets the requirements for purchase by Fannie Mae or Freddie Mac, the two government-sponsored enterprises that buy loans from lenders and package them for investors. The best-known requirement is size: the loan's original principal obligation must not exceed the conforming loan limit set for its county and its number of units. Meeting the limit is necessary rather than sufficient, since each enterprise also applies its own published eligibility standards to the borrower, the property and the loan itself.

The name is worth unpicking because three labels get used as though they were the same one. Conforming describes size and eligibility for purchase by the enterprises. Conventional describes the absence of a federal guaranty or insurance, and is defined in statute for each enterprise. Jumbo is a market word for a loan above the limit. The three overlap without lining up: a typical loan is both conventional and conforming, a jumbo loan is conventional and not conforming, and an FHA or VA loan is neither conventional nor conforming even when it is small, because those loans travel through different channels entirely.

Where the limit comes from, and why it is not one number. The statutory machinery is identical for the two enterprises, at 12 USC 1454(a)(2) for Freddie Mac and 12 USC 1717(b)(2) for Fannie Mae. Each is told to establish limitations on the maximum original principal obligation of the conventional mortgages it buys, and each statute then fixes base figures for one-, two-, three- and four-family residences and provides that they "shall be adjusted effective January 1 of each year" by the percentage increase in "the housing price index maintained by the Director of the Federal Housing Finance Agency". FHFA publishes the resulting values each November, off its own House Price Index, so they move on a different calendar from the tax figures that dominate the rest of personal finance.

Three separate provisions then break the single figure into many. Unit count: the statute sets four base figures, so a two-unit property carries a higher limit than a one-unit property in the same county. High-cost areas: where "115 percent of the median house price for such size residence exceeds the foregoing limitation", the limit rises "to the lesser of 150 percent of such limitation … or the amount that is equal to 115 percent of the median house price in such area". So the limit in an expensive county tracks local prices, but only up to a ceiling of 150 percent of the baseline. Special areas: the same limitations "may be increased by not to exceed 50 per centum with respect to properties located in Alaska, Guam, Hawaii, and the Virgin Islands." In practice that puts the baseline in those four places at the same figure as the general high-cost ceiling, $1,249,125, with the 150 percent high-cost ceiling then applied to that higher baseline in turn. FHFA publishes the resulting figure alongside the rest.

What happens when prices fall. The adjustment provision is asymmetric by design. "If the change in such house price index … is a decrease, then no adjustment shall be made for the next year, and the next adjustment shall take into account prior declines in the house price index, so that any adjustment shall reflect the net change in the house price index since the last adjustment. Declines in the house price index shall be accumulated and then reduce increases until subsequent increases exceed prior declines." The limit therefore ratchets: it never falls, and a period of falling prices shows up later as a smaller increase rather than as a cut. That is why the limit stayed flat for years after the 2008 housing crash instead of dropping.

Why the label matters to a borrower who will never meet Fannie Mae. A conforming loan has a known buyer, so the lender is not committing its own balance sheet for thirty years. That is the mechanism behind most of what is familiar about American mortgages: standardized documents, published eligibility criteria a borrower can read, and pricing that reflects a liquid market rather than one institution's appetite. Cross the limit and the loan has to find a different home, which is the subject of the jumbo loan entry.

The limit reaches beyond the enterprises. Two federal programs key their own numbers to it, and both are covered elsewhere: FHA's area loan limits are derived from the conforming limit under 12 USC 1709(b)(2)(A), and a veteran's remaining entitlement is capped against the Freddie Mac limit. Regulation Z uses it too, testing a first-lien loan's principal obligation against "the limit in effect as of the date the transaction's interest rate is set" to decide which higher-priced mortgage loan threshold applies.

FHFA calculates the change in its House Price Index over the four quarters ending in the third quarter, applies that percentage to the baseline limits, and publishes the new values in November, effective for loans acquired in the following calendar year. It publishes a county-by-county table at the same time, because a high-cost county's limit is a function of local median prices rather than of the baseline alone. A lender then checks a loan's original principal obligation against the limit for that county and unit count. Under it and otherwise eligible, the loan can be sold to an enterprise; over it, the lender needs another buyer or has to keep the loan.

A hypothetical example of the ratchet, using round illustrative figures rather than the real limits, since the mechanism is what is hard to picture. Suppose the baseline limit stands at $800,000 and the index falls 2 percent over the measuring period. No adjustment is made: the limit stays at $800,000 rather than dropping to $800,000 × 0.98 = $784,000.

The following year the index rises 3 percent. The prior decline is not forgotten. The adjustment reflects the net change in the index since the last adjustment, and 0.98 × 1.03 = 1.0094, a net rise of about 0.94 percent. So the limit goes to about $807,500 rather than the $800,000 × 1.03 = $824,000 a fresh 3 percent increase would have produced.

Two consequences follow from that arithmetic. A borrower never sees the limit cut, which keeps loans that were conforming at origination from being stranded. And after a downturn the limit lags the market on the way back up, which is exactly when the gap between a conforming loan and the alternative matters most. Figures are illustrative.

Pros

• The loan has a known buyer, so lenders can offer standardized terms and published eligibility criteria rather than case-by-case decisions.
• Eligibility rules are public, which means a borrower can find out in advance what a loan will be tested against.
• The limit ratchets rather than falling, so a decline in house prices does not shrink the pool of loans the enterprises may buy.
• High-cost counties get a higher limit automatically, keyed to local median prices rather than to a national average.

Cons

• The limit is a cliff. A loan a dollar over it is treated as a different product entirely.
• It moves once a year on FHFA's schedule, so a borrower near the line in November or December is exposed to which side of the calendar their loan lands on.
• Because the limit is county-specific, a figure quoted nationally is wrong in both directions in a great many places.
• Meeting the limit is not enough on its own. The enterprises' own eligibility standards still apply to the borrower, the property and the loan.
• The ceiling in high-cost areas is capped at 150 percent of the baseline, so in the most expensive markets the limit stops tracking local prices.