Conventional Loan

A conventional loan is a mortgage that is not insured or guaranteed by a federal agency, as distinct from a loan insured by the Federal Housing Administration, guaranteed by the Department of Veterans Affairs, or made under the Department of Agriculture's rural housing programs. It is a category of exclusion, which is why it has no application form, no program office and no eligibility handbook of its own: what makes a loan conventional is the absence of something.

The naming is more precise in law than in conversation, and the two statutes that define it do not use the same construction. Freddie Mac's charter states the broad functional version: "the term 'conventional mortgage' means a mortgage other than a mortgage as to which the Corporation has the benefit of any guaranty, insurance or other obligation by the United States or any of its agencies or instrumentalities" (12 USC 1451(i)). Fannie Mae's charter instead works from a list, authorizing it to deal in "mortgages which are not insured or guaranteed as provided in paragraph (1) (such mortgages referred to hereinafter as 'conventional mortgages')", where paragraph (1) names FHA insurance under the National Housing Act, insurance under title V of the Housing Act of 1949, and guarantees under the Servicemen's Readjustment Act of 1944 or chapter 37 of title 38 (12 USC 1717(b)(2)). One is a general test, the other an enumeration. In ordinary cases they reach the same answer.

Conventional and conforming are two axes, and confusing them is the most common error in this area. Conventional asks who is standing behind the loan, and the answer is nobody federal. Conforming asks whether the loan is small enough and otherwise eligible for Fannie Mae or Freddie Mac to buy. The combinations that exist are conventional and conforming, which is the mainstream case; conventional and non-conforming, which the market calls jumbo; and neither, which is what an FHA or VA loan is. The combination that cannot exist is conforming but not conventional, because the enterprises' purchase limits are written as limits on the conventional mortgages they buy. The label is therefore built into the statute rather than a matter of convention.

Where twenty percent actually comes from. The 80 percent line reads like an industry rule of thumb or a lender preference. It is neither. Both charters carry the restriction, and its operative terms are the same. Fannie Mae's is at 12 USC 1717(b)(2): "No such purchase of a conventional mortgage secured by a property comprising one- to four-family dwelling units shall be made if the outstanding principal balance of the mortgage at the time of purchase exceeds 80 per centum of the value of the property securing the mortgage, unless (A) the seller retains a participation of not less than 10 per centum in the mortgage; (B) for such period and under such circumstances as the corporation may require, the seller agrees to repurchase or replace the mortgage upon demand … in the event that the mortgage is in default; or (C) that portion of the unpaid principal balance of the mortgage which is in excess of such 80 per centum is guaranteed or insured by a qualified insurer." Freddie Mac's charter imposes the same prohibition, with the same three escapes, at 12 USC 1454(a)(2).

Three consequences follow. The threshold is a restriction on what the enterprises may buy, not a rule about what a lender may lend, which is why a portfolio lender is free to make an uninsured loan above 80 percent and keep it. Of the three escapes, the third is the one the market uses, and that is the statutory origin of private mortgage insurance: the excess over 80 percent has to be covered by a qualified insurer for the loan to be salable. And the test is applied to the outstanding balance "at the time of purchase", so it looks at the loan when the enterprise acquires it rather than only at origination. The insurance product itself, and the rules on when the borrower may cancel it, belong to the private mortgage insurance entry and are governed by a different statute entirely.

A quiet inclusion worth knowing. The same paragraph provides that "conventional mortgages" includes "a mortgage, lien, or other security interest on the stock or membership certificate issued to a tenant-stockholder or resident-member of a cooperative housing corporation … and on the proprietary lease, occupancy agreement, or right of tenancy in the dwelling unit". A cooperative purchase is financed against shares and a lease rather than against real property, and the statute reaches it anyway. Freddie Mac's charter carries a parallel provision in its definition of residential mortgage.

What being conventional actually changes for a borrower. There is no federal insurance premium and no funding fee, which are the recurring or upfront charges the government-backed programs use to pay for their guarantees. There is instead, at higher loan-to-value ratios, private mortgage insurance, which is cancellable on terms federal law sets and which the government programs' premiums often are not. Property and occupancy conditions come from the enterprises' selling guides or the lender's own policy rather than from an agency handbook. And credit and income standards are generally tighter than FHA's, which is the trade the borrower is making: no government insurance to pay for, and less accommodation on the way in.

A borrower applies to an ordinary lender. The lender underwrites to the standards of whoever will end up holding the loan, which for most conventional lending means Fannie Mae's or Freddie Mac's selling guide. If the balance exceeds 80 percent of the property's value, the loan needs mortgage insurance to be salable, and the borrower pays for it. The loan closes, and the lender either keeps it or delivers it to an enterprise or a private buyer.

A hypothetical example of where the threshold bites, since the arithmetic is what makes the statutory rule visible. Rosa buys a house for $500,000 and puts down 10 percent, so she borrows $500,000 − $50,000 = $450,000. Her balance is $450,000 ÷ $500,000 = 90 percent of value.

Neither enterprise may buy that mortgage at 90 percent unless one of the three statutory conditions is met. Eighty percent of $500,000 is $500,000 × 0.80 = $400,000, so the portion the statute is concerned about is $450,000 − $400,000 = $50,000, the balance above the 80 percent line. Route (C) covers exactly that portion: it requires that the part of the unpaid principal balance in excess of 80 percent be guaranteed or insured by a qualified insurer. That is why a conventional borrower putting down less than 20 percent is asked to pay for mortgage insurance, and it is also why the requirement is tied to a ratio rather than to a dollar amount.

Had Rosa put down $100,000 instead, the loan would be $400,000, exactly 80 percent, and none of the three conditions would be engaged at all. Figures are illustrative, and the coverage a lender actually requires is set by the enterprises' guides rather than by the statute, which requires only that the excess be covered.

Pros

• No federal insurance premium and no funding fee, so the recurring cost is the interest and, at higher ratios, mortgage insurance that can end.
• Private mortgage insurance is cancellable on terms federal law sets, which is the main structural advantage over the government-backed programs.
• It reaches property types and occupancy arrangements the agency programs restrict, including second homes and investment property, and expressly includes cooperative shares.
• Above the conforming limit it is the only route, since the government programs have limits of their own.

Cons

• Credit, income and reserve standards are generally tighter than FHA's, so the same borrower can qualify for one and not the other.
• Below 20 percent down, mortgage insurance is effectively unavoidable if the loan is to be sold, because the statute requires the excess over 80 percent to be covered.
• There is no agency handbook to appeal to. The standards come from a selling guide or from the lender's own policy.
• It offers no equivalent of VA's no-down-payment structure or FHA's more forgiving credit thresholds for borrowers who would qualify for those programs.