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A conventional loan is any mortgage which is not guaranteed or insured by the federal government. Conventional loans were the first traditional mortgage loans made by local lenders. The loans were held in the lender's investment portfolio until they were either paid in full or foreclosed upon. Although it enabled the borrower to build a business relationship with the lender, this practice was generally not in the lender's best financial interest. When rates rose, lenders found themselves in the position of receiving below-market interest on their loans, in addition to not being able to recycle the funds to lend to other borrowers.
With the advent of the secondary market in the late 1930s, lenders could assemble and sell their loan packages, thereby bringing funds back to be loaned out to other borrowers. Today, although some lenders still keep loans in portfolio, the overwhelming majority sell them to the secondary market.
There are a number of advantages that conventional loans could present to prospective borrowers, some of which are listed here:
- Lenders may be willing to keep the loan in their own lending portfolio, thus allowing more underwriting flexibility because the loan will not have to meet secondary market guidelines.
- Lenders may be more willing to negotiate or eliminate certain loan fees.
- The lender may allow collateral other than or in addition to the real property being mortgaged.
- A lender may be willing to finance personal property with the real estate loan, such as appliances and furniture.
- If the loan is held in portfolio, appraisals will only need to meet the lender's guidelines (or the secondary market's if the loan is sold), instead of the strict appraisal standards of the Federal Housing Administration (FHA) and the Veterans Administration (VA).
- If a borrower has difficulty obtaining Private Mortgage Insurance (PMI), the lender may self-insure the loan, increasing the interest rate of the loan to compensate for its greater risk.
- For the cash-short borrower, the lender may be willing to fund a portion of the closing costs in exchange for a higher loan interest rate.
- If the loan is to be held in portfolio, the lender may allow some creative financing options for the buyer.
However, conventional loans may also pose some disadvantages, including:
- Conventional loans generally require larger down payments than government-backed loans.
- Interest rates are set by each lender and can exceed those of FHA and VA loans.
- Origination fees and other costs are also determined by individual lenders and may therefore be higher than those of other programs.
- Because mortgage documents for conventional loans can vary by state and even by lender, the lender could specify that certain clauses be included in a mortgage contract; for example, alienation (due-on-sale), prepayment penalty, or acceleration clauses.
- Loans with greater than an 80 percent loan-to-value (LTV) ratio will require the borrower to purchase Private Mortgage Insurance.
- Some lenders may require that the borrower pay nonrefundable application or processing fees at the time of loan application.
- The lender may not allow some creative financing options for the buyer.
The rules regarding what a lender can and can't do in conventional mortgage lending is determined by the loan's ultimate destination. A lender who wants to sell loans to the secondary market has one set of rules that must be adhered to. If the borrowers require PMI, another set of rules have to be applied. Because a majority of all conventional loans are sold to the secondary market, those guidelines have become the general standard for conventional mortgages.
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