The Differences Between Conforming Loans and Non-Conforming Loans

Congratulations! If you are reading this, then you are most likely looking into becoming a homeowner. This is a big decision, and there’s a steep learning curve. There’s all kind of new things to learn.

Something that always confounds first-time homebuyers is navigating the mortgage process, especially when it comes to deciding what kind of loan you need for your mortgage.

Your mortgage loan will be categorized as conforming or non-conforming. It’s important to know the difference so that you can make the best decision about which type of mortgage loan is right for you.

Know the terminology

When looking at home loan categories, it’s easy to get confused by terms that sound very similar but are in actuality very different. So, to be clear, here are some basic terms that you need to know:

  • Conventional loans: Loans guaranteed/backed by a government-sponsored enterprise (GSE) such as Fannie Mae or Freddie Mac. A conventional loan can be either conforming or non-conforming.
  • Conforming loans: Meet loan limits and specific criteria for purchase by Fannie Mae and Freddie Mac.
  • Non-conforming loans: Do not meet standards of Fannie Mae and Freddie Mac regulations.

In the old days, when a bank would fund a mortgage, they would hang onto it for 30 years and make their money back slowly as you paid your interest. Now, banks will usually package together multiple mortgage loans into investment bundles and sell them to mortgage investors, creating a secondary mortgage market. This helps the banks their money back quickly, allowing them to lend out more mortgages and help sustain the housing market

Fannie Mae and Freddie Mac are two of the biggest mortgage investors on the market, and they have guidelines that dictate what kind of mortgage loans they can buy. If a loan adheres to the guidelines, it is classified as conforming. If it doesn’t, it becomes non-conforming.

The Federal Housing Finance Agency (FHFA) oversees both of these agencies.

There are several factors that differentiate conforming and non-conforming loans. We’ll discuss six of them. It’s important to understand them and how they may affect your application for a mortgage.

Six major differences between conforming and non-conforming loans

  1. Loan limits

This is the biggest difference between conforming and non-conforming loans.

The loan limit refers to the maximum dollar amount a loan can reach and still be purchased by Freddie Mac or Fannie Mae.

This limit is set by the FHFA and can be changed yearly. It was changed at the beginning of 2017 for the first time since 2007 and stands at $424,100 for a single unit dwelling.

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This is the national conforming loan limit for all of the lower 48 states. However, if you live in Hawaii, Alaska, Washington D.C or San Francisco, your conforming loan limit will be set at $636,150. That’s because these are considered high-cost markets. (source). The FHFA provides a list of loan limits by county, or you can check out this map.

To qualify for a conforming loan, you’ll need to purchase a house that puts you under the loan limit in your area.

If your loan exceeds the loan limit, you now have what’s called a “jumbo loan.” This puts you squarely in the non-conforming territory. Jumbo loans usually carry greater risk and less favorable terms and are therefore less appealing to those on the secondary market. (source)

  1. The down payment

Coming up with a down payment is one of the biggest challenges facing potential homebuyers. The traditional industry standard for a down payment is 20% of the home’s purchase price, and until recently, having less than that would have meant that your loan was non-conforming.

Fannie Mae and Freddie Mac have both introduced new programs that allow borrowers to put up as little as 3% down to buy a home. Both have specific criteria for eligibility

Fannie Mae’s HomeReady program requires:

  • borrowers to pay private mortgage insurance (this will likely increase your monthly payments)
  • borrowers to not have owned a primary residence for 3 years
  • a minimum credit score of 620

Freddie Mac’s Home Possible program requires that:

  • first-time homebuyers only, must attend homeownership counseling course
  • private mortgage insurance must be purchased
  • minimum credit score of 660

3% down means that somebody purchasing a $300,000 home would now need to come up with a down payment of $9,000. This is a much more affordable goal for first-time homebuyers and low-income families. Both of these programs are designed to allow potential homeowners that are low in cash reserves to enter the housing market with conforming mortgage loans.

Check out this article for more information on down payments.

  1. Credit score

Your current credit score can play a big role in determining whether your mortgage loan is conforming or non-conforming. Fannie Mae requires a minimum credit score of 620 for a fixed-rate mortgage, but exceptions can be made for lower scores. If for example, the borrower has no credit score, the loan can undergo a manual underwriting process to accept the lower score. (source)

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Keep in mind, the lower a borrower’s credit score, the higher the risk to the lender. This article has information on how your credit score impacts your life.

  1. Debt-to-income ratio (DTI)

DTI is your monthly debt divided by your monthly income, and it indicates to lenders your ability to make your monthly payments. It is expressed as a percentage, and the lower the number, the better.

For example, if you pay $100 a month on your credit card, $200 a month on an auto loan and $200 a month on a student loan, your monthly debt load is $500. If your income is $2000 a month, then your DTI is 25%.

Conforming loans have a maximum of 36%, but this can be extended to 45% if a borrower meets other criteria (e.g., credit score, reserve funds, etc.). (source)

If you are in the market for a mortgage, it’s important to have your DTI calculated; it will play a major role in determining your eligibility for a conforming loan.

  1. Loan-to-value ratio (LTV)

LTV is the dollar amount of the loan compared to the value of the home. For instance, if you qualified for the 3% down payment mortgage programs discussed above, your LTV would be 97%.

The LTV is important in determining repayment terms for a mortgage. Lower LTV indicates a lower risk for investors, while anything over 80% is considered higher-risk.

Again, higher LTV would traditionally relegate you to a non-conforming loan, but new initiatives by major mortgage investors mean that this may not be the case. Do your research, but keep in mind that a higher LTV means the borrower pays more in interest over the life of a loan. (source)

  1. Documentation

Having all of the proper documentation required for a mortgage loan can be a factor in determining whether your loan will be conforming or non-conforming.

Complete documentation of employment history, income, and assets are all very helpful when trying to obtain a conforming loan. These documents help to establish your net worth as a borrower, and a lender will include this when calculating the overall risk of lending you a mortgage.
Overall, whether your loan is conforming or non-conforming depends on your needs.

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The benefit of a conforming loan is that your interest rates are lower, meaning you pay less per month and ultimately pay less over the life of the loan.

Non-conforming loans may be the only option for lower-income borrowers, and those with lower credit scores. They are also great options for those needing a “jumbo loan” to purchase a house above the loan limit.

Non-conventional loans

Remember, a loan backed by a government-sponsored agency like Freddie Mac or Fannie Mae is called aconventional loan’. But if you are non-conforming and do not qualify for a conventional loan, what are your options?

The Federal Housing Administration (FHA) is an entity of the U.S Department of Housing and Urban Development (HUD). It helps to facilitate non-conventional loans to those who qualify.

It does not handle loans, but rather insures them, reducing the risk to the lender and improving your chances of approval.

To qualify for an FHA loan, you need the following:

  • Two years of steady employment
  • Stable or increasing income
  • Credit score of 580 or higher
  • Mortgage payments of 30% of gross income. Gross income means your income before taxes are taken out (source).

Finding an FHA-approved lender is your best bet for a mortgage if you have a low credit score, a higher DTI, or bankruptcy issues in your financial history.

However, you will need to have the home and property appraised to be sure it is compliant with the strict property guidelines that govern the FHA. If a lender hands out a loan that is later found to be non-compliant, the FHA may not fully insure it (source).  This article has good information on what an FHA compliant property looks like.

Do your research

By now, you should have a relatively clear understanding of what differentiates conforming loans from non-conforming loans, as well as the difference between conventional and non-conventional. Your credit score, income, current financial situation and the amount of the loan you need all contribute to your eligibility.

The most important thing when entering the real estate market is knowing your options and doing your research. Compare lenders, their rates and fees, and develop a thorough understanding of how they operate.