Real Estate Salesperson · Financing and settlement · 7 min read
Conventional, Fixed-Rate and Adjustable-Rate Loans
- Differentiate between conventional conforming, nonconforming, and government-backed loans, including private mortgage insurance rules.
- Explain the mechanics of fixed-rate mortgages, amortization structures, balloon loans, and interest-only notes.
- Analyze adjustable-rate mortgage components, including indices, margins, rate caps, payment caps, and negative amortization.
Conventional Loans: Conforming, Nonconforming, and Private Mortgage Insurance
One important distinction in residential financing is whether a loan has government insurance or a government guarantee. A conventional loan is a mortgage that is not insured or guaranteed by a government agency. This distinguishes conventional financing from government-backed mortgage programs such as FHA loans, VA loans, and USDA loans. In everyday practice, real estate salespersons work under a supervising broker to help clients navigate these financing categories when evaluating purchase offers.
Conventional loans are further divided into conforming and nonconforming mortgages. A conforming conventional loan meets the loan-size limit and other requirements for purchase by Fannie Mae or Freddie Mac, which are government-sponsored enterprises operating in the secondary mortgage market. Conforming loan requirements include specific loan-size limits as well as underwriting standards for borrower creditworthiness and debt-to-income ratios. A nonconforming conventional loan fails to meet one or more Fannie Mae or Freddie Mac purchase requirements, which may involve the loan-size limit or underwriting criteria. A prominent example is a jumbo loan, which is a type of nonconforming loan that exceeds the dollar limit set for conforming loans. Jumbo loans often feature stricter credit and cash-reserve requirements than conforming loans, though their interest rates are not necessarily higher.
When buyers purchase a property, lenders evaluate the loan-to-value (LTV) ratio. For a purchase loan, the loan-to-value ratio is the loan amount divided by the lesser of the property's appraised value and purchase price; for a refinance, lenders generally use the appraised value. Lenders generally require private mortgage insurance (PMI) on conventional loans when the loan-to-value ratio exceeds 80 percent. PMI protects the lender against financial losses resulting from borrower default on a conventional loan. Consequently, a borrower making a down payment of 20 percent or more on a conventional purchase loan typically avoids private mortgage insurance altogether.
The federal Homeowners Protection Act provides cancellation and termination rights for covered borrower-paid PMI on mortgages secured by a borrower's principal residence. Under this federal law, a borrower may request cancellation of private mortgage insurance when the loan balance reaches 80 percent of the property's original value, subject to payment-history and other requirements. Furthermore, the Homeowners Protection Act mandates that private mortgage insurance generally must terminate automatically on the date the loan balance is scheduled to reach 78 percent of the property's original value, provided the borrower is current on payments.
| Loan Category | Secondary Market Eligibility | Key Underwriting Characteristics |
|---|---|---|
| Conforming Conventional | Eligible for purchase by Fannie Mae or Freddie Mac | Must adhere to established loan-size limits, creditworthiness standards, and debt-to-income ratios. |
| Nonconforming (Jumbo) | Ineligible for Fannie Mae or Freddie Mac purchase | Exceeds conforming dollar limits; often requires stricter credit and cash reserves; rates are not necessarily higher. |
Common mistakes
- Believing that FHA or VA loans require conventional-loan PMI; conventional lenders commonly require PMI above 80 percent LTV, while FHA has its own mortgage insurance premiums and eligible VA loans generally have no monthly mortgage insurance.
- Assuming that the margin changes whenever the market index changes; the index moves according to market conditions, but the margin remains constant throughout the loan term.
- Confusing an interest rate cap with a payment cap; while an interest rate cap limits how much the rate percentage can rise, a payment cap restricts dollar payment increases and can trigger negative amortization if the payment cannot cover the accrued interest.
- Thinking that jumbo loans always carry higher interest rates than conforming loans; while jumbo loans often have stricter credit and cash-reserve guidelines, their interest rates are not necessarily higher.
Key points
- Conventional loans are not insured or guaranteed by any government agency, unlike FHA, VA, or USDA loans.
- Conforming conventional loans meet Fannie Mae or Freddie Mac purchase requirements, including applicable size limits; nonconforming loans fail at least one requirement, and jumbo loans specifically exceed the applicable size limit.
- Conventional lenders commonly require PMI above 80 percent LTV; for covered borrower-paid PMI on a principal residence, the Homeowners Protection Act generally permits a cancellation request at 80 percent of original value, subject to conditions, and requires automatic termination when the balance is scheduled to reach 78 percent if payments are current.
- With a level-payment, fully amortized fixed-rate loan, scheduled principal-and-interest payments remain constant as the interest share decreases and the principal share increases.
- A 15-year fixed-rate mortgage repays principal faster and accrues less total interest than a 30-year mortgage, but has a higher monthly payment for the same amount and rate.
- Adjustable-rate mortgage rates equal an economic index plus a constant margin, with adjustments bounded by initial, periodic, and lifetime caps.
- Payment caps can restrict payment increases but risk negative amortization, adding unpaid interest directly back into the principal debt balance.
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