Conventional Home Loans

Conventional Home Loans

Uncle Sam is a major player in the residential mortgage market. About one out of five home loans is either insured or guaranteed by an agency of the federal government.

These mortgages are called, you guessed it, government loans. The remaining 80 percent of residential mortgages originated in the United States are referred to as conventional loans.

Here's a quick recap of government loans:

Federal Housing Administration (FHA). The FHA was established in 1934 during the depths of the Great Depression to stimulate the U.S. housing market. It helps low-to-moderate income folks get mortgages by issuing federal insurance against losses to lenders who make FHA loans.

The FHA is not a moneylender. Borrowers must find an FHA-approved lender such as an S & L, bank, or other conventional lending institution willing to grant a mortgage that the FHA then insures. Due to their complexity, not all commercial lenders choose to participate in FHA loan programs.

• Department of Veterans Affairs (VA). Congress passed the Serviceman's Readjustment Act, commonly known as the GI Bill of Rights, in 1944. One of its provisions enables the VA to help eligible people on active duty and veterans buy primary residences. Like the FHA, the VA has no money of its own. It guarantees loans granted by conventional lending institutions that participate in VA mortgage programs.

• Farmers Home Administration (FmHA). Like the FHA and VA, the FmHA isn't a direct lender. Despite its name, you don't have to be a farmer to get a Farmers Home Administration loan. You do, however, have to buy a home in the sticks. The FmHA insures mortgages granted by participating lenders to qualified buyers who live in rural areas.

FHA, VA, and FmHA mortgages have more attractive features — little or no cash down payments, long loan terms, no penalties if you repay your loan early, and lower interest rates— than conventional mortgages. However, these loans aren't for everyone. Government loans are targeted for specific types of home buyers, have relatively low maximum mortgage amounts, and require an inordinately long time to obtain loan approval and funding.

In a hot market where homes generate multiple offers as soon as they're offered for sale, buyers using government loans almost always lose out to people utilizing conventional mortgages that can be funded much more quickly.

Primary or secondary mortgage market

Lenders make loans directly to folks like you in what is called the primary mortgage market. Very few lending institutions keep mortgages they originate in vaults surrounded by heavily armed guards. Lenders sell most of their mortgages before the ink has dried on the borrowers' signatures. These loans are purchased by pension funds, insurance companies, and other private investors as well as certain government agencies in the secondary mortgage market.

Why do mortgage lenders sell mortgages they originate? They want to make a profit and to obtain more funds to lend.

The ubiquitous Uncle Sam is an extremely important force in the secondary mortgage market through two federally chartered government organizations — the Federal National Mortgage Association (FNMA, or Fannie Mae to smarties like you) and the Federal Home Loan Mortgage Corporation (FHLMC, endearingly known as Freddie Mac). One of the primary missions of Fannie Mae and Freddie Mac is to stimulate residential housing construction and home purchases by pumping money into the secondary mortgage market.

Fannie Mae and Freddie Mac boost home purchases and construction by purchasing loans from conventional lenders and reselling them to private investors. These government programs are far and away the two largest investors in U.S. mortgages. Loan purchases by Fannie Mae and Freddie Mac annually account for well over 20 percent of total U.S. mortgage funds.

These programs aren't meant to subsidize rich folks. To that end, Congress establishes upper limits on mortgages Fannie Mae and Freddie Mac are authorized to purchase. Congress readjusts these maximum mortgage amounts annually to reflect changes in the prevailing average price of property. Any good lender can fill you in on Fannie Mae's and Freddie Mac's current loan limits.

Conforming or jumbo loans

This delicious tidbit of information can save you big bucks. Conventional mortgages that fall within Fannie Mae's and Freddie Mac's loan limits are referred to as conforming loans. Mortgages that exceed the maximum permissible loan amounts are either called jumbo loans or nonconforming loans.

You pay dearly for nonconformity. The higher the loan amount, the bigger the thud if your loan goes belly up. Reducing the loan-to-value ratio is one way lenders cut their risk. To that end, conventional lenders generally insist on more than the usual 20 percent down on jumbo loans over $500,000. You'll probably be required to make at least a 25-percent cash down payment.

Interest rates on nonconforming fixed-rate mortgages generally run from 3/8 to 1/2 a percentage point higher than conforming FRMs. When mortgage money is tight, the interest rate spread between conforming and jumbo FRMs is higher; when mortgage money is plentiful, the spread decreases.

If you find yourself slightly over Fannie Mae's and Freddie Mac's limit, don't despair. You can either buy a slightly less expensive home or increase your cash down payment juuuuuuuuuust enough to bring your mortgage amount under the conforming loan limit.

Long-term or short-term mortgages

Any loan that's amortized over 30 or more years is considered a long-term mortgage. Reversing that guideline, short-term mortgages are loans that must be repaid in less than 30 years.

These standards hark back to less complicated times before the late 1970s when people could get any kind of mortgage they wanted as long as it was a 30-year, fixed-rate loan. Back then, choices for a short-term mortgage were nearly as limited. Home buyers could have an FRM with either a 10- or 15-year term or a balloon loan with, for example, a 30-year amortization schedule and a 10-year due date.

They made the same monthly principal and interest payments for 10 years and then got hammered with a massive balloon payment to pay off the entire remaining loan balance.

The total interest charges on short-term mortgages are less than total interest paid for equally large long-term loans at the same interest rate. However, short-term loans usually have lower interest rates than comparable long-term mortgages. For example, the interest rate on a conforming 15-year, fixed-rate mortgage is generally about 1/2 a percentage point lower than a comparable 30-year FRM.

Even though short-term loans have lower interest rates than their long-term cousins, qualifying for a short-term loan is more difficult due to its higher monthly loan payments. Lenders generally don't want you spending much more than 28 percent of your gross monthly income on mortgage payments. Even if you can qualify for a short-term loan, it may not be in your best interests (pun intended) to irrevocably lock yourself into the higher monthly payments.