What's the Difference Between Conforming and Non-Conforming Loans?
If you’re in the market for your first home, you’ve probably read a lot about mortgages and loans. It can be a challenge to grasp the terminology and understand your options, especially if you’re new to the world of real estate financing.
One area where first-time homebuyers have a lot of confusion is understanding the differences between non-conforming and conforming loans. Sometimes, banks and mortgage lenders use these terms and don’t bother explaining them.
We always want to be sure our members know what the terms we use mean. So, with that in mind, let’s talk about conforming and non-conforming loans and the differences between them.
What is a Conforming Loan?
Fannie Mae and Freddie Mac are the two government-sponsored entities that drive the home loan market. You’re probably familiar with these names because they were in the news a lot during the housing crisis in 2007-2008.
These companies provide behind-the-scenes financing for lenders by allowing them to bundle mortgages and resell them. Loans that qualify to be purchased by Fannie Mae and Freddie Mac are considered conforming loans – in other words, they conform to the laws that enable these institutions to do what they do.
The national conforming loan limit is set by the Federal Housing Finance Agency (FHFA). As of 2019, the limit is $484,350, in most places. However, some high-cost markets have higher limits. In Washington, D.C., Alaska and some metro areas where housing is in high demand, the limit is $679,650. In cities in California and Hawaii, the limit is even higher.
The requirements for a conforming loan are:
A credit score of 620 or higher
A down payment between 5% and 20%
41% maximum debt-to-income ratio
Private mortgage insurance with a down payment of less than 20%
If you can meet these qualifications, you can get a conforming loan.
What is a Non-Conforming Loan?
Non-conforming loans are loans that don’t meet the legal requirements to be purchased by Fannie Mae and Freddie Mac. Most frequently, they are high-dollar loans. However, there are other things that might push a loan into the non-conforming category.
If you intend to buy a home with a price tag that doesn’t qualify for resale, then you’ll need to get a non-conforming loan, which is sometimes referred to as a jumbo loan. Because the financial institution you borrow from won’t be able to bundle your mortgage and sell it, the requirements are stricter than they are for a conforming loan. You’ll need:
A credit score of 680 or higher
A down payment of 15% or higher
A debt-to-income ratio of no more than 43%
Significant cash reserves
Lenders require more from borrowers with non-conforming loans because their risk is higher.
Which Option is Best?
Now, let’s talk about which option is better. Should you get a conforming loan or a non-conforming loan? The answer may be a simple one based on your budget, but let’s review the pros and cons of each.
The benefits of getting a conforming loan are:
You’ll have more wiggle room with your credit score, something that’s important if you’re working to repair your credit or have limited credit history.
You can often qualify for a lower interest rate than you could get with a jumbo loan.
You won’t have to come up with as high a down payment as you would with a non-conforming loan.
The takeaway here is that, overall, it’s easier to qualify for a conforming loan than it is to qualify for a non-conforming loan. The lower risk that lenders take on is reflected in your interest rates and the credit scores and other financial benchmarks required to qualify.
The primary benefit of getting a non-conforming loan is that you won’t be limited in the amount of your loan. If you’re in the market for a home that costs more than the conforming loan maximum, you’ll need to get a jumbo loan to pay for it.
Of course, if you have a high credit score and cash on hand, it may be worthwhile to get a non-conforming loan. Lenders will still give preferential treatment to those who have high credit scores. If you have the wherewithal to make a large down payment, then a non-conforming loan might be the best choice for you.
For most first-time homebuyers, a conforming mortgage is the best choice. If you have only a small down payment or your credit score has taken a hit, this type of loan is the best way to achieve your dream of homeownership.
As you navigate the world of real estate and mortgages, it’s essential to understand the terminology lenders use when they talk about mortgages. If you’d like to learn more about conforming and non-conforming loans, or learn about Addition Financial’s flexible mortgage options, including our Jumbo Loan product, please click here.