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Conventional Financing: Definition & Requirements

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson we will define and describe the general requirements of conventional financing. We will also explore the concepts and application of loan-to-value ratios as well as private mortgage insurance.

Conventional Lending Definition

Jen and Mike have saved up a down payment for the last few years and are finally ready to buy their first home. When they met with a loan officer, he told them they should consider conventional loans. They weren't quite sure what this meant, but wanted to understand it before committing to such a big purchase.

Conventional lending refers to mortgages that meet Fannie Mae and Freddie Mac underwriting standards. The uniformity of these mortgages allows lenders to package the loans into mortgage backed securities. A conventional loan can be a fixed or adjustable rate mortgage.

Underwriting Requirements

The three C's form the framework of mortgage underwriting. Credit, capacity, and collateral are all important considerations for a lender extending financing. Banks and lenders develop complex statistical models to aid loan approval decision making. The final decision rests with the mortgage underwriter.

The buyer's credit worthiness involves looking at the score and history. Do the borrowers have a good history of paying their bills on time? Have they ever been evicted, declared bankruptcy, or had a court judgment entered against them?

Capacity refers to the borrower's ability to pay. How much money do the borrower make? How long have they been at their jobs, and can they expect to earn the same or more in the future? Do they have money they can get to in an emergency to pay the mortgage if they have to find a new job?

Collateral is fairly straightforward. If the borrower can't or won't pay, the bank can repossess the house through foreclosure. Sometimes the house may not be worth enough as collateral, which is why lenders pay close attention to the loan-to-value ratio.

Loan-to-value ratio

Banks always carry some risk of the borrower failing to pay the mortgage. If foreclosure becomes necessary, the bank wants to ensure it has minimizes any loss. The loan-to-value ratio (LTV) is the proportion of the outstanding mortgage balance to the current value of the home. Lenders want a minimum of an 80% loan-to-value at the time of purchase. The borrower can meet this standard with a 20% down payment. Another option is to purchase private mortgage insurance.

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