Why Are There Two Types of Mortgages?
Mortgage lenders face significant risk when they provide loans. If a borrower defaults on their loan payments, the lender must go through the costly and time-consuming foreclosure process to recover their money. To reduce their exposure to risk, many lenders sell mortgages to government-sponsored enterprises (GSEs) such as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). Fannie Mae and Freddie Mac will only purchase loans that meet specific guidelines. These loans are considered “conforming,” meaning they adhere to the standards set by the GSEs. If a loan doesn’t meet these requirements, it is classified as “non-conforming.” While non-conforming loans offer advantages to certain borrowers, they come with higher interest rates due to the increased risk for lenders.What Are Conforming Mortgages?
Conforming mortgages are loans that meet the guidelines established by Fannie Mae and Freddie Mac. These guidelines include criteria such as credit score, debt-to-income ratio, and most importantly, the loan amount. The maximum loan limit for conforming mortgages is adjusted annually and varies depending on the region of the country. For 2023, the conforming loan limit for a single-family home in most areas of the United States is $726,200. However, in high-cost areas like Alaska, Hawaii, and certain regions of California, the limit is higher—up to $1,089,300. As long as your loan does not exceed the conforming loan limit for your area and meets the other criteria, it is classified as a conforming loan.Key Features of Conforming Mortgages:
- Lower Interest Rates: Because they pose less risk to lenders, conforming loans typically come with lower interest rates.
- Easier Qualification: Borrowers generally have an easier time qualifying for conforming loans if they meet the required credit score and debt-to-income ratio.
- Smaller Down Payments: Conforming loans often require lower down payments, sometimes as low as 3% for first-time homebuyers.
- Lower Total Cost: Over time, the lower interest rates and smaller down payments associated with conforming loans can save borrowers money.
What Are Non-Conforming Mortgages?
Non-conforming mortgages, also known as “jumbo loans,” are loans that exceed the conforming loan limits set by Fannie Mae and Freddie Mac. These loans are used to finance high-priced homes, typically luxury properties, second homes, or homes in areas with high property values. Because jumbo loans exceed the conforming loan limits, they carry more risk for lenders. As a result, non-conforming loans generally come with stricter qualification requirements and higher interest rates. Borrowers must demonstrate strong financial health, with excellent credit scores, higher down payments (often 20% or more), and significant income or assets.Key Features of Non-Conforming Mortgages:
- Higher Loan Amounts: Non-conforming mortgages allow you to borrow more than the conforming loan limit, making them ideal for purchasing more expensive homes.
- Stricter Qualification Requirements: To qualify for a jumbo loan, you’ll typically need a high credit score (often 700 or higher), a low debt-to-income ratio, and proof of substantial income or assets.
- Larger Down Payments: Borrowers usually need to make a down payment of at least 20% when taking out a non-conforming loan, though some lenders may require even more.
- Higher Interest Rates: Due to the increased risk to lenders, non-conforming loans come with higher interest rates compared to conforming loans.
How Conforming and Non-Conforming Mortgages Affect Interest Rates
One of the biggest differences between conforming and non-conforming mortgages is the interest rate you’ll pay on your loan. Since conforming loans meet the standards set by Fannie Mae and Freddie Mac, they carry less risk for lenders. As a result, conforming loans typically come with lower interest rates, making them more affordable in the long run. Non-conforming mortgages, on the other hand, do not meet the GSE guidelines. Lenders cannot sell these loans to Fannie Mae or Freddie Mac, which means they have to take on more risk themselves. To compensate for this risk, lenders charge higher interest rates for non-conforming loans. In addition, non-conforming loans may have other costs, such as higher closing fees or the requirement to purchase private mortgage insurance (PMI) if your down payment is less than 20%.Which Loan Type is Right for You?
Choosing between a conforming and non-conforming mortgage depends on a variety of factors, including your financial situation, the price of the home you’re purchasing, and your long-term financial goals. Here are some things to consider when deciding which type of loan is the best fit for you:- The Amount You Need to Borrow: If you’re purchasing a home that costs more than the conforming loan limit for your area, a non-conforming (jumbo) loan may be your only option.
- Your Credit Score and Financial Health: If you have a strong credit score, substantial assets, and a solid income, you may be able to qualify for a non-conforming mortgage. However, if your credit is less-than-perfect, a conforming loan may be easier to obtain.
- Your Down Payment: Non-conforming loans typically require larger down payments. If you don’t have enough savings to make a 20% or larger down payment, you may want to stick with a conforming loan.
- Your Long-Term Financial Goals: Non-conforming loans often come with higher interest rates and stricter repayment terms. If keeping your monthly payments low is a priority, a conforming loan may be the better choice.