Conventional loans are mortgages provided by banks, credit unions, or other traditional financing sources.
They are not offered or secured through a government entity.
That said, some conventional mortgages can be guaranteed by two specific government-backed entities: Fannie Mae and Freddie Mac.
In this article, we’ll break down the ins and outs of conventional loans.
You’ll learn about their key features, pros and cons, use cases, requirements and price, and whether they’re a good option for your commercial real estate needs.
Let’s dive in!
Key Features
Conventional loans originate from and are served by private mortgage lenders—banks, credit unions, and other financial institutions.
Many of these financial institutions also offer government-insured mortgage loans.
Generally speaking, conventional loans do not have the same features as government-insured loans (i.e. low credit score requirements, no down payment or mortgage insurance, etc.).
Conventional loans are secured by a first lien position.
Lenders who hold first lien position are paid back before all other liens. That means these lenders will be the first to be repaid if and when the borrower defaults and the property is used as collateral for that debt.
Conventional Loan Features
Conventional commercial loans come with a certain number of specific features.
- Underwriting parameters
Conventional lenders typically max out at 75-80% LTV. Some lenders stretch that limit to 85% for strong borrowers.
As a borrower, you should expect to invest “hard cash” equity in your purchase transaction and still maintain capital needed to service your debt for several months, all while maintaining a net worth greater or equal to the loan amount.
Properties should meet a DSCR of 1.25-1.55x, depending on the LTV and property type, at the underwriting rate.
- Term Length/Amortization
The term length of your conventional commercial loan will depend on your lender and on your property type.
Terms typically vary from 3-15 years. Amortization ranges from 10-30 years.
Depending on the structure of your loan, you might need to pay a “balloon payment” at the end of the term.
However, if your loan is “self-amortizing,” it’ll be fully paid off after the loan matures, and you’ll have no loan balance to pay off upon the loan’s maturity date.
Additionally, most conventional loans include a step-down prepayment schedule that comes into effect if the property is sold or refinanced before the end of the loan term. More on conventional loan prepayment penalty structures below.
- Recourse
Conventional commercial loans maybe i) non-recourse, ii) limited recourse, or iii) full recourse loans.
Borrowers are not personally liable to repay non-recourse loans. In the case of a debt of foreclosure, the collateralized property and its cash flows will serve as repayment of the debt.
That said, if the borrower engages in activity that could harm the property, springing recourse might come into effect.
For limited recourse loans, sponsors who guarantee the loan are responsible for a percentage of any difference between the loan balance and the sales price in the event of default or foreclosure.
Carve-outs for non-recourse loans also apply for limited recourse loans.
Under full recourse loans, the sponsors who guarantee the loan are responsible for any and all shortfalls between the loan balance and the sales price in the event of default and/or foreclosure, in addition to any legal or ancillary fees.
- Assumption
Conventional commercial loans may or may not be assumable.
Assumption occurs when the borrower wants to sell the commercial real estate that secures the loan, and the purchaser of the property wants to “assume” the loan.
After the sale and assumption are finalized, the purchaser owns the property. He or she is bound by the original terms of the loan. The original borrower no longer has an obligation to the property and the existing loan.
Assumption of loans benefits the borrower/seller because it allows him or her to avoid prepayment costs. It also gives the buyer the chance to assume a loan with potentially favorable terms.
In tight credit or high-interest rate environments, loan assumption is an especially valuable feature of conventional commercial loans.
- Timing
Conventional loans typically close 60-90 days after your lender issues a term sheet.
Conventional Loan Prepayment Structure
Prepayment structures for conventional loans vary depending on your lender and your lending institution.
The 3 typical prepayment structures are yield maintenance, break funding, or a step-down prepayment penalty.
We’ll break down each of these structures below.
- Yield maintenance
Yield maintenance allows bond investors to maintain the same yield as if the borrower fulfilled all scheduled mortgage payments until maturity.
Yield maintenance provisions usually contain a prepayment penalty “floor” of a minimum of 1%. They typically allow for prepayment without penalty during the last 3-6 months of the loan.
The prepayment penalty is usually calculated by a formula contained in the Note of the Loan Documents.
Talk to your lender for more info on yield maintenance prepayment penalty provisions.
- Breakfunding
Breakfunding compares the original cost of the funds to the cost of the funds at the time of the loan prepayment.
It’s a system used to prevent the lender from suffering an economic loss due to the prepayment of the loan before the maturity date. The difference between these two numbers is then multiplied by the loan balance and the remaining time on the loan. The total is discounted according to the time value of money.
Ask your lender for more details about break funding prepayment penalties.
- Declining (Step-Down) Prepayment Penalty
Declining prepayment penalties can be structured in a variety of ways.
Regardless, the prepayment penalty lessens by 1% per step, and the last 3-12 months remain open to prepay or refinance without penalty.
Declining prepayment plans are offered on shorter-term loans (5-10 years), but they can also be offered on longer terms as well.
Check out an example 5 year declining prepayment schedule below:
5% of the loan amount if prepaid in the 1st year, 4% if prepaid during the 2nd year, 3% if prepaid in the 3rd year, 2% if prepaid in the 4th year, 1% if prepaid in the 5th year.
Types of Conventional Loans
There are multiple types of conventional loans.
We’ll break down 6 of the most common types below.
- Conforming Conventional Loans
Conforming conventional loans meet the lending standards required by Fannie Mae and Freddie Mac.
The main criteria for conforming to conventional loans is that the loan amount falls under the annual determined dollar cap for your specific county.
In other words, conforming loans are loans whose amount remains below a certain dollar amount.
The baseline conforming loan limit for 2021 is $548,250, increased from $510,400 in 2020.
This limit will be higher in areas where the median house cost exceeds this number. That’s why borrowers in these high-cost areas can get conforming loans up to $822,375.
- Jumbo Conventional Loans
Jumbo conventional loans let you borrow above the legal lending limits for conforming loans.
They typically require a higher credit score than conforming loans (usually 700 and above). Additionally, to get approved for a jumbo conventional loan, you might need to have a low debt-to-income (DTI) ratio and also put down a larger down payment.
Even with these criteria, jumbo loans often come with high-interest rates simply because the higher loan amount presents a great financial risk to the lender.
- Portfolio Loans
Portfolio loans are conventional loans that lenders choose to keep in their portfolios, as opposed to selling the loan to the secondary market.
Portfolio loans give lenders more flexibility when underwriting. THat’s an advantage for borrowers, especially if you have a low credit score or high DTI ratio.
That said, portfolio loans typically come with higher interest rates. Also, they don’t always have the same borrower protections that come with conforming loans.
- Subprime Conventional Loans
Conforming loans require a DTI ratio below 50% and a credit score of 620 or higher.
If your credit isn’t 620 or above, consider applying for a subprime mortgage loan.
Subprime mortgage loans are non-conforming loans, and they typically come with high closing costs and interest rates.
- Amortized Conventional Loans
Fully amortized loans give borrowers a set monthly payment from the start to the end of the loan period—no balloon payment at the end of the loan term.
Amortized Conventional loans can have either fixed or adjustable mortgage rates.
- Adjustable Conventional Loans
Adjustable-rate mortgages give you a fixed interest rate for a set period (usually 3-10 years). Following that period, your interest rate can change each year based on market conditions.
Adjustable conventional loans typically start with lower interest rates than fixed conventional loans; however, they can cost more if the market mortgage rate increases over time.
Pros of Conventional Loans
There is no one-size-fits-all solution when it comes to commercial real estate financing.
That said, conventional loans present a number of specific benefits that make them an attractive option for many borrowers.
- Low-interest rates
Interest rates on conventional loans are largely tied to your credit score.
That means a high credit score can immediately help you qualify for a low-interest rate.
Additionally, once your LTV ratio reaches 80%, you can ask your lender to remove your insurance requirement.
- Higher loan limits
Conforming loans have limits, but jumbo conventional loans can help you take out a loan that will meet your needs.
Government-insured loans don’t often allow this type of flexibility.
- Flexibility
Conventional loans are all about flexibility.
That’s because they’re lent out by private mortgage lenders who don’t necessarily need to follow all the strict guidelines set by government agencies.
It’s likely that you’ll have an easier time finding a conventional loan with flexible down patent options and term lengths. Additionally, you’ll likely have a better chance at getting a loan if your credit doesn’t meet the standards for other government-issued or conforming loans.
Cons of Conventional Loans
Conventional loans can be an attractive option for many reasons. However, they’re not without their downsides.
- Strict qualifying guidelines
Because government-backed loans place less risk on the lender, they’re often easier to qualify for. Assuming you meet the agency’s baseline eligibility requirements, most people can qualify for government-backed loans.
However, conventional loans aren’t backed by the government.
Originating conventional loans place more risk on the lender, and that’s why they will often scrutinize your financial history and situation more closely.
- High credit score requirements
To qualify for a conventional loan, you’ll typically need a credit score of 620 or higher.
By contrast, you can qualify for an FHA-backed loan with a credit score as low as 500. You can qualify for a USDA loan with a minimum credit score of 580.
- High down payment requirements
Typical conventional loan lenders require a 3% minimum down payment. FHA loans usually require a minimum down payment of 3.5%.
Sometimes it’s best to accept a higher down payment in order to avoid paying a high-interest rate and/or purchasing a private mortgage.
Conventional Loans Use Cases
Conventional loans are frequently used by borrowers or investors looking to purchase an existing, occupied asset with a positive cash flow.
These investors typically possess a credit score over 700, and they’re often able to access low-cost capital relative to other loan products available to investors.
Conventional Loan Requirements
Conventional loans typically require the borrower to show a strong financial background and current position.
Some of the key eligibility criteria for conventional loans include:
- Good credit score — 620 or higher, depending on the transaction. FICO requirements might vary based on your lender.
- 3% minimum down payment — this is the minimum down payment, most conventional loans require approximately a 20% minimum down payment to eliminate your obligation to purchase mortgage insurance.
- Cash reserves — most lenders will require you to show a minimum amount of 2 months cash reserves after closing your conventional loan.
- Proof of income — you’ll need to show a steady income stream to cover the cost of your loan. If you’re self-employed, you’ll need to show 2 years of tax returns.
- Debt-to-income ratio — your DTI ratio is the amount of your monthly gross income paid out in recurring debts (car payment, credit card bills, student debt, etc.). Your DTI ratio should not exceed 45%. In limited cases, some lenders will allow a 50% DTI ratio.
Conventional Loan Rates
Conventional loan interest rates will change according to market conditions.
Right now, the average rate for commercial loans hovers around 3.25%.
Talk to your lender to learn more about interest rates for your specific type of conventional loan.
Conventional Loan Cost
Closing costs for conventional loans typically range from 3-6% of the purchase price. Most borrowers pay a one-time closing cost fee.
Conventional Loan Alternatives
Government-backed loans represent the main alternative to conventional loans.
Government-issued loans present certain specific features that make them a perfect fit for certain segments of borrowers.
3 common types of government-backed loans include:
- USDA Loans
These loans, insured by the US Department of Agriculture, help low-to-moderate income homebuyers purchase homes in eligible rural areas. They require no down payment and increased flexibility with credit score requirements.
- VA Loans
The US Department of Veteran Affairs backs these loans, designed for select members of the military community, their spouses and/or other beneficiaries. Importantly, VA loans require no down payment and no private mortgage insurance.
- FHA Loans
FHA loans are secured by the Federal Housing Administration, and they allow you to purchase a home with a credit score as low as 500 with 10% down payment or 580 with a 3.5% down payment. If your credit score isn’t high enough for a conventional loan, FHA loans can be a great option.
Out of all these alternatives, conventional loans still offer the best interest rates and the lowest fees. If your credit score is about 740 and you can afford a 20% down payment, a conventional loan will likely be your best option.
That said, if you have a low credit score, you might find it easier to qualify for a government-backed loan like an FHA-insured loan.
Remember that FHA-insured loans charge their own specific mortgage insurance (a mortgage insurance premium), which includes an upfront fee and ongoing charges.
