Most lenders would consider a conventional mortgage as a loan that conforms to the guidelines set forth by Freddie Mac and Fannie Mae, the two government sponsored enterprises (GSEs) that provide liquidity in the mortgage market.
Technically speaking, a conventional loan is any mortgage that is not guaranteed or insured by the US government, such as VA, FHA and USDA.
Conventional mortgages include portfolio loans, construction loans, and even subprime loans. But again, whenever a lender refers to a “conventional loan” they are most likely referring to conforming mortgages that are eligible for purchase by Fannie Mae and Freddie Mac.
According to Wikipedia:
In the United States, a conforming loan is a mortgage loan that conforms to GSE guidelines.
In general, any loan which does not meet guidelines is a non-conforming loan. A loan which does not meet guidelines specifically because the loan amount exceeds the guideline limits is known as a jumbo loan.
Starting in 1970, Fannie Mae was authorized by the United States Government to purchase residential mortgage loans. Fannie Mae worked with Freddie Mac to develop uniform mortgage documents and national standards for what would come to be known as a conforming loan.
The Office of Federal Housing Enterprise Oversight (OFHEO) set the criteria on what constitutes a conforming loan limit that Fannie Mae and Freddie Mac can buy. Criteria include debt-to-income ratio limits and documentation requirements.
The maximum loan amount is set based on the October-to-October changes in median home price, above which a mortgage is considered a jumbo loan, and typically has higher rates associated with it. This is because both Fannie Mae and Freddie Mac only buy loans that are conforming, to repackage into the secondary market, making the demand for a non-conforming loan much less.
Who Is Fannie and Freddie?
These publicly traded companies and Government Sponsored Enterprises (GSEs) are the largest source of mortgage money in the United States.
In the beginning, Fannie Mae was originally introduced as part of President Roosevelt’s New Deal, but was later privatized in 1968.
Freddie Mac, often referred to as Fannie Mae’s younger brother, was created in 1970. The sole purpose of the two agencies is to securitize mortgages and provide liquidity in the mortgage markets.
Why Securitize Mortgages?
The process of securitizing mortgage loans and selling them on the secondary market allows banks to continue writing loans for real estate.
If you were to go to your favorite lender and were approved for a mortgage loan of $250,000, they would have to provide the funds necessary to complete the transaction while receiving a payment each month for the next 30 years until the loan was paid off.
However, if the bank tied up their money for 30 years, they’d eventually run out of cash to lend on properties, auto loans, credit cards….
Fannie and Freddie provide that liquidity needed by purchasing the mortgages, bundling them with thousands of other similar loans and selling them as bonds on the mortgage backed securities market.
What Type Of Mortgages Do Fannie Mae and Freddie Mac Purchase?
1. They must meet the conforming loan limit which is evaluated every year
2. Loans with borrowers who have a minimum Credit Score
3. It meets the GSE guidelines in regards to Debt-to-Income ratios
4. Private Mortgage Insurance (PMI) is required for all loans where the borrower has less then 20% equity
5. Several more guidelines
It is important to understand that neither Freddie Mac nor Fannie Mae service the loans they purchase.
Basically, even though these companies purchase loans from various lenders, it is the lender who retains the servicing – just a fancy way of saying “we collect your payments.”