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. Those types of loans include 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. In fact, it would be very difficult for you to obtain a mortgage without the presence of these two entities.
Who are Fannie and Freddie?
These publicly traded companies, which are 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. This is a very important role in the housing market, and yet the average borrower knows very little about it. Well, that is about to change.
Why do they do this?
The bottom line is that it creates liquidity. 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. You would then pay them each and every month over the next 30 years until the loan is paid off. Meanwhile this would also tie up the lenders funds for the next 30 years. And this is where a potential problem can start.
What if the lender had only a million dollars to lend and they had already lent over $900,000 by the time you applied? Because the lender is almost at capacity for their mortgage lending, the previous borrowers would have to pay off their loans in order for the bank to provide the funds for your loan. Your options? Either come up with $150,000 more in cash or forget the idea of getting your loan. But what if there was another way? Well luckily there is.
Fannie and Freddie provide that liquidity needed. They will purchase the mortgages and bundle them with thousands of other similar loans and sell them as bonds on the mortgage backed securities market. In the above example, this would free up the $900,000 the lender had in other mortgages and allow for more funds to be available. In reality, those numbers are quite larger. Instead of millions of dollars, they are dealing with billions of dollars.
What types of mortgages do Fannie and Freddie purchase?
1. They must meet the conforming loan limit. This is evaluated each and every year and is valid for that calendar year.
2. Loans with borrowers who have a minimum FICO 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 percent equity.
5. It also meets a bevy of other guidelines. If you really ambitious and are looking for a new coffee table book, the guides can be found here and here.
It is important to understand that neither Freddie Mac nor Fannie Mae ever service the loans they purchase. So, when the companies purchase loans from various lenders, it is the lender who retains the servicing – just a fancy way of saying “we collect your payments.”
By now, you should see just how important Fannie Mae and Freddie Mac are to not only the mortgage industry, but the entire housing industry. It would be hard to imagine how mortgages would be made if they didn’t exist. So, even though they may not provide the mortgage money for EVERY type of loan, they are still a key component to conventional mortgages, and without them, obtaining a mortgage would be even more difficult than it currently is today.
Kevin Lanham, a loan officer and FHA specialist at Pacor Mortgage Corp, can be reached at: