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. Generally, 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.
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 in all probability referring to conforming mortgages that are eligible for purchase by Fannie Mae and Freddie Mac.
The process of securitizing mortgage loans and selling them on the secondary market allows banks to continue writing loans for real estate. For Example: 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.
Fannie and Freddie follow the below criterion to evaluate mortgages they 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. Many 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 nice way of saying “we collect your payments.”