What are Traditional Loans?
Traditional loans, also known as conventional loans or traditional mortgages, are facilitated by a financial institution. Financial institutions make their money by charging fixed or adjustable interest rates on the total amount borrowed for the term of the loan. As a part of this process, financial institutions or lenders, offer programs that help buyers obtain financing.
Lenders in a traditional loan are most focused on the followwing criteria:
- Credit Scores of the Borrower
- Borrower’s Debt-to-Income Ratio
- Borrower’s Minimum Down Payment
In a traditional loan, minimum down payments can range from 5-20%, with credit scores larger than 700. A borrower’s debt-to-income of 30% or less is also required in a traditional loan. Debt-to-income is the percentage of monthly income spent on debt payments. In a traditional loan you, as the borrower, have the freedom to choose from financial institutions that offer mortgage loans. If you shop around, you will notice that small variations from lender to lender exist, but for the most part lenders are most concerned with the lending criteria mentioned above.
A traditional loan has more associated fees when compared to other ways to fund a real estate investment. Some of these fees can be associated with insurance, appraisals, inspections, origination fees etc., so upfront they can become costly. On the other hand, traditional loans tend to process the quickest for those looking to borrow in a timely manner.
Example of a Traditional Loan
A borrower will typically engage in a traditional loan for a homeownership or rental real estate investment. Lenders will work with buyers to choose the right real estate program with a primary focus on credit scores, debt-to-income ratios, and down payment amounts to determine interest rates for loans. For instance, let’s take a typical mortgage loan for $325,000, that has an interest rate of 4.23% with a term of thirty years. The number of payments over thirty years equates to three hundred and sixty payments, with a total monthly payment of $1,595. The total loan, or principal plus interest, paid over the thirty years calculates to $574,201. The lender in this example makes $249,201 on this particular mortgage loan when all is said and done.
For first-time homeowners, it is common to use a broker to facilitate the relationship between the borrower and lender. If you are a financially experienced buyer or a serious investor looking at rental properties, it may be beneficial to work directly with the lender. Lenders have the final say when it comes to amounts, programs, interest rates, sudden changes etc., so working directly with them, if possible, is a no brainer. After solidifying a down payment amount, most lenders will require at least six months of cash reserves available per property. That means you need to have available funds, usually in a checking account, in the amount of six months worth of mortgage payments prior to closing on a deal. Lenders will also require two or more years of W-2 employment information. This will be used to calculate your annual income. If self-employed, you will be required to provide two years or more of tax returns, a letter from the CPA who audited your tax information and year-to-date profit and loss statements.
Traditional loans are great for borrowers with good or excellent credit. The lending process for a traditional loan is a quicker process, but keep in mind there are more fees involved with a traditional loan. If you are looking to invest, have good credit, have enough capital put aside for a reasonable down payment, and six months worth of potential mortgage payments, a traditional loan may be the best option for your next real estate investment.