Of all the different types of mortgage loans available to borrowers, conventional loans — those not backed by the government — are the most common. Although conventional loans can be more difficult to qualify for than government-backed loans, they’re often the least expensive option for borrowers who can pay 20% down on their home purchase.
The loans are backed by Fannie Mae and Freddie Mac, government-sponsored enterprises. Both companies support the secondary mortgage market that makes funds available for lenders to loan out and guarantees loans to reduce lenders’ risk.
Keep reading to learn more about Fannie Mae and Freddie Mac and their role in helping you finance your home purchase.
Fannie Mae and Freddie Mac Explained
The Federal National Mortgage Association, or FNMA, and Federal Home Loan Mortgage Corporation, or FMCC, are shareholder-owned companies chartered by Congress in 1938 and 1970, respectively. Better known as Fannie Mae and Freddie Mac, the companies have a common mission: Provide liquidity and promote stability and affordability in the U.S. housing finance industry. What that boils down to is that both entities ensure that mortgage lenders have a reliable source of funds they can use to originate affordable home loans for consumers.
Fannie Mae and Freddie Mac are part of what’s known as the secondary mortgage market. The secondary market is a network that connects investors to the mortgage originators and borrowers that make up the primary market. Here’s how it works:
How Fannie Mae and Freddie Mac Work
- Borrowers take out home loans from mortgage lenders.
- Mortgage lenders sell loans to Fannie Mae and Freddie Mac.
- Fannie Mae and Freddie Mac package the loans and sell them to investors as mortgage-backed securities.
- Investors purchase the loans as shares with the expectation that the shares will increase in value.
When the lenders sell the loans, they recoup funds they can use to make more loans. This helps to keep rates low, and it keeps lenders from having to collect penalties from borrowers who refinance their loans or repay them early, to make up for lost interest.
At its inception, Fannie Mae was a U.S. government agency created to buy, hold and sell mortgage loans insured by the Federal Housing Administration. It began purchasing loans insured by the Veterans Administration — now Veterans Affairs — 10 years later. Fannie Mae subsequently transitioned from a government agency to a private, “mixed-ownership” corporation.
The Housing and Urban Development Act of 1968 reorganized Fannie Mae, turning it into a for-profit, shareholder-owned company that funded its own operations through the securities markets. The 1968 act also placed Fannie Mae under the regulatory authority of HUD, which required the GSE to support affordable housing. Fannie Mae’s mandate was expanded in 1970 to allow it to purchase conventional loans — loans not backed by the government.
Today, Fannie Mae is one of America’s leading sources of mortgage financing for residential and rental housing, purchasing loans from a variety of lenders, including thrifts, mortgage companies, commercial banks and finance companies. It plays an instrumental role in the accessibility of 30-year fixed-rate loans — the standard home loan in the U.S., thanks to its predictable payments over the life of the loan. It also provides a number of loan products, such as single-family loans to help consumers purchase or refinance a home.
The HUD Act of 1968 also created the Government National Mortgage Association, known as Ginnie Mae, which is a government-owned corporation that operates under the HUD umbrella. Whereas Fannie Mae’s mandate is to purchase and securitize government-backed and conventional mortgage loans, Ginnie Mae guarantees on-time payments on privately issued securities backed by FHA, VA and other government mortgage programs.
The 1970 Emergency Home Finance Act expanded the secondary mortgage market to help thrifts, which generally consist of savings and loan institutions and credit unions, mitigate interest rate risk. Interest rate risk is a phenomena by which fixed-rate bond prices drop as interest rates increase.
Freddie Mac issued its first conventional loan mortgage-backed security in 1971. Today, Freddie Mac makes a variety of loan products available to its partner lenders, including single-family-home loans to help consumers purchase, refinance or renovate a home.
Fannie Mae and Freddie Mac: 2008 Bailout
At the time of the 2008 financial crisis and collapse of the housing market, Fannie Mae and Freddie Mac owned or guaranteed 40% of all home loans in the U.S. — $5 trillion worth of loans in danger of default, CNBC reported. The Treasury Department bailed them out to keep them afloat, and the federal government took them over by placing them in conservatorship. The GSEs were required to pay a 10% dividend on the bailout money.
The $191 billion bailout worked. As of early 2021, Fannie Mae and Freddie Mac had paid the government about $301 billion in dividends, resulting in about $110 billion in profit for the government, but they hadn’t yet repaid any of the principal.
As a result of the crisis and the role subprime mortgages — i.e., bad-credit loans — played in the crash, the Consumer Financial Protection Bureau established rules requiring mortgage lenders to verify consumers’ ability to repay their loans before extending them credit.
Qualifying for a Conventional Loan
Fannie Mae and Freddie Mac now have fairly strict criteria for the loans they purchase. The requirements vary according to the loan product and the borrower’s qualifications. These are the standard eligiblity requirements for a manually underwritten purchase loan:
- Maximum loan-to-value ratio: 95%
- Maximum debt-to-income ratio: 36% with a credit score of 620 to 680, depending on down payment amount and cash reserves; 45% with a credit score of 660 to 720, depending on down payment amount and cash reserves
- Minimum credit score: 620 for a fixed-rate loan with at least 25% down and a maximum debt-to-income ratio of 36%; 660 with at least 25% down and a maximum debt-to-income ratio of 45%
Fannie Mae and Freddy Mac both have 97% LTV loans for borrowers who meet special criteria such as having low or moderate income. However, you’ll be required to pay private mortgage insurance if you put less than 20% down on any loan.
Good To Know
Conventional loans can be conforming or non-conforming. The maximum loan amount for a conforming loan in most areas of the U.S. is $548,250 in 2021. Above that, you’ll need a jumbo loan.
Fannie Mae and Freddie Mac and COVID-19 Pandemic
If Fannie Mae or Freddie Mac own your mortgage loan and you’re having trouble paying due to a COVID-related issue, you have until Sept. 30 to request a forbearance. The forbearance pauses your mortgage payments for up to six months, with no late fees or other penalties. Although forbearance isn’t forgiveness, your loan servicer — the company to which you make your payments — will spread the payments over time. Contact your loan servicer to discuss this and other options for preventing foreclosure.
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- Federal Housing Finance Agency. 2020. "FHFA Announces Conforming Loan Limits for 2021."
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