7.2 Loan Types, Lender Requirements, PMI, and Mortgage Insurance
Key Takeaways
- Conventional loans are not government-backed; PMI is required when the loan-to-value ratio exceeds 80 percent (down payment under 20 percent).
- FHA loans require an upfront and annual MIP that often lasts the life of the loan; VA loans charge a one-time funding fee but no monthly mortgage insurance.
- Loan-to-value (LTV) equals loan amount divided by the lesser of price or appraised value; lenders use the lesser figure.
- Lenders qualify borrowers with two debt ratios: a front-end (housing) ratio and a back-end (total debt) ratio, plus credit score and reserves.
- PMI on conventional loans automatically terminates at 78 percent LTV of original value; borrowers may request cancellation at 80 percent.
Conventional vs. Government-Backed
Loans fall into two camps. Conventional loans are not insured or guaranteed by a government agency; the lender bears the risk and offsets it with credit and down-payment standards. Government-backed loans (FHA, VA, USDA) reduce lender risk through insurance or a guarantee, which lets borrowers qualify with smaller down payments.
The word backed matters: FHA loans are insured, VA loans are guaranteed, and USDA loans carry a government guarantee fee. Conventional loans conforming to Fannie Mae and Freddie Mac limits are the most common and are heavily traded on the secondary market.
Loan-to-Value (LTV)
LTV is the central risk ratio. It equals the loan amount divided by the lesser of the sale price or the appraised value.
LTV = Loan Amount / (lesser of price or value)
Worked example: A home is priced at 300,000 but appraises at 290,000. The buyer applies for a 261,000 loan. Lenders use the lesser figure, 290,000.
LTV = 261,000 / 290,000 = 90 percent
A 90 percent LTV means a 10 percent down payment, which on a conventional loan triggers PMI because the LTV exceeds 80 percent. A common trap is dividing by the price when the appraisal is lower; always use the smaller number.
A property is priced at 250,000 and appraises at 240,000. The buyer takes a loan of 192,000. What is the loan-to-value ratio the lender will use?
PMI vs. MIP
Mortgage insurance protects the lender, not the borrower, against default loss. Two acronyms dominate exam questions.
- PMI (Private Mortgage Insurance): Applies to conventional loans when LTV exceeds 80 percent. It is private, not government-backed.
- MIP (Mortgage Insurance Premium): Applies to FHA loans. It has an upfront component (added to the loan) plus an annual premium paid monthly, and on most FHA loans it lasts the life of the loan.
PMI cancellation thresholds (conventional, federal Homeowners Protection Act):
- The borrower may request cancellation at 80 percent LTV of original value.
- PMI automatically terminates at 78 percent LTV of original value, when the borrower is current.
Loan Program Comparison
Table: Loan Programs and Insurance
| Program | Typical Down | Insurance / Fee | Backing | Best For |
|---|---|---|---|---|
| Conventional | 3 to 20 percent | PMI if LTV over 80 percent | None | Stronger credit profiles |
| FHA | As low as 3.5 percent | Upfront + annual MIP | Insured | Lower credit / low down |
| VA | Often zero | One-time funding fee, no monthly MI | Guaranteed | Eligible veterans |
| USDA | Often zero | Guarantee fee | Guaranteed | Income-qualified rural buyers |
Key distinctions: VA loans have no monthly mortgage insurance, only a funding fee. USDA loans carry income limits and geographic limits. FHA's MIP is harder to remove than conventional PMI.
How Lenders Qualify Borrowers
Underwriting looks at the four C's: credit, capacity, capital, and collateral. Capacity is measured with two debt-to-income ratios.
- Front-end (housing) ratio: monthly housing expense (PITI) divided by gross monthly income.
- Back-end (total debt) ratio: all monthly debt (PITI plus car loans, student loans, credit cards) divided by gross monthly income.
Worked example: A borrower earns 6,000 gross per month. Proposed PITI is 1,500.
Front-end ratio = 1,500 / 6,000 = 25 percent.
If the borrower also has 600 in other monthly debt, total debt is 2,100, so the back-end ratio = 2,100 / 6,000 = 35 percent. Lenders compare these against program limits; the back-end ratio is almost always the binding constraint because it captures all obligations.
Reserves, Points, and Buydowns
Lenders may also require reserves (months of payments held in savings) and review the borrower's down-payment source. Large recent deposits often must be documented to confirm they are not undisclosed debt. Borrowers can lower the rate by paying discount points, where one point equals one percent of the loan amount. A buydown is a temporary rate reduction, frequently paid by a seller as a concession. These costs flow onto the closing statement and influence the APR disclosed under federal lending rules.
Exam clue: if a loan has a 95 percent LTV, the down payment is 5 percent, the LTV exceeds 80 percent, and the conventional borrower will carry PMI until the balance falls to the cancellation thresholds described above.
Which statement about mortgage insurance is correct?
Amortization and ARM Mechanics
Most mortgages are fully amortizing: each level payment covers interest first, then principal, so the balance reaches zero at term's end. Early payments are mostly interest; later payments are mostly principal.
| Loan structure | Behavior |
|---|---|
| Fully amortizing | Level payment; balance zero at maturity |
| Interest-only (then) | Pays only interest for a period, then amortizes |
| Balloon | Small payments, then a large lump sum due |
| Adjustable-rate (ARM) | Rate = index + margin, adjusting periodically within caps |
ARM Caps
An ARM ties the rate to an index plus a fixed margin, limited by periodic caps (per adjustment) and a lifetime cap. A 2/6 cap means up to 2% per adjustment and 6% over the life of the loan.
Exam trap: In an ARM, the margin is fixed for the life of the loan; the index moves, so the rate changes with the index within the caps.
When PMI Drops Off
On a conventional loan, private mortgage insurance (PMI) protects the lender when the down payment is under 20% (LTV above 80%). Under the federal Homeowners Protection Act, PMI must automatically terminate when the balance reaches 78% of the original value, and a borrower may request cancellation at 80%.
Exam trap: FHA's MIP often lasts the life of the loan; conventional PMI can be removed at 80% (request) or auto-terminates at 78%.