7.2 Loan Types, Lender Requirements, PMI, and Mortgage Insurance
Key Takeaways
- Fully amortized loans reach a zero balance at maturity, straight (interest-only) loans end in a balloon payment, and ARMs adjust on an index plus margin within periodic and lifetime caps.
- Conventional loans require private mortgage insurance (PMI) when LTV exceeds 80%, FHA loans charge an upfront and annual MIP, and VA loans charge a one-time funding fee instead of monthly mortgage insurance.
- Loan-to-value (LTV) equals the loan amount divided by the lesser of sale price or appraised value and measures the lender's exposure.
- Under the Homeowners Protection Act, PMI auto-terminates at 78% LTV based on original value and is cancelable on request at 80%; PMI protects the lender, not the borrower.
- Lenders qualify borrowers with front-end (PITI / gross income) and back-end (total debt / gross income) ratios, where PITI is principal, interest, taxes, and insurance.
Matching Borrowers to Loan Programs
Lenders structure loans around two variables candidates must master: how the interest and principal are repaid, and whether the loan is conventional or government-backed. The exam tests the vocabulary of each structure and the insurance that protects the lender against default.
Amortized, Straight, and Adjustable Loans
- Fully amortized loan — each level payment covers interest first, then principal, so the balance reaches zero at maturity. Early payments are mostly interest; later payments are mostly principal.
- Straight (term/interest-only) loan — the borrower pays interest only during the term and the full principal as a balloon at the end.
- Adjustable-rate mortgage (ARM) — the rate is tied to an index plus a margin and adjusts periodically; caps limit how much the rate can rise per period and over the life of the loan.
Worked amortization example: on a $200,000 loan at 6% annual interest, the first month's interest is $200,000 × 0.06 ÷ 12 = $1,000. If the level payment is $1,199, then $199 reduces principal in month one. Next month interest is computed on the new, slightly lower balance—so the principal portion grows each month. This is why early years build little equity through amortization.
Conventional vs. Government-Backed Loans
| Loan type | Backed by | Key feature | Insurance |
|---|---|---|---|
| Conventional | Private lenders | Not government-insured | PMI if LTV > 80% |
| FHA | Federal Housing Admin. | Low down payment (3.5%) | MIP (upfront + annual) |
| VA | Dept. of Veterans Affairs | 0% down for eligible vets | Funding fee, no monthly MI |
| USDA | Rural Development | Rural, income-limited | Guarantee fee |
FHA loans are insured; VA loans are guaranteed. FHA requires a Mortgage Insurance Premium (MIP); VA charges a one-time funding fee instead of monthly mortgage insurance.
Loan-to-Value and PMI
Loan-to-value (LTV) ratio = loan amount ÷ the lesser of sale price or appraised value. It measures the lender's exposure.
Worked example: a $285,000 loan on a $300,000 home is an LTV of 95% ($285,000 ÷ $300,000). Because that exceeds 80%, the conventional lender requires private mortgage insurance (PMI) protecting the lender against default on the high-risk portion.
Under the federal Homeowners Protection Act (HPA), PMI on most loans automatically terminates when the balance reaches 78% LTV based on the original value, and a borrower may request cancellation at 80% LTV. This threshold is a frequent exam target. PMI protects the lender, NOT the borrower—a classic trap distractor.
Lender Qualifying Ratios
Lenders evaluate a borrower's capacity with two debt ratios:
- Front-end (housing) ratio — monthly housing payment (PITI) ÷ gross monthly income.
- Back-end (total debt) ratio — total monthly debt (PITI + car, cards, student loans) ÷ gross monthly income.
PITI stands for Principal, Interest, Taxes, and Insurance. Worked example: a borrower earning $6,000/month with a $1,560 PITI has a 26% front-end ratio ($1,560 ÷ $6,000).
Worked Example: LTV and PMI
Loan-to-value (LTV) = Loan Amount / the lower of price or appraised value. On a $300,000 home with a $270,000 loan, LTV = 270,000 / 300,000 = 90%. Conventional loans above 80% LTV generally require private mortgage insurance (PMI), which protects the lender, not the borrower. Under the federal Homeowners Protection Act, PMI must be automatically terminated at 78% LTV based on the original amortization schedule, and a borrower may request cancellation at 80%. A borrower who puts 20% down (80% LTV) avoids PMI entirely.
Do not confuse PMI (conventional) with the FHA's MIP (mortgage insurance premium) or the VA's one-time funding fee.
Government-Backed Loan Details
FHA loans are insured by the Federal Housing Administration, allow down payments as low as 3.5%, and charge both an upfront and annual MIP; they are assumable with qualification. VA loans, guaranteed by the Department of Veterans Affairs for eligible veterans, can offer up to 100% financing with no down payment and no monthly mortgage insurance, funded instead by the funding fee. USDA Rural Development loans serve qualifying rural buyers with no down payment.
All three are government-backed but originated by ordinary lenders, in contrast to conventional loans that carry no government insurance or guarantee. The exam often asks which program fits a no-down-payment veteran (VA) or a low-down first-time buyer (FHA).
On a $300,000 home, a borrower obtains a conventional $270,000 loan. What is the LTV, and is PMI typically required?
Which statement about FHA and VA loans is correct?
keyTakeaways
- Amortized loans reach zero at maturity; straight loans end in a balloon; ARMs adjust on an index plus margin within caps.
- Conventional loans use PMI when LTV exceeds 80%; FHA uses MIP; VA charges a funding fee.
- LTV = loan ÷ lesser of price or appraised value.
- PMI auto-terminates at 78% LTV and is cancelable on request at 80% under the HPA; it protects the lender, not the borrower.
- Lenders qualify borrowers with front-end and back-end ratios using PITI.
Summary
Loan structure (amortized, straight, ARM) and loan source (conventional vs. FHA/VA/USDA) define the borrower's obligations and the insurance protecting the lender. Mastering LTV calculations, the 80/78% PMI thresholds, MIP versus VA funding fees, and PITI-based qualifying ratios covers the most heavily tested financing computations on the national exam.