7.2 Loan Types, Lender Requirements, PMI, and Mortgage Insurance
Key Takeaways
- LTV = loan amount divided by property value (use the lower of price or appraisal); a $270,000 loan on a $300,000 home is 90% LTV.
- Conventional loans require PMI above 80% LTV; borrower-paid PMI auto-terminates at 78% LTV under the Homeowners Protection Act.
- FHA charges MIP (upfront plus annual) and, for most loans put down under 10%, MIP lasts the life of the loan; VA uses a one-time funding fee and no monthly MI.
- Underwriting weighs the Four Cs — Credit, Capacity (DTI), Capital (down payment/reserves), and Collateral (appraisal).
- Discount points are prepaid interest: one point equals 1% of the loan amount and buys down the rate.
The Four Loan Programs
Know each program's down payment, mortgage insurance, and target borrower.
| Program | Backing | Typical Down | Mortgage Insurance | Best For |
|---|---|---|---|---|
| Conventional | None (often sold to Fannie/Freddie) | 3%–20% | PMI if LTV > 80% | Stronger credit/assets |
| FHA | Insured by FHA | 3.5% (580+ score) | MIP (upfront + annual) | Lower credit / first-time |
| VA | Guaranteed by VA | 0% | None — funding fee instead | Eligible veterans |
| USDA | Guaranteed by USDA | 0% | Guarantee fee | Rural, income-limited |
Conforming loans meet Fannie Mae/Freddie Mac limits; loans above the limit are jumbo and are not sold to the GSEs. FHA, VA, and USDA all have owner-occupancy requirements.
Loan-to-Value (LTV)
LTV = loan amount ÷ value, where value is the lesser of the sale price or the appraised value. Higher LTV means higher lender risk and usually mortgage insurance.
Worked example. A home sells for $300,000 and appraises at $300,000. The buyer puts $30,000 down.
- Loan amount = $300,000 − $30,000 = $270,000
- LTV = $270,000 ÷ $300,000 = 90%
Because 90% exceeds 80%, a conventional loan requires PMI.
Low-appraisal trap. If that same home appraised at only $285,000, LTV is figured on $285,000, and the lender lends on the lower figure — the buyer must cover the gap in cash or renegotiate.
PMI vs. MIP vs. Funding Fee
All protect the lender (not the borrower) against default, but the rules differ.
- PMI (Private Mortgage Insurance) — conventional only, when LTV > 80%. Under the federal Homeowners Protection Act, borrower-paid PMI must auto-terminate at 78% LTV of original value, and the borrower may request cancellation at 80%.
- MIP (Mortgage Insurance Premium) — FHA only. Includes an upfront premium (rolled into the loan) plus an annual premium. For most FHA loans with under 10% down, MIP lasts the life of the loan — it does not fall off at 78%.
- VA funding fee — a one-time fee (often financed); no monthly mortgage insurance. Exempt for veterans with service-connected disabilities.
Exam trap: PMI can be canceled; FHA MIP on a low-down loan generally cannot — that is why borrowers refinance out of FHA.
Underwriting: The Four Cs and DTI
Lenders evaluate four pillars:
- Credit — score and repayment history.
- Capacity — ability to repay, measured by debt-to-income (DTI) ratios.
- Capital — down payment and post-closing reserves.
- Collateral — the property, confirmed by the appraisal.
Two DTI ratios:
- Front-end (housing) ratio = PITI ÷ gross monthly income.
- Back-end (total) ratio = (PITI + all other debt) ÷ gross monthly income.
Worked example. Gross monthly income $6,000; proposed PITI $1,500; other debts $600. Front-end = $1,500 ÷ $6,000 = 25%. Back-end = $2,100 ÷ $6,000 = 35%. Both comfortably under common 28%/36% guidelines, so capacity looks strong.
Points and Pre-Approval
Discount points are prepaid interest that buy down the rate. One point = 1% of the loan amount. On a $270,000 loan, two points cost $270,000 × 0.02 = $5,400. A common rule of thumb is that one point lowers the rate roughly 0.25%, but always read the scenario's numbers.
Do not confuse:
- Discount points — buy down the interest rate.
- Origination fee — pays the lender for making the loan.
Finally, distinguish buyer readiness:
- Pre-qualification — informal, unverified estimate; weak.
- Pre-approval — based on verified income, assets, and credit; sellers treat it as far stronger.
Loan Types and Mortgage Insurance
Loans are conventional or government-backed. A conventional loan is not insured by the government; if the borrower puts down less than 20%, the lender requires private mortgage insurance (PMI), which protects the lender against default and can be canceled once the loan-to-value ratio reaches roughly 78-80%.
An FHA loan is insured by the Federal Housing Administration, allows low down payments, and carries a Mortgage Insurance Premium (MIP) that, for most modern FHA loans, lasts the life of the loan. A VA loan is guaranteed by the Department of Veterans Affairs for eligible veterans, may require no down payment, and charges a one-time funding fee instead of monthly mortgage insurance.
Lenders qualify borrowers using debt ratios and the property's appraised value. Loan-to-value (LTV) equals the loan amount divided by the lesser of price or appraised value. Worked example: a buyer purchases a $500,000 home appraising at $480,000 with a $400,000 loan; LTV = $400,000 / $480,000 = 83.3%, so PMI would be required on a conventional loan. A conforming loan meets Fannie Mae/Freddie Mac limits; loans above the limit are jumbo loans with stricter terms.
Qualifying Ratios
Lenders apply two debt ratios. The front-end (housing) ratio divides the proposed monthly housing payment (principal, interest, taxes, insurance, and any HOA dues, abbreviated PITI) by gross monthly income. The back-end (total debt) ratio divides all monthly debt obligations by gross monthly income. Worked example: a borrower earns $10,000 per month with a proposed PITI of $2,600 and other debts of $700. Front-end ratio = $2,600 / $10,000 = 26%; back-end ratio = $3,300 / $10,000 = 33%. Both fall within common conventional limits (about 28% and 36%), so the borrower likely qualifies.
A buyer purchases a $300,000 home with a $270,000 conventional loan. When must borrower-paid PMI automatically terminate under the Homeowners Protection Act?
On a $250,000 loan, how much do two discount points cost?