7.2 Loan Types, Lender Requirements, PMI, and Mortgage Insurance

Conventional vs. government-backed loans

Loans split into two broad families. Conventional loans are not insured or guaranteed by the federal government; the lender relies on the borrower's credit and the property as collateral. A conventional loan is conforming when it meets Fannie Mae and Freddie Mac size limits and underwriting rules so it can be sold on the secondary market, and non-conforming (e.g., jumbo) when it exceeds those limits.

Government-backed loans reduce lender risk through federal insurance or guarantees, which lets lenders accept smaller down payments and lower scores. The three to know are FHA (insured), VA (guaranteed), and USDA (guaranteed, rural).

The three government programs

Note the wording: FHA insures, VA guarantees. FHA charges mortgage insurance premium (MIP); VA charges a one-time funding fee instead of monthly mortgage insurance. VA loans also use a Certificate of Eligibility and a VA appraisal that issues a Certificate of Reasonable Value.

PMI vs. government mortgage insurance

Private mortgage insurance (PMI) is required on conventional loans when the borrower puts down less than 20% (LTV above 80%). PMI protects the lender against default loss, not the borrower. Under the federal Homeowners Protection Act, the borrower may request PMI cancellation at 80% LTV, and the servicer must automatically terminate PMI at 78% LTV based on the original amortization schedule (assuming the loan is current).

Do not confuse PMI (conventional) with MIP (FHA's government mortgage insurance). FHA MIP often lasts the life of the loan for low-down-payment borrowers and cannot be canceled the same way PMI can. VA loans carry no monthly mortgage insurance at all.

Cancelling PMI and comparing insurance costs

Knowing when mortgage insurance ends is a favorite question. Under the Homeowners Protection Act, a borrower may request PMI cancellation at 80% LTV of original value and the servicer must automatically terminate it at 78% LTV, both based on the original amortization schedule and a current loan.

Worked example: A buyer pays $250,000 with a $237,500 loan (95% LTV), triggering PMI. To reach 80% LTV the balance must fall to $200,000 ($250,000 x 0.80); the borrower could request cancellation once the amortized balance hits $200,000, and the servicer must drop PMI automatically at $195,000 (78%).

Trap: PMI (conventional) and MIP (FHA) are not interchangeable. Low-down-payment FHA MIP generally cannot be cancelled by the HPA's 78% rule — the borrower must refinance out of FHA to shed it.

Loan-to-value ratio (worked example)

The LTV ratio = loan amount divided by the lesser of sale price or appraised value. It drives down payment size, PMI, and rate.

Worked example: A buyer agrees to pay $300,000, but the appraisal comes in at $290,000. The lender will lend based on the lower figure. For a 90% LTV loan: 0.90 x $290,000 = $261,000 loan. The buyer must cover the gap: $300,000 price - $261,000 loan = $39,000 down (the larger down payment absorbs the low appraisal). If the appraisal had matched the $300,000 price, 90% LTV would be $270,000 with $30,000 down. The low appraisal cost this buyer an extra $9,000 in cash. This is why low appraisals frequently kill or renegotiate deals.

Qualifying the borrower

Lenders evaluate the four Cs: credit, capacity (income/debt), capital (assets/reserves), and collateral (the appraised property). Capacity is measured with two ratios:

• Front-end (housing) ratio = monthly PITI (principal, interest, taxes, insurance) divided by gross monthly income.
• Back-end (total debt) ratio = PITI plus all recurring debts (car, cards, student loans) divided by gross monthly income.

Worked example: A borrower earns $6,000/month gross. PITI is $1,560. Front-end ratio = $1,560 / $6,000 = 26%. Add $540 in other monthly debt: back-end = $2,100 / $6,000 = 35%. Many conventional programs target roughly 28% front-end and 36% back-end, though automated underwriting and compensating factors (large reserves, strong credit) allow higher ratios.

Amortization, points, and buydowns

Most residential loans are fully amortized: each level payment covers all the interest due plus enough principal to retire the loan by the end of the term. Early payments are mostly interest; later payments are mostly principal. Contrast this with a term (interest-only) loan that requires a balloon payment of the full principal at the end, and a partially amortized loan with a smaller balloon.

Lenders may charge discount points to raise yield: one point = 1% of the loan amount, and each point typically buys down the rate by roughly one-eighth percent. Worked example: on a $200,000 loan, 2 discount points cost 2% x $200,000 = $4,000 paid at closing. A temporary buydown (such as a 2-1 buydown) lowers the rate for the first years; a permanent buydown lowers it for the full term. Origination fees and points are part of why APR exceeds the note rate.