7.2 Loan Types, Lender Requirements, PMI, and Mortgage Insurance
Key Takeaways
- LTV = loan amount divided by the lower of value or price; higher LTV means more lender risk.
- Conventional loans use PMI above 80% LTV; FHA uses MIP with upfront and annual premiums.
- Mortgage insurance protects the lender, not the borrower.
- VA loans charge a funding fee with no monthly MI; USDA serves eligible rural buyers.
- Underwriting weighs the Four Cs and DTI; pre-approval beats pre-qualification.
Lenders price loans according to risk, and the exam expects you to know how the major loan programs differ and how borrowers qualify. The starting point is the loan-to-value ratio (LTV), which compares the loan amount to the property's value or sale price, whichever is lower. A higher LTV means a smaller down payment and more lender risk, which usually triggers mortgage insurance. LTV = loan amount divided by value, expressed as a percentage. Lenders use LTV alongside the borrower's credit and income to set both approval and the interest rate.
Conventional vs. Government Loans
Conventional loans are not insured or guaranteed by the federal government. Those meeting Fannie Mae/Freddie Mac limits are conforming; larger ones are jumbo loans. Government loans include FHA (insured by the Federal Housing Administration), VA (guaranteed by the Department of Veterans Affairs for eligible veterans), and USDA (for eligible rural buyers). Government programs generally allow lower down payments and looser credit in exchange for added fees or insurance.
Table: Loan Program Comparison
| Program | Typical Down Payment | Insurance / Fee | Best For |
|---|---|---|---|
| Conventional | 3%-20% | PMI if LTV > 80% | Strong credit, larger down payment |
| FHA | As low as 3.5% | Upfront + annual MIP | Lower credit / smaller down payment |
| VA | Often 0% | Funding fee (no monthly MI) | Eligible veterans / service members |
| USDA | Often 0% | Guarantee fee | Eligible rural-area buyers |
PMI vs. MIP
Private Mortgage Insurance (PMI) applies to conventional loans when the LTV exceeds 80% (down payment under 20%). It protects the lender, not the borrower, against default loss. Under the federal Homeowners Protection Act, PMI generally cancels automatically once the balance reaches 78% of original value, and a borrower may request cancellation at 80%.
FHA's Mortgage Insurance Premium (MIP) serves the same lender-protection role but includes both an upfront premium and an ongoing annual premium that often lasts the life of the loan. Because MIP is harder to remove than PMI, many FHA borrowers later refinance into a conventional loan once they have enough equity to drop mortgage insurance.
Underwriting: The Four Cs
Lenders evaluate risk using the Four Cs:
- Credit — score and repayment history.
- Capacity — income relative to debt obligations (measured by DTI).
- Capital — savings, reserves, and the down payment source.
- Collateral — the appraised property securing the loan.
Stronger credit and lower DTI generally earn lower interest rates and better terms. Lenders document down payment sources; gift funds usually require a gift letter.
Debt-to-Income (DTI) Ratios
DTI measures how much income is consumed by debt. The front-end (housing) ratio divides the proposed monthly housing payment (principal, interest, taxes, insurance, and any HOA, often called PITI) by gross monthly income. The back-end ratio divides total monthly debt (housing plus car loans, student loans, credit cards) by gross income. Lower ratios improve approval odds, and tighter DTI signals less risk.
For example, a borrower with $6,000 gross monthly income and a proposed $1,680 housing payment has a 28% front-end ratio ($1,680 / $6,000). Add $720 in other monthly debt, and total payments of $2,400 give a 40% back-end ratio ($2,400 / $6,000). Many programs favor back-end ratios at or below the low-to-mid 40s, though strong compensating factors can allow more.
Worked Example: LTV and PMI
A home sells for $300,000 and the buyer puts down $30,000. Loan amount = $300,000 - $30,000 = $270,000. LTV = $270,000 / $300,000 = 90%. Because LTV exceeds 80%, the conventional borrower pays PMI until the balance falls to about 80% of original value ($240,000), at which point cancellation may be requested; automatic termination occurs near 78% ($234,000).
Pre-Qualification vs. Pre-Approval
Pre-qualification is an informal estimate based on unverified information the borrower states; it carries little weight. Pre-approval is a more rigorous process in which the lender verifies income, assets, and credit and issues a conditional commitment for a specific loan amount. Sellers strongly prefer offers backed by pre-approval because the financing is far more likely to close. After full underwriting, an approved loan results in a loan commitment; a denial requires an adverse action notice explaining the reason.
Interest Rate Structures and Points
Loans carry either a fixed rate (constant for the full term) or an adjustable rate (ARM) that resets periodically based on an index plus a margin. ARMs use caps to limit how much the rate can rise per adjustment and over the life of the loan, protecting borrowers from payment shock when rates reset. Discount points are prepaid interest paid at closing to buy down the rate; one point equals 1% of the loan amount. Paying points lowers the monthly payment but raises upfront cash to close.
Common Traps
- PMI/MIP protects the lender, never the borrower.
- VA loans charge a funding fee, not monthly mortgage insurance.
- Pre-qualification is an informal estimate; pre-approval is verified and far stronger to a seller.
- Conforming vs. jumbo depends on loan size limits, not on credit quality alone.
- One discount point equals 1% of the loan amount, not the sale price.
- ARM caps limit rate increases per period and over the loan's life to curb payment shock.
A home is valued at $400,000 and the buyer borrows $340,000. What is the LTV, and is PMI typically required on a conventional loan?
Which statement about mortgage insurance is correct?