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

Conventional Loans

A conventional loan is not insured or guaranteed by the government. Conforming conventional loans meet the purchase guidelines and loan-limit ceilings of Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), so they can be sold on the secondary market. Jumbo loans exceed those limits and usually carry stricter qualifying terms.

Because there is no government backstop, conventional lenders manage risk through down payment size, credit standards, and private mortgage insurance when equity is thin.

Government-Backed Loan Programs

Table: Government Loan Programs

The FHA insures the lender against loss; the VA guarantees a portion of the loan rather than insuring it. USDA loans target rural and some suburban areas and impose household income caps. A frequent trap: FHA insures, VA guarantees - the agencies do not lend the money directly.

Mortgage Insurance: PMI vs. MIP

Private mortgage insurance (PMI) applies to conventional loans when the borrower puts down less than 20% (loan-to-value above 80%). It protects the lender, not the borrower, against default loss. Under the Homeowners Protection Act, PMI must automatically terminate once the principal balance reaches 78% LTV of the original value, and borrowers may request cancellation at 80%.

The FHA equivalent is the mortgage insurance premium (MIP), which includes an upfront charge and an ongoing annual premium. On many FHA loans, MIP lasts the life of the loan and cannot be cancelled simply by reaching 80% LTV - a common point of confusion with PMI.

Lender Qualifying and LTV

The loan-to-value (LTV) ratio equals the loan amount divided by the lesser of price or appraised value. Lower LTV means more borrower equity and less lender risk. Because lenders fund against the lesser figure, a low appraisal raises the effective LTV even when the contract price is unchanged.

Worked Example

A home appraises at $250,000 and sells for $250,000. The buyer borrows $200,000.

• LTV = $200,000 / $250,000 = 80%
• Down payment = $50,000 (20%)

Because LTV is exactly 80%, the conventional lender does not require PMI. Had the buyer borrowed $225,000 (90% LTV), PMI would apply.

Now change one fact: the same $250,000 contract appraises at only $240,000. The lender uses the lesser value, so the $200,000 loan now equals $200,000 / $240,000 = 83.3% LTV - above 80%, so PMI is triggered unless the buyer pays down the loan or brings extra cash.

Debt-to-Income Ratios

Beyond the property, the lender qualifies the borrower with two debt-to-income (DTI) ratios built from gross monthly income:

• Front-end (housing) ratio = monthly housing payment (PITI: principal, interest, taxes, insurance, plus HOA/PMI) divided by gross monthly income.
• Back-end (total debt) ratio = PITI plus all other recurring debt (car, student, credit-card minimums) divided by gross monthly income.

Conventional guidelines commonly target roughly 28% front-end and 36% back-end, while many FHA loans allow higher ratios (often near 31% / 43%) because of the government insurance.

Worked Example

A borrower earns $6,000 gross per month. The proposed PITI is $1,500, and existing debts total $600.

• Front-end = $1,500 / $6,000 = 25% (within the 28% guide)
• Back-end = ($1,500 + $600) / $6,000 = $2,100 / $6,000 = 35% (within the 36% guide)

The borrower qualifies on both ratios. If the lender capped the back-end ratio at 36%, the maximum total debt would be 0.36 x $6,000 = $2,160, leaving only $660 of room above PITI.

Exam Trap: PITI includes taxes and insurance, not just principal and interest. Forgetting the T and I understates the housing ratio.

The Secondary Mortgage Market

Lenders rarely hold every loan to maturity. The primary market is where borrowers obtain loans; the secondary market is where those loans are bought and sold so lenders can replenish cash and make more loans.

Table: Secondary-Market Players

Fannie Mae and Freddie Mac set the conforming limits and underwriting rules that define a salable loan; loans above the limit are jumbo and stay in the primary market or sell privately. Ginnie Mae is a government agency that guarantees mortgage-backed securities built from FHA and VA loans. A frequent trap: Ginnie Mae guarantees securities, it does not buy whole loans from lenders the way Fannie and Freddie do.

Why this matters to a salesperson: a buyer using a loan slightly above the conforming limit may face a higher jumbo rate or a larger down payment, and a buyer needing a low down payment may be steered toward FHA (3.5%) or, if eligible, a 0%-down VA or USDA loan. Knowing these programs lets the agent set realistic expectations about down payment, mortgage insurance, and which homes a buyer can finance.