7.2 Loan Types, Lender Requirements, PMI, and Mortgage Insurance
Key Takeaways
- Conventional loans are not government-backed; FHA loans are insured, and VA loans are guaranteed.
- PMI applies to conventional loans above 80% LTV; FHA loans carry MIP regardless of down payment.
- Loan-to-value (LTV) equals loan amount divided by the lesser of price or appraised value.
- Lenders qualify borrowers using front-end (housing) and back-end (total debt) ratios.
- Amortized loans pay both principal and interest so the balance reaches zero at maturity; interest is computed on the remaining balance.
Loan types
Conventional loans are not insured or guaranteed by the government. A conforming conventional loan meets Fannie Mae / Freddie Mac limits; a loan above those limits is a jumbo loan. FHA loans are insured by the Federal Housing Administration, allow low down payments (as little as 3.5%), and require MIP (mortgage insurance premium). VA loans are guaranteed by the Department of Veterans Affairs for eligible veterans, often with no down payment, and carry a one-time funding fee instead of monthly mortgage insurance.
Memorize the verbs: FHA insures, VA guarantees, conventional has neither. Both FHA and VA loans are originated by approved private lenders, not by the government itself.
| Loan | Backing | Down payment | Insurance/fee |
|---|---|---|---|
| Conventional | None | Typically 5%-20% | PMI if LTV > 80% |
| FHA | Insured | As low as 3.5% | Upfront + annual MIP |
| VA | Guaranteed | Often 0% | One-time funding fee |
Loan-to-value (LTV)
LTV = loan amount divided by the lesser of the sales price or appraised value. If a home is priced at $300,000 but appraises at $290,000, the lender bases LTV on $290,000. A $232,000 loan on that home is $232,000 / $290,000 = 80% LTV.
PMI and mortgage insurance
Private mortgage insurance (PMI) protects the lender (not the borrower) on conventional loans when the down payment is under 20% (LTV above 80%). Under the Homeowners Protection Act, PMI must be automatically terminated when the loan reaches 78% LTV of original value on schedule, and a borrower may request cancellation at 80%. FHA MIP is different: it is required on all FHA loans regardless of down payment and, for most modern FHA loans with low down payments, lasts the life of the loan.
Qualifying the borrower
Lenders use two debt ratios:
- Front-end (housing) ratio = monthly PITI (principal, interest, taxes, insurance) divided by gross monthly income.
- Back-end (total debt) ratio = PITI plus all other recurring debt, divided by gross monthly income.
Worked example: Gross monthly income is $6,000. Proposed PITI is $1,560; car and student loans add $540.
- Front-end = $1,560 / $6,000 = 26%
- Back-end = ($1,560 + $540) / $6,000 = $2,100 / $6,000 = 35%
If the lender's guidelines cap front-end at 28% and back-end at 36%, this borrower qualifies on both.
Repayment structures
- Amortized (fully amortizing) — level payments cover interest first, then principal; balance hits zero at maturity.
- Straight (term/interest-only) — periodic interest only, full principal due at the end as a balloon.
- Adjustable-rate (ARM) — rate moves with an index plus a margin; watch caps.
- Balloon — small payments then one large final payment.
Interest math: On a $200,000 amortized loan at 6% annual interest, the first month's interest is $200,000 x 0.06 / 12 = $1,000. If the total payment is $1,199, then $199 goes to principal, lowering next month's interest base. Over time the interest share shrinks and the principal share grows - the reverse of how it begins. This is why early payments build equity slowly.
ARM components and points
An adjustable-rate mortgage has an index (a published benchmark) plus a fixed margin the lender adds; together they set the adjusted rate. Periodic caps limit how much the rate can move per adjustment, and a lifetime cap limits the total increase. A discount point equals 1% of the loan amount paid up front to buy down the interest rate; on a $250,000 loan, two points cost $5,000. An origination fee also commonly equals 1% but pays for processing rather than lowering the rate.
More qualifying notes
Lenders verify income, assets, employment, and credit score, and order an appraisal to confirm the collateral's value supports the loan. If the appraisal comes in below the contract price, the lender lends against the lower value, so the buyer must pay the difference in cash or renegotiate. A higher credit score generally yields a lower rate and may lower the required PMI premium. Down-payment funds usually must be seasoned (in the account a set period) or documented if gifted, so underwriters can confirm they are not a hidden loan.
Secondary market and special programs
Lenders sell closed loans on the secondary market to Fannie Mae and Freddie Mac, freeing capital to originate more loans; Ginnie Mae guarantees pools of government-backed (FHA/VA) loans. This is why conforming guidelines matter - they make loans saleable. USDA rural development loans offer zero-down financing in eligible rural areas with income limits. FHA 203(k) loans roll renovation costs into the purchase loan. None of these change the core distinction: FHA insures, VA guarantees, USDA guarantees rural loans, and conventional carries PMI when LTV exceeds 80%.
Reading an LTV/PMI trap
Exam questions often pair an appraisal that differs from price with a PMI threshold. Always compute LTV on the lesser figure, then compare to 80%. A loan at exactly 80% LTV does not require PMI; only loans above 80% do. Watch for FHA fact patterns where the question asks about PMI - FHA loans carry MIP, not PMI, and MIP applies regardless of the down payment, so "no PMI because 25% down" is a wrong answer for an FHA loan.
A buyer purchases a home priced at $310,000 that appraises at $300,000 and obtains a $240,000 conventional loan. What is the loan-to-value ratio, and is PMI likely required?