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

Loan programs at a glance

Conventional loans follow Fannie Mae/Freddie Mac guidelines and are not insured by the government. FHA loans are insured by the government so lenders accept lower credit/down payments. VA loans are guaranteed (not insured) for eligible veterans. Know the verbs: FHA insures, VA guarantees, conventional has neither.

Loan-to-value (LTV) ratio

LTV = loan amount / value, where 'value' is the lesser of sale price or appraised value. This is the single most-tested financing calculation.

Worked example: A home is priced at $300,000 but appraises at $290,000. The buyer wants a $261,000 loan.

• Use the lesser value: $290,000.
• LTV = $261,000 / $290,000 = 0.90 = 90% LTV.
• Because 90% > 80%, the conventional loan would require PMI.

Worked example 2: A $250,000 purchase with a $50,000 down payment → loan = $200,000.

• LTV = $200,000 / $250,000 = 80%. Exactly 80% LTV (20% down) → no PMI on a conventional loan.

Trap: If the appraisal comes in below the price, the lender lends on the appraised value, and the buyer must cover the gap in cash or renegotiate.

Qualifying the borrower (the 3 C's)

Lenders evaluate capacity, credit, and collateral (some add capital, character):

• Capacity is measured with debt-to-income (DTI) ratios. A front-end (housing) ratio compares PITI to gross monthly income; a back-end (total debt) ratio adds all recurring debts.
• Credit is the credit score / payment history.
• Collateral is the property, verified by the appraisal — the appraisal exists to protect the lender, ensuring the loan does not exceed the value.

Worked DTI: Gross monthly income $6,000; proposed PITI $1,560. Front-end = $1,560 / $6,000 = 26%. If total monthly debts are $2,160, back-end = $2,160 / $6,000 = 36%. Typical conventional limits are roughly 28% front / 36% back.

PMI vs. MIP and federal cancellation rules

• PMI (private mortgage insurance) applies to conventional loans with LTV above 80%. It protects the lender against borrower default — not the borrower.
• MIP (mortgage insurance premium) applies to FHA loans: an upfront premium (often financed) plus annual premiums paid monthly.
• VA funding fee: one-time fee in lieu of monthly mortgage insurance; can be financed.

Under the federal Homeowners Protection Act (HPA) for borrower-paid PMI on most conventional loans:

• Borrower request: PMI must be canceled on request once the balance reaches 80% LTV of original value (if in good standing).
• Automatic termination: lender must drop PMI automatically at 78% LTV of original value.

Trap: MIP on many modern FHA loans is not automatically removable like PMI — borrowers often refinance to a conventional loan to escape it.

Fixed vs. adjustable and amortization

• Fixed-rate, fully amortized loan: the rate never changes and each level payment covers interest plus enough principal to retire the loan by the end of the term. Early payments are mostly interest; late payments are mostly principal.
• Adjustable-rate mortgage (ARM): the rate = an index (a market benchmark) + a margin (the lender's fixed markup). Caps limit how much the rate can move per adjustment period and over the life of the loan, protecting the borrower.
• Interest-only / balloon loans: payments may not fully amortize, leaving a large balloon payment of remaining principal due at maturity.

Memory hook: Index moves, margin is fixed. If a question asks which part of an ARM rate the borrower's behavior or the market changes, it is the index.

The secondary mortgage market

Lenders rarely keep loans on their books. They sell them into the secondary market to replenish cash for new lending. Key players: Fannie Mae and Freddie Mac buy conventional conforming loans, and Ginnie Mae guarantees securities backed by government (FHA/VA) loans. Their underwriting standards effectively set the rules conventional lenders follow — including the conforming loan limits above which a loan becomes a non-conforming jumbo loan.

Conforming vs. jumbo trap: a loan can be 'conventional' yet too large to be 'conforming.' Jumbo loans exceed the agency limit, are not bought by Fannie/Freddie, and usually carry stricter qualifying and higher rates. Discount points (1 point = 1% of the loan) can be paid at closing to buy down the interest rate; each point typically lowers the rate by a fraction of a percent.

Conventional vs. government loans at a glance

The exam loves the PMI vs. MIP distinction: PMI is private mortgage insurance on conventional loans and, under the federal Homeowners Protection Act, must auto-terminate at 78% LTV of original value (and be cancellable on request at 80%). MIP is the FHA's own insurance and, on most modern FHA loans with low down payments, lasts the life of the loan.

Qualifying ratios — a worked example

Lenders size a loan with two debt ratios. The front-end (housing) ratio = monthly PITI ÷ gross monthly income; the back-end (total DTI) = (PITI + all other monthly debt) ÷ gross monthly income.

Worked example: a borrower earns $8,000/month. With a 28% front-end limit, the maximum PITI = 0.28 x $8,000 = $2,240. With a 36% back-end limit, total debt payments may not exceed 0.36 x $8,000 = $2,880, so if the borrower already pays $700 in car and card debt, the housing payment is capped at $2,880 − $700 = $2,180 — the back-end ratio, not the front-end, becomes the binding constraint. Exam items reward the candidate who computes both ratios and uses the lower allowable PITI.