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

Conventional vs. government-backed loans

The national exam groups loans into conventional (not insured or guaranteed by a government agency) and government loans (FHA-insured, VA-guaranteed, and USDA rural loans). Conventional loans are made by private lenders and often sold to Fannie Mae or Freddie Mac. Government loans expand access for buyers who would otherwise struggle to qualify, by reducing the lender's risk through insurance or a guarantee.

FHA, VA, and USDA at a glance

FHA charges MIP (Mortgage Insurance Premium); conventional loans charge PMI (Private Mortgage Insurance). VA loans charge a one-time funding fee but no recurring mortgage insurance.

Private Mortgage Insurance (PMI) and the 80% rule

Lenders require PMI on conventional loans when the borrower puts down less than 20%, because a higher loan-to-value ratio is riskier. PMI protects the lender, not the borrower, if the loan defaults. Under the federal Homeowners Protection Act, PMI must automatically terminate when the loan balance reaches 78% of the original value (with payments current), and a borrower may request cancellation at 80% LTV. This 78%/80% pair is a frequent exam trap.

Loan-to-value and qualifying ratios (worked example)

Loan-to-value (LTV) = loan amount ÷ lesser of price or appraised value. On a $300,000 home with a $30,000 down payment, the loan is $270,000, so LTV = 270,000 ÷ 300,000 = 90%. Because that exceeds 80%, PMI is required.

Lenders also test repayment capacity with qualifying ratios:

• Front-end (housing) ratio = monthly housing payment (PITI) ÷ gross monthly income.
• Back-end (total debt) ratio = all monthly debt payments ÷ gross monthly income.

A conventional guideline is roughly 28% front-end and 36% back-end. If a buyer earns $6,000/month, a 28% front-end limit caps PITI at $1,680.

Loan structures and points

• Fixed-rate loans keep the same interest rate and payment for the full term.
• Adjustable-rate mortgages (ARMs) adjust the rate periodically against an index plus a margin, often with caps.
• Discount points lower the interest rate; one point equals 1% of the loan amount. On a $200,000 loan, two points cost $4,000.
• PITI stands for Principal, Interest, Taxes, and Insurance — the full monthly housing cost lenders evaluate.

Conventional vs. government loan programs

The exam expects you to match each loan type to its insurer or guarantor and its borrower profile:

FHA insures the lender against loss; it does not make the loan. VA guarantees a portion of the loan so eligible veterans can borrow with little or no down payment. A conforming conventional loan meets the loan limits and underwriting standards set by Fannie Mae and Freddie Mac, who buy loans on the secondary market; a loan above the limit is a jumbo (nonconforming) loan. Recognizing which agency insures, guarantees, or purchases a loan is a recurring exam point.

Working a qualifying-ratio problem

Qualifying ratios convert income into a maximum payment. Example: A buyer earns $7,200 per month in gross income, has $400 in other monthly debt, and the lender uses a 28% front-end and 36% back-end guideline.

• Front-end limit (PITI) = $7,200 x 0.28 = $2,016
• Back-end limit (all debt) = $7,200 x 0.36 = $2,592
• Less existing debt of $400 leaves $2,592 - $400 = $2,192 available for PITI under the back-end test

The lower of the two caps controls, so this buyer qualifies for up to $2,016 in PITI (the front-end limit binds here). When other debt is high, the back-end test usually binds instead. Always compute both and take the smaller result. Pairing the right ratio with the right base income, and remembering that the more restrictive limit governs, resolves the lender-qualification questions in this section.

Underwriting: what the lender actually checks

Qualifying ratios are only part of underwriting, the process a lender uses to decide whether to make the loan. Underwriters evaluate the classic four Cs of credit: capacity (income and the qualifying ratios that measure ability to repay), credit (the borrower's history and credit score), capital (savings, reserves, and the down payment), and collateral (the property's value, confirmed by the appraisal). A weakness in one C can sometimes be offset by strength in another, but a low appraisal or a high debt load is hard to overcome.

The appraisal protects the lender by confirming the collateral is worth at least the loan amount; if the property appraises below the contract price, the lender will lend only against the lower figure, forcing the buyer to bring more cash or renegotiate. Reserves are months of payments the borrower can show after closing, which reassure the lender against short-term setbacks.

For government loans the standards differ: FHA is more lenient on credit and down payment but charges mortgage insurance, while VA focuses on the veteran's entitlement and residual income. Seeing underwriting as the four Cs, with the appraisal guarding the collateral, ties the qualifying math to the lender's full decision and answers the broader loan-approval questions on this section.