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

Loan categories

A conventional loan carries no government backing. A conforming conventional loan meets Fannie Mae / Freddie Mac limits and guidelines; a jumbo loan exceeds the conforming limit and is non-conforming.

Know the verbs: FHA insures, the VA guarantees. FHA does not make loans — it insures lenders against loss. The VA does not lend either; it guarantees a portion so eligible veterans can borrow with little or no down payment.

Loan-to-value (LTV) ratio

LTV = loan amount ÷ value, where value is the lesser of sales price or appraised value. LTV drives the down payment, the need for PMI, and the lender's risk.

Worked example — LTV and down payment

A home is priced at $300,000 and appraises at $290,000. The lender will use the lesser, $290,000. On a loan of $261,000:

• LTV = $261,000 ÷ $290,000 = 90%
• Because LTV exceeds 80%, the conventional borrower must pay PMI.
• The buyer's cash includes the gap between the $300,000 price and the $290,000 appraisal — the loan is capped on value, not price.

Mortgage insurance

• PMI (private mortgage insurance): required on conventional loans when LTV exceeds 80%. It protects the lender, not the borrower. Under federal rules it generally auto-terminates at 78% LTV based on the original amortization schedule.
• MIP (mortgage insurance premium): the FHA equivalent — an upfront premium plus an annual premium. MIP applies even with larger down payments and, on many newer FHA loans, lasts much of the loan term.
• VA funding fee: a one-time fee instead of monthly insurance; some disabled veterans are exempt.

Trap: students confuse who is protected. Mortgage insurance protects the lender against borrower default — it is not a benefit policy for the buyer.

Conventional PMI vs. FHA MIP

Cancellation is a favorite exam contrast. Conventional PMI can be removed: it auto-terminates at 78% LTV on the original schedule, and a borrower may request cancellation at 80%. FHA MIP is far stickier — on most modern FHA loans with the minimum down payment, MIP lasts the life of the loan, so the only escape is to refinance into a conventional loan. That difference often decides which loan a borrower keeps long-term.

The VA funding fee rolls into the loan or is paid at closing once, then disappears; there is no monthly insurance. Exempt categories include certain disabled veterans. So three borrowers with identical loans can carry three very different insurance costs depending solely on loan type.

Qualifying the borrower

Lenders evaluate the classic factors — credit, capacity, capital, collateral — through two debt ratios:

• Front-end (housing) ratio = monthly housing expense (PITI) ÷ gross monthly income.
• Back-end (total debt) ratio = total monthly debt (PITI + car, cards, student loans) ÷ gross monthly income.

Worked example — qualifying ratios

Gross monthly income is $6,000. Proposed PITI is $1,560. Other monthly debts total $540.

• Front-end = $1,560 ÷ $6,000 = 26%
• Back-end = ($1,560 + $540) ÷ $6,000 = $2,100 ÷ $6,000 = 35%

If the lender's guideline is 28/36, this borrower qualifies on both ratios (26 ≤ 28 and 35 ≤ 36).

Amortization structures

• Fully amortized: level payments retire principal and interest by maturity; early payments are mostly interest.
• Interest-only: payments cover only interest for a period; principal balance does not drop.
• Balloon: small payments then one large final lump sum of remaining principal.
• Adjustable-rate (ARM): rate ties to an index plus a margin; caps limit periodic and lifetime increases.
• Reverse mortgage (HECM): for older homeowners; the lender pays the borrower, and the rising balance is repaid when the borrower sells, moves, or dies.

ARM math reminder: the fully indexed rate = index + margin. If the index is 4.5% and the margin is 2.25%, the note rate (absent a cap) is 6.75%.

The index moves with the market and is outside the lender's control; the margin is fixed for the life of the loan and is the lender's spread. Watch for the teaser rate trap: a low introductory rate is not the fully indexed rate, and once the intro period ends the payment can jump to index plus margin within the cap. Caps come in three flavors — initial adjustment cap, periodic cap, and lifetime cap — and the exam expects you to apply each in order. A negative amortization ARM can let the balance grow when the capped payment does not even cover the interest due, which is the opposite of a fully amortized loan.

Loan Programs: Conventional, FHA, VA, and USDA

The exam expects you to match a borrower to the right program:

A conforming conventional loan meets Fannie Mae/Freddie Mac limits; a loan above the limit is a jumbo loan with stricter terms. FHA and VA set maximum loan amounts and require an approved appraisal; the VA appraisal produces a Certificate of Reasonable Value (CRV). Watch the trap that VA and USDA loans can require zero down, while FHA's minimum is 3.5% for qualifying borrowers.

Worked Example: PMI Removal at 80% LTV

Conventional PMI exists to protect the lender on high-LTV loans and falls away as the loan is paid down. Under the federal Homeowners Protection Act, the borrower may request cancellation at 80% LTV and the servicer must automatically terminate PMI at 78% LTV based on the original value, provided payments are current.

Worked example: a home was purchased for $250,000 with a $225,000 loan (90% LTV), so PMI applied at closing.

• 80% of original value = $250,000 × 0.80 = $200,000. The borrower may request PMI cancellation once the balance reaches $200,000.
• 78% of original value = $250,000 × 0.78 = $195,000. The servicer must drop PMI automatically at this balance.

Note the key contrast for the exam: conventional PMI is cancelable, but FHA MIP generally lasts the life of the loan when the down payment is below 10%, which is a recurring distractor pairing.