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

Conventional vs. Government-Backed Loans

A conventional loan is not insured or guaranteed by the government. A conforming conventional loan meets the purchase standards (including loan limits) of Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation); a non-conforming or jumbo loan exceeds those limits.

Government-backed loans reduce lender risk:

• FHA (Federal Housing Administration) loans are insured by the government, allow low down payments (as little as 3.5%), and require MIP (Mortgage Insurance Premium).
• VA (Department of Veterans Affairs) loans are guaranteed for eligible veterans, allow 0% down, and charge a one-time funding fee instead of monthly insurance.
• USDA loans support rural-property buyers with low or no down payment.

PMI vs. MIP — Don't Confuse Them

Private Mortgage Insurance (PMI) applies to conventional loans. Lenders require it when the down payment is below 20% (i.e., Loan-to-Value above 80%). PMI protects the lender, not the borrower. Under the federal Homeowners Protection Act, PMI must be automatically terminated when the loan balance reaches 78% of the original value, and a borrower may request cancellation at 80%.

MIP applies to FHA loans and includes both an upfront premium and an annual premium. On most modern FHA loans with low down payments, MIP lasts the life of the loan, which is a frequent exam distinction from cancellable PMI.

Loan-to-Value Ratio (Worked Example)

The Loan-to-Value (LTV) ratio measures risk:

LTV = Loan Amount / Property Value (or sale price, whichever is lower)

Example: A home appraises at $300,000 and the buyer borrows $255,000.

• LTV = $255,000 / $300,000 = 0.85 = 85% LTV
• Down payment = $300,000 - $255,000 = $45,000 = 15% down

Because 85% LTV exceeds 80%, the lender requires PMI on this conventional loan. A higher LTV means less borrower equity and higher lender risk, which typically raises the rate or insurance cost.

How Lenders Qualify Borrowers

Underwriting weighs the borrower's ability and willingness to repay. Two debt-to-income (DTI) ratios are standard:

PITI stands for Principal, Interest, Taxes, and Insurance — the full monthly housing payment. Lenders also review credit score, verified income, reserves, and the appraisal. A high credit score and low DTI improve approval odds and pricing.

Worked Qualifying Example and Interest-Rate Structure

DTI worked example. A buyer earns $7,000 gross per month. The proposed PITI is $1,750 and other monthly debts (car, student loan, minimum card payment) total $600.

• Front-end ratio = $1,750 / $7,000 = 25% (under the ~28% guide — good).
• Back-end ratio = ($1,750 + $600) / $7,000 = $2,350 / $7,000 = 33.6% (under ~36%-43% — qualifies).

If the back-end ratio had landed at 45%, the buyer would likely need to pay down debt, increase the down payment, or buy a less expensive home. The exam often gives you the income and asks whether the buyer qualifies under stated ratios.

Fixed vs. adjustable. A fixed-rate loan keeps the same rate and payment for the full term. An adjustable-rate mortgage (ARM) starts lower, then resets to an index plus margin at set intervals, bounded by periodic and lifetime rate caps. The margin is the lender's fixed markup; the index (such as SOFR) moves with the market. A buyer who expects rates to rise or plans to stay long-term usually prefers a fixed rate.

Special Loan Structures and the Secondary Market

A few loan structures recur on the national portion:

The secondary mortgage market is where lenders sell loans to free up capital to lend again. Fannie Mae and Freddie Mac buy conforming conventional loans, while Ginnie Mae (Government National Mortgage Association) guarantees pools of FHA and VA loans.

This is why conforming loan limits matter: a loan that meets Fannie/Freddie standards can be sold easily, while a non-conforming jumbo loan stays on the lender's books and usually carries a higher rate. The primary market (where the borrower gets the loan) and the secondary market (where investors buy it) are a common exam pairing — the borrower never deals directly with the secondary market.

Government-Loan Details Worth Memorizing

FHA, VA, and USDA loans each carry signature facts the exam likes to test side by side:

Trap: FHA loans are insured; VA loans are guaranteed — the exam swaps these verbs to bait wrong answers. Also note VA charges a funding fee instead of ongoing mortgage insurance, so a question describing "monthly mortgage insurance for the life of the loan" points to FHA MIP, not VA.

Cancellation contrast restated: conventional PMI auto-terminates at 78% LTV (and is cancelable on request at 80%), while FHA MIP on most modern low-down-payment loans does not drop off — the borrower must refinance to escape it. That single difference is among the most reliable mortgage-insurance points on the national portion.