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

Loan-to-value drives mortgage insurance

Loan-to-value (LTV) is the loan amount divided by the property's value or sale price, whichever is lower. It is the single most tested financing ratio because it measures the lender's risk.

Worked example: A buyer purchases a home appraised at $300,000 for $310,000 and borrows $270,000. Use the lower of value or price: $300,000. LTV = $270,000 / $300,000 = 90%. Because the down payment is under 20%, the lender will require private mortgage insurance.

Conventional loans and PMI

Conventional loans are not insured or guaranteed by a government agency. When the LTV exceeds 80% (down payment under 20%), the lender requires private mortgage insurance (PMI) to protect the lender if the borrower defaults. PMI is not for the borrower's benefit.

Under the federal Homeowners Protection Act, the borrower may request PMI cancellation at 80% LTV, and the servicer must automatically terminate it at 78% LTV, both based on the original amortization schedule and a current-payment requirement.

Government-backed loans

• FHA loans are insured by the Federal Housing Administration and require a Mortgage Insurance Premium (MIP) — an upfront premium financed into the loan plus an annual premium paid monthly. FHA allows lower down payments and more flexible credit, so the insurance offsets lender risk.
• VA loans are guaranteed by the Department of Veterans Affairs for eligible veterans. They allow 0% down and charge no monthly mortgage insurance, but a one-time funding fee applies (waived for some disabled veterans).

Trap: insured vs. guaranteed vs. conventional

FHA insures, VA guarantees, and conventional loans are neither — they may carry private PMI. Do not call FHA insurance "PMI"; PMI is a conventional-loan term, and FHA uses MIP.

Fixed vs. adjustable

A fixed-rate loan keeps the same interest rate and principal-and-interest payment for the full term. An adjustable-rate mortgage (ARM) ties the rate to an index (a published benchmark) plus a fixed margin (the lender's markup). Index + margin = the fully indexed rate. ARMs include caps: a periodic cap limits each adjustment, and a lifetime cap limits the total increase over the loan's life.

Three ARM-related terms get tested. Watch for a teaser rate (a low introductory rate that later resets to the fully indexed rate) and for negative amortization, where a too-low payment fails to cover interest so the unpaid interest is added to principal and the balance grows. A balloon loan keeps payments low but requires one large final payment of the remaining balance at the end of the term.

Lender qualifying

Lenders evaluate the borrower with qualifying ratios that compare debt to income:

• Front-end (housing) ratio = monthly housing expense (PITI) / gross monthly income.
• Back-end (total debt) ratio = (housing expense + all recurring debts) / gross monthly income.

Worked example: A borrower earns $6,000 gross per month. PITI is $1,500 and other monthly debts are $600. Front-end = $1,500 / $6,000 = 25%. Back-end = ($1,500 + $600) / $6,000 = $2,100 / $6,000 = 35%. Both fall within common conventional guidelines, so the borrower likely qualifies.

Lenders also weigh credit score, reserves, and collateral value (the appraisal). The appraisal protects the lender by confirming the property supports the loan; if the appraisal comes in below the price, the lender lends against the lower value, raising the buyer's required cash.

Discount points and the secondary market

Lenders quote discount points to adjust yield. One point equals 1% of the loan amount, and paying points up front lowers the interest rate. A rough exam rule: each discount point paid lowers the rate by about 1/8% (0.125%), though the exact effect is set by the lender.

Worked example: A buyer takes a $240,000 loan and pays 2 discount points. Cost = 2% x $240,000 = $4,800 due at closing. If each point trims roughly 0.125% from the rate, two points lower the quoted rate by about 0.25%. Do not confuse discount points (a yield/rate buydown) with the origination fee, which compensates the lender for processing the loan.

Where loans go after closing

Most loans are sold into the secondary mortgage market. The primary market is where borrowers get loans (banks, credit unions, mortgage bankers). The secondary market is where existing loans are bought and sold, freeing lenders to make new loans.

Because Fannie Mae and Freddie Mac set conforming loan limits and underwriting standards, a loan above the limit is a jumbo (nonconforming) loan, which typically carries stricter qualifying and a higher rate. Understanding this flow explains why lenders insist on standardized documentation: the loan must be sellable to a secondary-market investor.