9: Conventional Financing

9.1 What a Conventional Loan Is

A conventional loan is a loan that is not insured or guaranteed by a government agency. The lender relies on the borrower’s creditworthiness and on the property as collateral, without the backstop of FHA insurance or a VA guaranty. Conventional loans are the largest category of home loans, and the conventional conforming loan, one that also meets Fannie Mae and Freddie Mac standards, is the default product of the mortgage market. A conventional loan can be conforming or nonconforming; a jumbo loan, for instance, is conventional but non-conforming because it exceeds the conforming size limit.

The absence of government backing shapes the conventional loan’s features. Because the lender bears the risk directly, the lender cares intensely about the down payment, the borrower’s credit, and the ratios that measure risk, and it manages the risk of a small down payment through private mortgage insurance rather than government insurance. Conventional lending is, in this sense, the purest expression of the lender’s own risk assessment.

9.2 The Down Payment and Loan-to-Value Ratio

The down payment is the portion of the purchase price the buyer pays in cash, and the loan covers the rest. The relationship between the loan and the value of the property is captured by the loan-to-value ratio, the single most important risk measure in mortgage lending. The loan-to-value ratio, abbreviated LTV, is the loan amount divided by the lesser of the purchase price or the appraised value, expressed as a percentage:

\[\text{LTV} = \dfrac{\text{Loan Amount}}{\text{Value}} \nonumber\]

A larger down payment means a smaller loan relative to value, a lower LTV, and less risk to the lender, because the borrower has more equity at stake and the property is more likely to be worth at least the loan balance if values fall. A smaller down payment means a higher LTV and more risk. The LTV drives many lending decisions: the rate, the need for mortgage insurance, and sometimes whether the loan is made at all.

Worked Example: Loan-to-Value Ratio

A buyer purchases a home for $500,000 and makes a down payment of $100,000, borrowing $400,000. The appraisal equals the purchase price. The loan-to-value ratio is:

\[ \begin{align*} \text{LTV} &= \dfrac{\text{Loan Amount}}{\text{Value}} \\[4pt] &= \dfrac{$400,000}{$500,000} \\[4pt] &= 0.80 = 80\% \end{align*}\]

The down payment of $100,000 is 20 percent of the price, the complement of the 80 percent LTV. Now suppose the appraisal had come in low, at $480,000, while the price remained $500,000. The LTV is calculated on the lesser of price or value, so the lender uses $480,000: the maximum loan at 80 percent LTV would be 0.80 times 480,000, which is $384,000, and the buyer would have to increase the down payment or renegotiate to bridge the gap. The example shows why the appraisal matters to the loan and why the LTV is computed on the lesser figure: the lender will not lend against value that the appraisal does not support.

Worked Example: Combined Loan-to-Value Ratio

When a property secures more than one loan, lenders measure risk by the combined loan-to-value ratio, abbreviated CLTV, which adds all the loans secured by the property and divides by the value.

A buyer purchases a $600,000 home with a first loan of $420,000 and a second loan of $60,000, putting $120,000 down. The CLTV is the sum of the loans divided by the value:

\[ \begin{align*} \text{LTV} &= \dfrac{\sum \text{Loan Amounts}}{\text{Value}} \\[4pt] &= \dfrac{$420,000 + $60,000}{$600,000} \\[4pt] &= 0.80 = 80\% \end{align*}\]

The first loan alone is a 70 percent LTV, but the combined financing reaches 80 percent. Lenders care about the CLTV because the total debt against the property, not just the first loan, determines the risk that a forced sale will fail to cover what is owed. The example shows why a borrower cannot evade the risk measures simply by splitting the financing into two loans; the combined ratio captures the full leverage.

9.3 Private Mortgage Insurance

When a conventional loan has a high LTV, typically above 80 percent, the lender faces greater risk and ordinarily requires private mortgage insurance, abbreviated PMI. Private mortgage insurance protects the lender, not the borrower, against loss if the borrower defaults and the foreclosure sale does not cover the loan. The borrower pays the premium, often as a monthly addition to the payment, until the requirement ends.

The requirement is tied to the LTV. As the borrower pays down the loan and as the property’s value is established, the LTV falls, and federal law provides that PMI on many loans must be canceled when the loan balance reaches a specified percentage of the original value, and automatically terminated at a lower threshold, provided the borrower is current. PMI thus is not permanent; it covers the lender during the period of highest risk and ends as the borrower builds equity. The practical lesson for the borrower is that a down payment of 20 percent avoids PMI on a conventional loan, while a smaller down payment makes the home accessible sooner at the cost of paying PMI until enough equity accumulates. A knowledgeable licensee can explain this tradeoff clearly.

9.4 Fixed-Rate and Adjustable-Rate Conventional Loans

Conventional loans come in fixed-rate and adjustable-rate forms, and the choice allocates interestrate risk between borrower and lender.

A fixed-rate loan carries an interest rate that does not change for the life of the loan, so the principaland-interest payment is constant and predictable. The borrower is protected against rising rates, and the lender bears the risk that rates will rise above the fixed rate. The thirty-year fixed-rate loan is the archetypal American mortgage, valued for its stability.

An adjustable-rate loan, examined more fully in the chapter on alternative financing, carries a rate that adjusts periodically based on a published index, so the payment can rise or fall over time. The borrower accepts interest-rate risk in exchange for a lower initial rate. The fixed-rate loan trades a higher initial rate for certainty; the adjustable-rate loan trades certainty for a lower initial rate. The right choice depends on the borrower’s expected time in the home, tolerance for payment risk, and view of where rates are heading, judgments a professional can help frame.

Worked Example: PMI and the Down Payment Decision

A buyer can afford a home priced at $400,000 and is deciding between a 20 percent down payment of $80,000, which avoids PMI, and a 10 percent down payment of $40,000, which preserves cash but requires PMI on the resulting 90 percent LTV loan.

Frame the Tradeoff

With 20 percent down, the loan is $320,000 at an 80 percent LTV, no PMI is required, and the monthly payment carries no insurance premium, but the buyer commits $80,000 in cash. With 10 percent down, the loan is $360,000 at a 90 percent LTV, the buyer keeps $40,000 in reserve, but pays PMI until the LTV falls to the cancellation threshold through paydown or appreciation. The buyer must weigh the cost of PMI over the period it will be paid against the value of keeping $40,000 available for reserves, repairs, or investment. There is no universally correct answer; a buyer short on cash may sensibly accept PMI to buy sooner, while a buyer with ample cash may prefer to avoid it. The example shows how the LTV, the PMI requirement, and the down payment decision interlock, and why explaining the tradeoff is part of competent service.

Source: Mrizek, Jeffrey A. Real Estate Finance, First Edition. Licensed CC BY 4.0. This content-only chapter copy omits learning objectives, key terms, review questions, case studies, and chapter quizzes.