Real Estate Exam [National] 70, Conventional Loans Explained

Today we are covering conventional loans

for the national portion of the real estate exam.

A conventional loan is a mortgage that is not insured

or guaranteed by the federal government,

which distinguishes it from FHA, VA, or USDA loans.

These loans are strictly private sector transactions

between a lender and a borrower.

On the exam, you must understand

that the risk in a conventional loan

is primarily held by the lender

and the private mortgage insurance company

if applicable.

Conventional loans are broadly categorized

as either conforming or non-conforming.

Conforming loans follow the specific underwriting guidelines

established by the Federal National Mortgage Association,

known as Fannie Mae,

and the Federal Home Loan Mortgage Corporation, known as Freddie Mac.

These two entities are government-sponsored enterprises

that operate in the secondary mortgage market.

When a lender originates a conforming loan,

they can sell it to Fannie or Freddie,

which frees up capital for the lender to issue more loans.

If a loan exceeds the maximum dollar limit set by these entities,

it is considered a non-conforming or jumbo loan.

You will frequently see questions regarding

the loan to value ratio or LTV.

In the conventional loan world,

the magic number to remember is 80%.

If a borrower provides a down payment of at least 20%,

the loan to value ratio is 80% or lower,

and the lender generally does not require mortgage insurance.

However, if the borrower puts down less than 20%,

the lender will require private mortgage insurance,

which is commonly referred to as PMI.

A common exam trap involves the purpose of PMI.

You must remember that PMI is designed to protect the lender

from financial loss if the borrower defaults on the loan.

It does not protect the borrower.

The premium for this insurance is paid by the borrower

until the equity in the home reaches a certain level,

typically 22%, according to the Home Owner's Protection Act.

Credit worthiness is another major factor for conventional loans.

These loans generally require higher credit scores

and more stable income histories than government-backed loans.

The exam will often test you on debt to income ratios,

which lenders use to qualify borrowers.

For conventional loans, the standard ratios

are 28% for the front end and 36% for the back end.

The front end ratio refers to the percentage

of a borrower's gross monthly income

that goes toward the housing expense,

which includes principal, interest, taxes,

and insurance or PTI.

The back end ratio is the percentage

of gross monthly income that covers the PTI

plus all other long-term recurring debts,

such as car payments, student loans, or credit card minimums.

If a question asks you to determine

the maximum loan amount a borrower can qualify for,

you must calculate both ratios and select

the lower of the two amounts to ensure

the borrower meets both requirements.

Let us look at an exam style example.

Imagine a borrower earns $6,000 per month in gross income

to find their maximum allowed housing payment

under the front end ratio, you would multiply 6,000 by 0.28,

which equals $1,680.

Then you would check the back end ratio

by multiplying 6,000 by 0.36, which equals $2,160.

If that borrower already has $500 in existing monthly debt,

you subtract that from the $2,160 leaving $1,660.

In this scenario, the borrower is limited by the back end ratio

because $1,660 is less than the $1,680

allowed by the front end ratio.

A helpful mental shortcut for your studies

is the phrase conventional private protection.

This reminds you that the loan is private,

and that PMI is the protection mechanism for the lender.

Always be on the lookout for trick questions

that suggest Fannie Mae is a government agency.

While it was created by Congress, it is a private corporation

and its guidelines define the conforming loan market.

Understanding the difference between a government insured

loan and a private conventional loan

is essential for passing the finance section

of your national real estate exam.

Focus on that 80% LTV threshold and the 2836 ratios

to avoid the most common pitfalls on test day.