General Mortgage Knowledge — Conventional Loan Products
mlopractice study guide with diagrams.
General Mortgage Knowledge — Conventional Loan Products
Learning Objectives
By the end of this chapter, you should be able to:
Define a conventional loan and distinguish it from government-insured loans (FHA, VA, USDA).
Identify the characteristics of conforming and non-conforming conventional loans, including the role of Fannie Mae and Freddie Mac.
Explain the purpose and structure of private mortgage insurance (PMI), including cancellation rules under the Homeowners Protection Act.
Describe common conventional loan terms: fixed-rate, adjustable-rate (ARM), interest-only, and balloon loans.
Recall the standard underwriting factors: credit, capacity, collateral, and the debt-to-income (DTI) ratio limits.
Recognize the differences between primary residence, second home, and investment property requirements.
Identify the key disclosures and timing rules that apply specifically to conventional loans under Regulation Z and RESPA.
Avoid the classic exam traps that mix up program rules, disclosure timelines, and borrower protections.
1.1 What Is a Conventional Loan?
A conventional loan is any mortgage loan that is not insured or guaranteed by a federal government agency. This is the single most important definition. If a loan is backed by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the U.S. Department of Agriculture (USDA), it is a government loan, not conventional.
Conventional loans are typically held in private portfolios or sold to the secondary market. They are subject to federal consumer protection laws — including the Truth in Lending Act (TILA), the Real Estate Settlement Procedures Act (RESPA), and the Equal Credit Opportunity Act (ECOA) — but they do not follow the specific underwriting rules of FHA or VA.
1.1.1 Conforming vs. Non-Conforming
Within the conventional category, loans are divided into two groups:
Conforming loans meet the criteria set by the Federal Housing Finance Agency (FHFA) for purchase by Fannie Mae or Freddie Mac. The most critical criterion is the conforming loan limit, which is adjusted annually. For 2024, the general limit for a single-family home is $766,550 in most of the United States, with higher limits in designated high-cost areas. A loan at or below this limit is conforming; a loan above it is jumbo and non-conforming.
Non-conforming loans do not meet Fannie Mae or Freddie Mac purchase standards. The most common example is a jumbo loan (above the conforming limit). Other examples include loans with unusual terms, such as interest-only or negative amortization, which the GSEs may not purchase.
Exam Trap: Candidates often confuse "conventional" with "conforming." A conventional loan is defined by the absence of government insurance. A conforming loan is defined by its eligibility for purchase by the GSEs. A jumbo loan is conventional but non-conforming. A loan can be conventional and conforming, conventional and non-conforming, or government and non-conforming (e.g., an FHA loan above the FHA limit is not possible, but VA loans have no limit in practice — do not confuse the two).
1.2 Fixed-Rate Conventional Loans
A fixed-rate mortgage (FRM) has an interest rate that remains constant for the entire loan term. The most common terms are 15-year and 30-year fixed. The 30-year fixed is the most popular conventional product in the United States.
Key characteristics:
Monthly principal and interest (P&I) payments are stable for the life of the loan.
The amortization schedule is fully amortizing, meaning the loan is paid off by the end of the term.
Prepayment is generally allowed without penalty, though some loans may have prepayment penalties (restricted under federal law for certain loans).
Exam Trap: A 15-year fixed loan will have a higher monthly payment than a 30-year fixed loan for the same principal amount, but the total interest paid over the life of the loan is significantly lower. Candidates sometimes reverse this logic.
1.3 Adjustable-Rate Mortgages (ARMs)
An adjustable-rate mortgage (ARM) has an interest rate that changes periodically based on an underlying index. The loan documents specify:
Initial rate — the rate for the first period, often a "teaser" rate below the fully indexed rate.
Index — the benchmark rate (e.g., SOFR, CMT, or LIBOR for legacy loans). The index is outside the lender's control.
Margin — a fixed percentage added to the index to calculate the fully indexed rate. The margin is set by the lender.
Adjustment period — how often the rate changes (e.g., annually).
Rate caps — limits on how much the rate can increase at each adjustment (periodic cap) and over the life of the loan (lifetime cap). A common structure is a 5/1 ARM with a 2/2/5 cap: initial fixed rate for 5 years, then adjusts every 1 year, with a 2% periodic cap and a 5% lifetime cap.
Payment caps — some ARMs limit how much the monthly payment can increase, which may cause negative amortization if the payment is less than the interest due. Negative amortization is prohibited or heavily restricted for qualified mortgages.
Exam Trap: The fully indexed rate is index + margin, not just the index. A borrower with a 5/1 ARM at a 3% initial rate, a 2% margin, and a current index of 4% has a fully indexed rate of 6%. The first adjustment will not necessarily jump to 6% if a periodic cap applies — the rate can only move by the cap amount.
1.4 Interest-Only and Balloon Loans
Interest-only (IO) loans allow the borrower to pay only the interest for a specified period (e.g., 5 or 10 years). After the interest-only period, the loan converts to a fully amortizing payment schedule, which results in a significant payment increase. These loans are typically non-conforming and carry higher risk.
Balloon loans require a large lump-sum payment at maturity. For example, a 5/25 balloon has a 5-year term with payments amortized over 25 years, and the remaining balance is due at the end of 5 years. Balloon loans are generally not qualified mortgages (QMs) and are subject to stricter ability-to-repay rules.
Exam Trap: Do not confuse an interest-only period with negative amortization. Interest-only means the borrower pays exactly the interest due — the principal balance does not increase. Negative amortization occurs when the payment is less than the interest due, causing the principal balance to grow.
1.5 Private Mortgage Insurance (PMI)
Private mortgage insurance (PMI) is required on conventional loans when the down payment is less than 20% of the property value (i.e., the loan-to-value ratio, or LTV, exceeds 80%). PMI protects the lender, not the borrower, in the event of default.
1.5.1 Homeowners Protection Act (HPA)
The Homeowners Protection Act of 1998 (12 U.S.C. 4901) governs PMI cancellation for borrower-paid PMI on residential mortgages. Key rules:
Automatic termination: PMI must be automatically terminated when the borrower's LTV reaches 78% of the original property value, provided the borrower is current on payments.
Borrower-requested cancellation: The borrower may request cancellation when the LTV reaches 80% of the original value, subject to a good payment history and no subordinate liens.
Disclosure requirements: The lender must provide an initial disclosure at closing explaining the borrower's rights to cancel PMI, and annual disclosures thereafter.
Exam Trap: The HPA applies to borrower-paid PMI on conventional loans, not to FHA mortgage insurance premiums (MIP). FHA MIP has its own rules and generally cannot be cancelled for loans with less than 10% down. Candidates frequently mix up PMI and MIP.
1.6 Underwriting Factors: The Four C's
Conventional underwriting evaluates the borrower using four primary factors:
59.Credit — credit score and history. Fannie Mae and Freddie Mac use a tri-merge credit report, taking the middle score of three bureaus. For a co-borrower, the lender uses the lower of the two middle scores. Minimum scores vary by program, but 620 is a common floor for conventional loans.
60.Capacity — the borrower's ability to repay, measured by the debt-to-income (DTI) ratio. The standard conventional limit is 43% for a qualified mortgage, though Fannie Mae allows up to 45% or 50% with compensating factors. The DTI is calculated as total monthly housing expense (principal, interest, taxes, insurance, HOA dues) plus all recurring monthly debts, divided by gross monthly income.
61.Collateral — the property value and condition, determined by an appraisal.
62.Capital — the borrower's down payment and cash reserves.
Exam Trap: The DTI limit for conventional loans is often stated as 28/36 — the front-end ratio (housing expense) should not exceed 28% of gross income, and the back-end ratio (total debt) should not exceed 36%. However, for the SAFE exam, the 43% back-end limit is the critical threshold for a qualified mortgage under the Ability-to-Repay rule. The 28/36 is a guideline, not a statutory cap.
1.7 Occupancy Types
Conventional loans are priced and underwritten differently based on occupancy:
Primary residence — the borrower occupies the property most of the year. This is the lowest risk and has the most favorable terms.
Second home — a property occupied by the borrower for part of the year, but not the primary residence. It must be a single-unit dwelling, borrower-occupied for some period, and not rented full-time.
Investment property — a property purchased for rental income or resale, not occupied by the borrower. These loans require higher down payments (typically 20–25%) and higher interest rates.
Exam Trap: A borrower cannot claim a property as a second home if it is a rental property. Lenders verify occupancy to prevent occupancy fraud, which is a form of mortgage fraud. The exam may present a scenario where a borrower intends to buy a duplex, live in one unit, and rent the other — this is a primary residence (owner-occupied), not an investment property.
1.8 Key Disclosures and Timing for Conventional Loans
Conventional loans are subject to the TILA-RESPA Integrated Disclosure (TRID) rule, which applies to most closed-end consumer mortgages. The two key disclosures are:
Loan Estimate (LE) — must be provided within 3 business days of receiving the borrower's application (defined as six pieces of information: name, income, Social Security number, property address, estimated property value, and loan amount). The LE shows the loan terms, projected payments, and closing costs.
Closing Disclosure (CD) — must be provided at least 3 business days before loan consummation (closing). The CD finalizes the terms and costs.
Important TRID rules:
The LE and CD have tolerance limits for closing costs. Certain fees (e.g., lender origination charges) cannot increase at all (zero tolerance). Others (e.g., third-party services the borrower can shop for) can increase by up to 10%. Others (e.g., taxes and insurance) have no tolerance.
If the APR increases by more than 0.125% (0.25% for irregular loans) or a loan term changes, a revised CD must be provided, and the 3-business-day waiting period restarts.
Exam Trap: The 3-day rescission period under TILA (for refinances of a primary residence) is 3 business days, but it is separate from the TRID 3-business-day CD review period. The rescission period begins after closing and allows the borrower to cancel the loan. The TRID period occurs before closing. Candidates often merge these two timelines.
1.9 Anti-Discrimination and Fair Lending
Conventional loans are subject to the Equal Credit Opportunity Act (ECOA) and its implementing regulation, Regulation B (12 CFR 1002) . ECOA prohibits discrimination based on race, color, religion, national origin, sex, marital status, age, or receipt of public assistance.
The lender must provide an adverse action notice within 30 days of receiving a completed application if the loan is denied.
The notice must state the specific reasons for denial or inform the borrower of the right to request reasons within 60 days.
Exam Trap: ECOA applies to all credit, not just mortgages. The Fair Housing Act (administered by HUD) also prohibits discrimination in housing, but ECOA is the primary statute for credit decisions. The exam may test which law applies to a credit denial — the answer is ECOA/Regulation B.
1.10 Ability-to-Repay and Qualified Mortgages
Under the Dodd-Frank Act, lenders must make a reasonable, good-faith determination that the borrower has the ability to repay the loan. This is the Ability-to-Repay (ATR) rule, implemented in Regulation Z (12 CFR 1026.43) .
A Qualified Mortgage (QM) is a loan that meets specific criteria, including:
No negative amortization, interest-only, or balloon features (with limited exceptions).
Total points and fees do not exceed 3% of the loan amount.
The borrower's DTI does not exceed 43% (for general QMs).
The loan term does not exceed 30 years.
A QM provides the lender with a rebuttable presumption of compliance with the ATR rule, meaning the borrower must prove the lender did not make a reasonable determination.
Exam Trap: The 43% DTI limit is a QM requirement, not a general conventional loan requirement. A lender can make a non-QM loan with a higher DTI if it documents the borrower's ability to repay. The exam may ask which loans are automatically considered QMs — the answer is those meeting the 43% DTI and other criteria.
1.11 Common Exam Traps
98.Conventional vs. Government: A loan with PMI is still conventional. PMI is private insurance, not government insurance. FHA loans have MIP, which is government insurance. Do not confuse the two.
99.Conforming vs. Non-Conforming: The conforming loan limit changes annually and is higher in Alaska, Hawaii, and high-cost areas. A loan above the limit is jumbo, not government.
100.PMI Cancellation: The HPA requires automatic termination at 78% LTV, but the borrower can request cancellation at 80% LTV. The 78% is based on the original property value, not the current market value.
101.TRID Timing: The Loan Estimate is due in 3 business days after application. The Closing Disclosure is due 3 business days before closing. If the APR changes by more than 0.125%, the CD must be re-disclosed and the waiting period restarts.
102.Rescission vs. TRID: The right of rescission is 3 business days after closing for refinances of a primary residence. It does not apply to purchase transactions. TRID's 3-day period is before closing.
103.DTI Limits: The 28/36 ratio is a guideline. The 43% DTI is the QM threshold. A borrower with a 45% DTI may still get a non-QM loan.
104.ARM Index: The fully indexed rate is index + margin, not just the index. The initial rate is often a teaser, and the first adjustment is limited by the periodic cap.
105.ECOA Timing: The adverse action notice must be given within 30 days of a completed application. If the application is incomplete, the lender must notify the borrower of incompleteness within 30 days.
106.Occupancy Fraud: A borrower who claims an investment property as a second home to get a lower rate is committing fraud. The exam may test the difference between a second home (borrower-occupied part-time) and an investment property (rented).
107.Balloon vs. Interest-Only: A balloon loan has a lump-sum payment at maturity. An interest-only loan has a period of interest-only payments, then converts to amortizing payments. Neither is a QM.
1.12 Summary
Conventional loans are the backbone of the U.S. mortgage market. They are defined by the absence of government insurance, and they may be conforming (eligible for GSE purchase) or non-conforming (jumbo). Fixed-rate and ARM structures dominate, with PMI required for low-down-payment loans. The HPA governs PMI cancellation, TRID governs disclosure timing, and ECOA prohibits discrimination. The ATR rule and QM standards set the underwriting framework. On the SAFE exam, you must be precise about definitions, deadlines, and the distinctions between similar concepts — especially conventional vs. government, conforming vs. non-conforming, and the various 3-day rules.
