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

Conventional vs. government loans

The first split the exam draws is conventional vs. government-backed.

• Conventional — not insured or guaranteed by a government agency. A conforming conventional loan meets Fannie Mae / Freddie Mac size limits and underwriting guidelines (so it can be sold on the secondary market). A loan above the limit is a jumbo (nonconforming) loan.
• FHA — insured by the Federal Housing Administration. Low down payment (as little as 3.5%), but the borrower pays mortgage insurance premiums.
• VA — guaranteed by the Department of Veterans Affairs for eligible veterans. Often 0% down, no monthly mortgage insurance, but a one-time funding fee.
• USDA / Rural Development — guaranteed loans for eligible rural properties and income-qualified buyers; can be 0% down.

Mortgage insurance: PMI vs. MIP

Lenders protect themselves against default on high-balance loans with mortgage insurance. Do not confuse the two:

Trap: mortgage insurance protects the lender, not the borrower — yet the borrower pays for it. Homeowners Protection Act (HPA): PMI must auto-terminate when the loan reaches 78% of original value on schedule, and the borrower may request cancellation at 80% LTV.

Underwriting ratios: LTV and DTI

Lenders qualify borrowers with two key ratios.

Loan-to-Value (LTV) = loan amount divided by the lesser of price or appraised value.

• Home price $200,000, loan $160,000 -> LTV = 160,000 / 200,000 = 80%. At exactly 80% no PMI is required.
• If the appraisal comes in at $190,000 on a $200,000 contract, LTV is based on the lower $190,000: a $160,000 loan is now 160,000 / 190,000 = 84.2%, triggering PMI.

Debt-to-Income (DTI) measures the borrower's monthly obligations against gross monthly income.

• Front-end (housing) ratio = housing payment (PITI) / gross monthly income.
• Back-end (total) ratio = all monthly debt (PITI + cards, car, student loans) / gross monthly income.

Worked DTI example

A borrower earns $6,000/month gross. Proposed PITI is $1,500. Other monthly debts: $400 car loan + $200 credit cards = $600.

• Front-end = 1,500 / 6,000 = 25%
• Back-end = (1,500 + 600) / 6,000 = 2,100 / 6,000 = 35%

If the lender's guideline is 28% front / 36% back, this borrower qualifies on both. Trap: PITI stands for Principal, Interest, Taxes, Insurance — taxes and insurance count even though they are not loan repayment.

Amortization types

• Fully amortized — level payments retire principal and interest by maturity; nothing owed at the end.
• Interest-only — payments cover interest only; principal stays the same.
• Balloon — small payments then one large lump sum (the balloon) at maturity.
• Adjustable-rate (ARM) — interest rate adjusts to an index plus margin; caps limit how much it can rise per period and over the life of the loan.

Discount points and the secondary market

Discount points are prepaid interest a borrower pays at closing to buy down the note rate. One point equals 1% of the loan amount. On a $200,000 loan, 2 points cost 2% x $200,000 = $4,000. Each point typically lowers the rate by roughly an eighth to a quarter percent, so points make sense for borrowers who will hold the loan long enough to recoup the cost through lower payments.

Why this matters: lenders sell closed loans on the secondary market to investors so they can free up cash to make new loans.

• Primary market — where borrowers obtain loans directly from lenders.
• Secondary market — where existing loans are bought and sold. Fannie Mae and Freddie Mac buy conforming conventional loans; Ginnie Mae guarantees securities backed by FHA/VA loans.

Trap: the secondary market does not lend to consumers — it buys loans from primary lenders.

Lender requirements at a glance

Beyond ratios, underwriters verify the four C's of credit:

The appraisal protects the lender by confirming the collateral is worth enough. If value comes in low, the lender bases LTV on the lower figure, which can force the buyer to add cash, renegotiate, or walk (if a financing/appraisal contingency exists). A higher credit score generally yields a lower interest rate, which is why credit repair before applying can save a borrower far more than chasing a slightly lower point cost.

California Financing Protections and Programs

California uses deeds of trust rather than mortgages for most home loans (a three-party instrument with a trustee), and the state adds borrower protections the DRE tests.

Anti-Deficiency Protection

Under Code of Civil Procedure 580b, a lender on a purchase-money loan for an owner-occupied one-to-four-unit dwelling generally cannot pursue a deficiency judgment if a foreclosure sale brings less than the balance owed. So a buyer who used the loan to buy the home, then loses it to foreclosure, typically does not owe the shortfall.

Under 580d, a lender that forecloses non-judicially (the fast trustee's-sale route, the norm in California) also waives the right to a deficiency. A lender wanting a deficiency on a non-purchase loan must use the slower judicial foreclosure, which then triggers the borrower's statutory right of redemption.

Usury and the CalHFA Programs

California's constitutional usury limit caps certain private loans, but loans made or arranged by licensed real estate brokers and institutional lenders are exempt — a common exam point. The California Housing Finance Agency (CalHFA) offers below-market loans and down-payment assistance (such as the MyHome program) to eligible first-time buyers, paired with FHA, VA, or conventional first loans.

A Worked LTV-and-PMI Problem

A buyer purchases a $600,000 California home with a $90,000 down payment and a $510,000 conventional loan. LTV = $510,000 / $600,000 = 85%. Because LTV exceeds 80%, PMI is required. If the home later appraises at $680,000 and the balance amortizes to $476,000, LTV falls to 70%, and the borrower may request PMI cancellation; it must auto-terminate at 78% of original value under the HPA.

Trap: Most California home loans are deeds of trust, not mortgages. A question describing a "trustee's sale" is testing the non-judicial foreclosure of a deed of trust, where the lender waives any deficiency under 580d.