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

Lenders offer many products, but the exam groups them into a few testable families. The first divide is conventional vs. government-backed. Conventional loans are not insured or guaranteed by the federal government; government-backed loans are FHA-insured, VA-guaranteed, or USDA-guaranteed.

Government-Backed Loans

Trap: FHA does not make loans — it insures loans made by approved lenders. The VA guarantees; USDA guarantees. Only the lender lends.

PMI vs. MIP — the most-missed pair

• PMI (Private Mortgage Insurance) applies to conventional loans when the down payment is less than 20% (LTV above 80%). It protects the lender, not the borrower.
• MIP (Mortgage Insurance Premium) applies to FHA loans — an upfront premium plus an annual premium.

Under the federal Homeowners Protection Act, PMI must be automatically terminated when the balance reaches 78% of original value, and the borrower may request cancellation at 80%. FHA MIP, by contrast, often lasts the life of the loan if the down payment was under 10%.

Fixed vs. Adjustable, and Amortization

• Fixed-rate: rate and principal-and-interest payment never change — predictable.
• Adjustable-rate (ARM): a teaser rate for an initial period, then it adjusts to an index + margin, constrained by caps (periodic and lifetime). Risk = payment shock.
• Fully amortizing: each payment covers interest plus enough principal to retire the loan by term's end.
• Interest-only / balloon: lower early payments but a large lump (balloon) due at the end — refinance or sale risk.

Underwriting: How Lenders Qualify Borrowers

Lenders weigh the four C's: Credit, Capacity (income), Capital (reserves/down payment), and Collateral (the property's appraised value). Two ratios dominate:

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

PITI = Principal + Interest + Taxes + Insurance. Common conventional guidelines target roughly 28% front / 36% back.

Worked Example — Qualifying Ratios

Buyer earns $7,200/month gross. Proposed PITI is $1,900; other monthly debts total $650.

1. Front-end = $1,900 ÷ $7,200 = 26.4% — under 28%, passes.
2. Back-end = ($1,900 + $650) ÷ $7,200 = $2,550 ÷ $7,200 = 35.4% — under 36%, passes.

Now test PMI. Buyer purchases at $380,000 with $38,000 down (10%). LTV = $342,000 ÷ $380,000 = 90% — above 80%, so PMI is required until the balance reaches 80%, with automatic cancellation at 78%.

Loan-to-Value (LTV) and Points

LTV = loan amount ÷ lesser of price or appraised value. A lower LTV (bigger down payment) means less lender risk and usually no PMI.

Discount points buy down the interest rate: 1 point = 1% of the loan amount, paid at closing. On a $300,000 loan, 2 points = $6,000. An origination fee (often 1 point) compensates the lender for making the loan and does not reduce the rate.

Specialty Conventional Products

Beyond plain fixed and ARM loans, examiners expect a handle on a few structures:

• Conforming loan — meets Fannie Mae/Freddie Mac limits and underwriting; easily sold on the secondary market.
• Jumbo loan — exceeds conforming limits; stricter underwriting, often higher rate.
• Construction loan — short-term, interest-only draws during building, then converts or is replaced by permanent financing.
• Bridge (swing) loan — short-term financing to buy a new home before the old one sells.
• Reverse mortgage (HECM) — for borrowers 62+; converts equity to payments, repaid when the owner sells, moves, or dies.

Buydowns and the Appraisal Contingency

A temporary buydown (e.g., a 2-1 buydown) lowers the rate for the first year or two before settling to the note rate — useful when a seller pays points to make payments affordable early. Do not confuse a buydown (lowers payments) with PMI (insures the lender).

Lenders will not lend more than the property is worth, so an appraisal sets the ceiling: LTV uses the lesser of price or appraised value. If a $400,000 contract appraises at only $380,000, an 80% LTV loan is based on $380,000 ($304,000), and the buyer must cover the $20,000 gap or renegotiate under an appraisal contingency.

Assumptions and Loan Servicing

Whether a buyer can assume the seller's existing loan turns on the alienation (due-on-sale) clause. Most conventional loans are not assumable because of that clause, but FHA and VA loans are generally assumable with lender approval — a strong selling point when the existing rate is below market.

After closing, the lender often transfers servicing (collecting payments, managing escrow) to another company; RESPA requires advance notice of a servicing transfer, and the borrower's terms cannot change. Note the difference: selling the loan on the secondary market changes who owns the debt, while transferring servicing changes only who collects the payment — neither alters the note rate or balance.