4.2 Loan Types and Lenders

Conventional Loans: Conforming, Jumbo, and PMI

A conventional loan is any loan that is not insured or guaranteed by the government. Conventional loans split into two groups:

• Conforming loans meet the underwriting standards and loan limits set by Fannie Mae and Freddie Mac, so they can be sold on the secondary market.
• Jumbo loans exceed the conforming loan limit. Because they cannot be sold to the GSEs, they carry stricter credit standards and often higher rates.

When a borrower puts down less than 20% (loan-to-value above 80%), conventional lenders require private mortgage insurance (PMI), which protects the lender against default. Under the federal Homeowners Protection Act, a borrower may request PMI cancellation at 80% LTV of the original value, and the lender must automatically terminate PMI when the balance is scheduled to reach 78% LTV, provided the loan is current.

Government-Backed Loans

Government programs insure or guarantee the lender, allowing easier qualifying and lower down payments:

FHA, VA, and USDA Details

FHA loans are insured by the Federal Housing Administration. The borrower pays an Upfront Mortgage Insurance Premium (UFMIP) of 1.75% of the loan amount (usually financed into the loan) plus an annual MIP paid monthly. FHA allows down payments as low as 3.5% for qualified credit scores, making it popular with first-time buyers.

VA loans are guaranteed by the Department of Veterans Affairs for eligible veterans, active-duty service members, and certain surviving spouses. Key points the exam tests:

• No down payment and no monthly mortgage insurance.
• A one-time VA funding fee replaces mortgage insurance. For first-time use with no down payment it is 2.15% of the loan amount; it drops with a down payment of 5% or more and is higher on subsequent use.
• Borrowers receiving VA disability compensation are exempt from the funding fee.
• Entitlement is the dollar amount the VA guarantees on the veteran's behalf; it is restored when a prior VA loan is paid off.

USDA loans (Rural Development) offer 0% down in designated rural and suburban areas, subject to household income limits, with an upfront guarantee fee and a small annual fee.

Fixed vs. Adjustable and Amortization

A fixed-rate mortgage keeps the same rate and payment for the entire term. An adjustable-rate mortgage (ARM) has a rate that changes periodically. Its components:

• Index — a published benchmark (e.g., SOFR, Treasury) the rate is tied to.
• Margin — a fixed percentage the lender adds to the index. Rate = index + margin.
• Caps — limit increases: a periodic cap limits each adjustment, and a lifetime cap limits the total rise over the loan's life.

Loans also differ by how they pay off:

• Fully amortized — each payment covers principal and interest; the balance reaches zero at maturity.
• Partially amortized — payments don't fully retire the loan, leaving a balloon payment at the end.
• Straight (interest-only / term) loan — the borrower pays only interest, then the entire principal at maturity.

Points, Buydowns, and Loan-to-Value

Discount points are prepaid interest paid to the lender at closing to lower the interest rate. One point equals 1% of the loan amount and typically reduces the rate by about 0.25%. On a $200,000 loan, one point costs $2,000. Buyers "buy down" the rate when they plan to stay long enough to recoup the cost through lower payments. A buydown can be permanent (points) or temporary (e.g., a 2-1 buydown that lowers the rate 2% in year one and 1% in year two).

Do not confuse discount points with an origination fee, which is the lender's charge for processing the loan rather than for buying down the rate.

Loan-to-value (LTV) ratio measures risk: it is the loan amount divided by the lesser of the sale price or appraised value. A $180,000 loan on a $200,000 home is a 90% LTV. Higher LTV means a smaller down payment, more lender risk, and (on conventional loans) mandatory PMI above 80%.

Lenders and Loan Origination

• Mortgage bankers lend their own funds and then often sell the loans on the secondary market.
• Mortgage brokers do not lend their own money; they match borrowers with lenders for a fee.
• Loan origination is the process of taking the application, underwriting, and funding the loan. Underwriters assess the four C's: credit, capacity (income/debt ratios), capital (down payment/reserves), and collateral (the appraised property).

Underwriters also weigh debt-to-income ratios: a front-end (housing) ratio compares the proposed housing payment to gross income, while the back-end ratio adds all recurring debts. If the appraised value comes in below the contract price, the lender bases the loan on the lower appraised value, so the buyer must either renegotiate or bring extra cash to keep the loan-to-value within program limits.