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

Conventional, FHA, and VA Loans

Loans fall into two broad buckets. Conventional loans are not insured or guaranteed by the federal government; the lender bears the risk and sets the terms. Government loans include FHA-insured and VA-guaranteed loans.

• FHA loans are insured by the Federal Housing Administration. FHA does not lend money; it insures approved lenders against loss. Low down payments (as little as 3.5%) make FHA popular with first-time buyers.
• VA loans are guaranteed by the Department of Veterans Affairs for eligible veterans and service members. They allow up to 100% financing (no down payment) and require no monthly mortgage insurance.

PMI vs. MIP — Don't Confuse Them

Private Mortgage Insurance (PMI) protects the lender on conventional loans when the borrower puts down less than 20%. Under the Homeowners Protection Act, PMI must automatically terminate when the loan balance reaches 78% of the original value, and the borrower may request cancellation at 80%. FHA's MIP serves the same lender-protection role but follows FHA rules.

Loan-to-Value (LTV) Ratio

LTV = Loan Amount / Property Value (lesser of price or appraisal), expressed as a percentage. A higher LTV means more lender risk.

Worked example: A buyer purchases a home for $250,000 with a $25,000 down payment.

• Loan amount = $250,000 - $25,000 = $225,000
• LTV = $225,000 / $250,000 = 90%

Because this exceeds 80% LTV, a conventional lender will require PMI. The borrower could avoid PMI by putting down $50,000 (20%), producing an 80% LTV. Always use the lesser of the sale price or appraised value as the denominator.

Worked example — PMI cancellation thresholds

Under the federal Homeowners Protection Act, a borrower may request PMI cancellation when the loan balance reaches 80% of the original value, and the servicer must automatically terminate it at 78% (if payments are current).

Worked example: A home was purchased for $300,000 with 10% down, financing $270,000 (90% LTV), so PMI applies.

• Borrower may request cancellation at 80% LTV: 0.80 × $300,000 = a $240,000 balance.
• Automatic termination at 78%: 0.78 × $300,000 = a $234,000 balance.

The borrower asks for cancellation once the balance hits $240,000; if no request is made, the lender drops PMI by the time the balance reaches $234,000. FHA's MIP, by contrast, generally cannot be canceled this way — on most modern FHA loans with low down payments, MIP lasts the life of the loan, a key distinction the exam tests directly.

Amortized vs. Other Repayment Structures

• Fully amortized loan — equal periodic payments cover both interest and principal; the balance reaches zero at the end of the term. Early payments are mostly interest; later payments are mostly principal.
• Interest-only loan — payments cover only interest; principal is due as a balloon later.
• Term (straight) loan — interest-only payments with the entire principal due at maturity in one lump sum.
• Balloon loan — partially amortized; smaller regular payments leave a large balloon payment at the end.
• Adjustable-rate mortgage (ARM) — the interest rate adjusts periodically based on an index plus a margin, subject to rate caps.

Lender Qualifying Standards

Lenders assess borrowers through debt-to-income (DTI) ratios and the property through an appraisal.

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

Worked example: Gross monthly income $6,000; proposed PITI $1,500; other monthly debt $600.

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

Many conventional programs cap these around 28% front and 36% back, so this borrower qualifies comfortably.

Conforming Loans and the Secondary Market

Loans that meet Fannie Mae and Freddie Mac guidelines are conforming and can be sold on the secondary mortgage market, freeing lender capital to make new loans. Loans above the conforming limit are jumbo loans. The primary market originates loans to borrowers; the secondary market buys and sells existing loans. This distinction is a frequent exam point: borrowers interact with the primary market, while Fannie Mae, Freddie Mac, and Ginnie Mae operate in the secondary market.

Discount Points, Buydowns, and Yield

Lenders quote rates that can be lowered by paying discount points up front. One point equals 1% of the loan amount, and as a rule of thumb each point paid lowers the rate by roughly one-eighth (0.125%), though the exact figure varies by lender.

Worked example: On a $200,000 loan, 2 discount points cost 2% × $200,000 = $4,000, paid at closing to buy down the rate. Do not confuse discount points (prepaid interest that adjusts yield) with the origination fee, which compensates the lender for processing the loan. A temporary buydown (such as a 2-1 buydown) lowers the rate for the first years only.

Special Financing Arrangements

Several seller- and buyer-side financing tools appear on the exam:

• Purchase-money mortgage — the seller finances part of the price for the buyer.
• Assumption — the buyer takes over the seller's existing loan and its rate; lender approval is usually required and a due-on-sale clause can block it.
• Contract for deed (land contract) — the seller keeps legal title until the buyer completes payments; the buyer holds equitable title and possession.
• Blanket mortgage — one loan covers multiple parcels, with a partial release clause freeing lots as they sell.
• Wraparound and package (real plus personal property) mortgages round out the list.