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

Conventional vs. government loans

Loan programs split into conventional and government-backed, and the verbs matter on the exam.

• Conventional — not insured or guaranteed by the government. Conforming conventional loans meet Fannie Mae/Freddie Mac standards and dollar limits; non-conforming (jumbo) loans exceed those limits and carry stricter terms.
• FHA-insured — the Federal Housing Administration insures the lender against loss. Low down payments (as little as 3.5%), more flexible credit, but the borrower pays mortgage insurance premiums (MIP).
• VA-guaranteed — the Department of Veterans Affairs guarantees a portion of the loan for eligible veterans. Often 0% down and no monthly mortgage insurance, but a one-time funding fee.
• USDA Rural Development — guaranteed loans for eligible rural and suburban buyers within income limits, often with no down payment.

Know the verbs cold: FHA insures, VA guarantees, and conventional loans are neither insured nor guaranteed by the government. The secondary market (Fannie Mae, Freddie Mac, Ginnie Mae) buys these loans from originating lenders, replenishing funds so lenders can keep making new loans.

PMI vs. government mortgage insurance

Private mortgage insurance (PMI) applies to conventional loans when the down payment is under 20% (LTV above 80%). It protects the lender, not the borrower, against default loss.

Under the federal Homeowners Protection Act, PMI on most loans automatically terminates at 78% LTV of the original value (and a borrower may request cancellation at 80%).

FHA charges its own MIP: an upfront premium (financed into the loan) plus an annual premium paid monthly. On many FHA loans MIP now lasts the life of the loan, so it does not auto-cancel at 78% the way conventional PMI does. VA loans carry no monthly mortgage insurance at all — just the one-time funding fee, which can be financed and may be waived for veterans with a service-connected disability.

Exam distinction: PMI is private insurance on conventional loans; FHA MIP is government mortgage insurance; VA uses a guaranty instead of insurance. All of them protect the lender, never the borrower. Do not confuse any of these with homeowner's hazard insurance, which protects the property owner against fire and casualty loss and is required as part of the monthly PITI payment.

Worked example — LTV and PMI

A home appraises for $300,000 and the contract price is $310,000. The buyer makes a $45,000 down payment.

1. LTV uses the lower of price or appraised value as the base: $300,000.
2. Loan amount = $300,000 − $45,000 = $255,000.
3. LTV = $255,000 ÷ $300,000 = 85%.

Because 85% LTV exceeds 80%, the borrower must pay PMI on a conventional loan. To avoid PMI, the buyer needed 20% down of $300,000 = $60,000. Trap: candidates often use the $310,000 price as the base — always use the lower figure.

Qualifying the borrower: DTI ratios

Lenders measure ability to repay with two debt-to-income ratios:

• Front-end (housing) ratio = total monthly housing payment (PITI: principal, interest, taxes, insurance) ÷ gross monthly income.
• Back-end (total) ratio = PITI + all other recurring monthly debt ÷ gross monthly income.

Worked example: Gross monthly income = $8,000. PITI = $2,000; car + student loans = $640.

• Front-end = $2,000 ÷ $8,000 = 25%.
• Back-end = ($2,000 + $640) ÷ $8,000 = $2,640 ÷ $8,000 = 33%.

If the program caps ratios at 28%/36%, this borrower qualifies on both. Lenders weigh the four C's: capacity (income/DTI), credit, capital (assets/reserves), and collateral (the appraised property).

Amortization and loan structures

Understanding how a loan repays is heavily tested, often with a small calculation.

• Fully amortized loan — level payments cover interest and principal so the balance reaches zero at term's end. Early payments are mostly interest; later payments are mostly principal.
• Interest-only / straight (term) loan — periodic interest only, with the full principal due as a balloon at the end.
• Adjustable-rate mortgage (ARM) — the rate moves with an index plus a fixed margin, subject to periodic and lifetime caps that limit increases.
• Balloon loan — smaller periodic payments followed by one large final payment.

Interest is charged on the outstanding balance, not the original amount. To find one month's interest: balance × annual rate ÷ 12. Example: $255,000 × 6% ÷ 12 = $1,275 interest in month one. As principal is paid down, each month's interest portion shrinks and the principal portion grows. Discount points (1 point = 1% of the loan) are prepaid interest a borrower pays to buy down the rate; roughly each point lowers the rate about one-eighth of a percent.

Term loans, assumptions, and seller financing

Beyond standard bank loans, the exam covers alternative financing the borrower may encounter.

• Assumption — a buyer takes over the seller's existing loan. FHA and VA loans are often assumable (with lender approval); most conventional loans block this with a due-on-sale clause. A novation releases the original borrower from liability, while a simple assumption may leave the seller secondarily liable.
• Purchase-money mortgage (seller financing) — the seller acts as the lender and takes back a note for part of the price.
• Contract for deed (land contract) — the buyer makes installment payments and the seller keeps legal title until the balance is paid; the buyer holds equitable title and possession.
• Wraparound and blanket loans — a wraparound includes the existing loan within a larger new loan; a blanket loan covers several parcels and uses a partial release clause to free individual lots as they sell.

These structures matter because the question may describe the arrangement without naming it and ask you to identify the financing type or who holds title.