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

Amortization and Loan Structures

Most residential loans are fully amortized: each level payment covers accrued interest first, with the remainder reducing principal. Early in the term, payments are mostly interest; over time the principal portion grows. At maturity the balance reaches zero.

Other structures appear on the exam:

• Straight (term) loan: interest-only payments, with the entire principal due as a lump sum (balloon) at the end.
• Partially amortized / balloon: payments amortize part of the loan, leaving a balloon balance at maturity.
• Adjustable-rate mortgage (ARM): the rate moves with an index plus a margin; caps limit periodic and lifetime increases.
• Graduated payment mortgage (GPM): payments start low and rise, sometimes causing negative amortization when payments do not cover interest.

Conventional, FHA, and VA Loans

Conforming conventional loans meet Fannie Mae / Freddie Mac limits; jumbo loans exceed them. FHA loans are insured (the FHA reimburses lender losses); VA loans are guaranteed (the VA repays a portion of lender loss). Know that FHA insures, VA guarantees — a frequent trap.

PMI vs. MIP vs. the VA Funding Fee

Private Mortgage Insurance (PMI) protects the lender (not the borrower) on conventional loans with less than 20% down. Under the Homeowners Protection Act, the borrower may request PMI cancellation at 80% loan-to-value (LTV), and the lender must automatically terminate PMI at 78% LTV based on the original amortization schedule, provided payments are current.

FHA MIP (Mortgage Insurance Premium) includes an upfront premium plus an annual premium. On most modern FHA loans with low down payments, MIP lasts the life of the loan. The VA funding fee is a one-time charge that replaces monthly mortgage insurance entirely.

Loan-to-Value and Qualifying Ratios — Worked Examples

LTV: A home appraises at $300,000 and the buyer borrows $240,000. LTV = $240,000 / $300,000 = 80%. At exactly 80% LTV, no PMI is required on a conventional loan.

Front-end (housing) ratio: monthly PITI / gross monthly income. If PITI is $1,800 and gross income is $6,000, the ratio is $1,800 / $6,000 = 30%.

Back-end (total debt) ratio: (PITI + other monthly debt) / gross income. With $1,800 PITI plus $600 in other debt: $2,400 / $6,000 = 40%.

PITI = Principal + Interest + Taxes + Insurance — the four parts of a typical escrowed payment. Lenders compare these ratios to maximum thresholds to qualify the borrower.

Discount Points, Buydowns, and the Secondary Market

Discount points are prepaid interest paid at closing to lower the note rate; one point equals 1% of the loan amount. As a rough rule, each point paid reduces the rate by about one-eighth of one percent, though the exact effect varies. A buydown uses points to reduce the rate temporarily or permanently, lowering early payments.

Lenders rarely keep loans; they sell them on the secondary market to Fannie Mae, Freddie Mac, and Ginnie Mae, which replenishes capital so lenders can make new loans. Ginnie Mae backs government (FHA/VA) loans. Underwriting standards from these agencies — credit score, debt ratios, documentation — drive what the primary market lender can approve. A loan that does not meet agency guidelines may still be made as a portfolio (non-conforming) loan the lender keeps.

Worked Example: When PMI Drops Off

PMI (private mortgage insurance) protects the lender, not the borrower, on conventional loans with less than 20% down (above 80% LTV). Under the federal Homeowners Protection Act, PMI must automatically terminate when the loan amortizes to 78% LTV of the original value, and the borrower may request cancellation at 80% LTV if payments are current.

A buyer purchases at $300,000 with 10% down ($30,000), borrowing $270,000 (90% LTV) and paying PMI.

• Cancellation request allowed once the balance reaches 80% of $300,000 = $240,000.
• Automatic termination at 78% = $234,000 balance.

Contrast with FHA: its MIP (mortgage insurance premium) now generally lasts the life of the loan when the down payment is under 10%, and includes an upfront premium financed into the balance. VA loans carry no monthly insurance but a one-time funding fee.

Worked Example: Front-End and Back-End Ratios

Lenders qualify borrowers with two ratios. The front-end (housing) ratio = total housing payment (PITI) / gross monthly income. The back-end (total debt) ratio = (PITI + all recurring debt) / gross monthly income.

A borrower earns $6,000/month, with proposed PITI of $1,560 and other debts of $540.

• Front-end = $1,560 / $6,000 = 26%.
• Back-end = ($1,560 + $540) / $6,000 = $2,100 / $6,000 = 35%.

Against a common 28%/36% conventional guideline, this borrower qualifies on both. The exam tests the formulas and the order: housing-only first, then total obligations.

Worked Example: Discount Points and the Yield Trade-Off

A discount point equals 1% of the loan amount and is prepaid interest that buys down the interest rate, raising the lender's yield. The rule of thumb the exam uses: each point typically lowers the rate by about 0.25%.

A borrower takes a $280,000 loan and pays 2 points to reduce the rate.

• Cost of points = 2% x $280,000 = $5,600 paid at closing.
• Approximate rate reduction = 2 x 0.25% = 0.5% (e.g., 6.5% down to 6.0%).

Points are a buyer/borrower cost unless the contract assigns them to the seller (a seller concession). On VA and FHA loans there are limits on what fees the veteran/borrower may pay, another tested wrinkle.

Conforming Loans, Jumbo Loans, and the Secondary Market

A conventional loan is not government-insured. A conforming conventional loan meets Fannie Mae / Freddie Mac purchase limits and underwriting standards, so it can be sold on the secondary market; a loan above the limit is a jumbo loan, kept by the lender or sold privately, usually at a higher rate.

The secondary market (Fannie Mae, Freddie Mac, Ginnie Mae) buys loans from originators, replenishing cash so lenders can keep lending — Ginnie Mae specifically guarantees pools of FHA and VA loans.

The exam ties this back to PMI: lenders require PMI on high-LTV conventional loans precisely so the loans qualify as low-risk enough to sell to Fannie/Freddie.