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

Loan types

Conventional loans are not insured or guaranteed by a government agency. They follow lender (and often Fannie Mae/Freddie Mac) underwriting standards. A conventional loan with less than 20% down generally requires private mortgage insurance (PMI) to protect the lender against default loss.

FHA loans are insured by the Federal Housing Administration. FHA does not lend money; it insures approved lenders. FHA loans allow low down payments and require a Mortgage Insurance Premium (MIP) — an upfront premium plus annual premiums — regardless of down payment size.

VA loans are guaranteed by the U.S. Department of Veterans Affairs for eligible veterans. They allow up to 100% financing (no down payment) and charge a VA funding fee rather than monthly mortgage insurance.

Memory hook: FHA insures, VA guarantees, conventional has neither government backing.

Amortized vs. term loans

• Fully amortized loan: each level payment covers interest plus principal; the balance reaches zero at the end of the term. Early payments are mostly interest; later payments are mostly principal.
• Term (straight) loan: interest-only payments during the term, then the full principal is due as a balloon at maturity.
• Adjustable-rate mortgage (ARM): the rate adjusts to an index plus a margin; caps limit how much it can change.

Lender qualifying tools

Loan-to-Value (LTV) = loan amount divided by the lesser of price or appraised value.

Worked example: A buyer purchases a $300,000 home with a $60,000 down payment. The loan is $240,000. LTV = 240,000 / 300,000 = 80%. At exactly 80% LTV (20% down), conventional PMI is generally not required. If the buyer put only $30,000 down, the loan is $270,000, LTV = 90%, and PMI would be required.

Debt-to-Income (DTI): lenders cap the share of gross monthly income going to housing (front-end) and total debt (back-end). Example: gross income $6,000/month, max back-end DTI 43% → maximum total debt payments = 6,000 x 0.43 = $2,580/month.

Discount points: one point = 1% of the loan amount (not the price) and is prepaid interest to lower the rate. Example: 2 points on a $240,000 loan = 240,000 x 0.02 = $4,800.

Trap: PMI can typically be cancelled on a conventional loan once enough equity builds; FHA MIP often stays for the life of the loan when the down payment is small. Do not confuse PMI (conventional) with MIP (FHA).

Special loan structures the exam tests

Beyond the standard amortized loan, several structures appear regularly:

• Conforming vs. nonconforming: a conforming loan meets Fannie Mae/Freddie Mac limits and guidelines; a jumbo loan exceeds the conforming limit and is nonconforming.
• Construction loan: short-term financing disbursed in draws as construction progresses; usually interest-only, then replaced by permanent ("take-out") financing.
• Bridge (swing) loan: short-term financing covering the gap between buying a new home and selling the old one.
• Reverse mortgage (HECM): lets qualifying senior homeowners convert equity to payments; the balance rises over time and is repaid when the owner sells, moves, or dies.
• Wraparound mortgage: a new, larger loan that "wraps" an existing loan the seller keeps paying — only works if the underlying loan has no enforceable due-on-sale clause.
• Buydown: points or seller contributions reduce the rate temporarily (e.g., 2-1 buydown) or permanently.

The secondary mortgage market

Lenders sell loans to the secondary market to replenish lending funds. Know the players: Fannie Mae (FNMA) and Freddie Mac (FHLMC) buy conventional conforming loans; Ginnie Mae (GNMA) guarantees securities backed by government loans (FHA/VA). The primary market is where borrowers get loans; the secondary market is where those loans are bought and sold.

Worked DTI trap: a borrower earns $7,200/month gross with a front-end (housing) cap of 28%. Maximum PITI = 7,200 x 0.28 = $2,016/month. Even if back-end debt looks fine, the housing ratio alone can cap the loan. PITI stands for Principal, Interest, Taxes, and Insurance — the full monthly housing obligation lenders measure.

Government Loans and Worked Qualifying Ratios

Three government programs recur. FHA loans are insured by the Federal Housing Administration, allow down payments as low as 3.5%, and require MIP (mortgage insurance premium) — both upfront and annual — that, for most current FHA loans, lasts the life of the loan. VA loans are guaranteed for eligible veterans, often allow 0% down, charge a one-time funding fee, and require no monthly mortgage insurance. USDA rural-development loans also allow 0% down in eligible areas.

Worked qualifying example: A buyer earns $6,000 gross monthly. Using a conventional 28/36 ratio, the housing (front-end) cap is 28% × 6,000 = $1,680 for PITI, and the total debt (back-end) cap is 36% × 6,000 = $2,160 for PITI plus all recurring debt. If the buyer already pays $500 in car and card minimums, the maximum PITI is the lower of $1,680 or (2,160 − 500 = $1,660), so $1,660 governs. Remember PMI on a conventional loan cancels automatically at 78% LTV under the Homeowners Protection Act, unlike most FHA MIP.