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

Conventional vs. Government Loans

Loans divide into conventional (not insured or guaranteed by the government) and government-backed (FHA-insured, VA-guaranteed, USDA-guaranteed). The exam loves the distinction between insured and guaranteed:

• FHA loans are insured by the Federal Housing Administration. FHA does not lend; approved lenders lend, and FHA insurance protects the lender against loss. Borrowers pay MIP (Mortgage Insurance Premium): an upfront premium plus an annual premium.
• VA loans are guaranteed by the Department of Veterans Affairs for eligible veterans, often with no down payment and no monthly mortgage insurance, but with a one-time funding fee.
• USDA loans guarantee rural-property loans for income-eligible buyers.

PMI vs. MIP

PMI (Private Mortgage Insurance) applies to conventional loans when the down payment is less than 20% (loan-to-value above 80%). It protects the lender, not the borrower.

Under the Homeowners Protection Act (HPA), on most conventional loans:

• PMI auto-terminates when the balance reaches 78% LTV based on the original value/schedule.
• The borrower may request cancellation at 80% LTV.

FHA MIP is different: depending on the loan, MIP may last the life of the loan and is not governed by the HPA's 78%/80% rule. Do not confuse PMI cancellation rules with FHA MIP.

Loan-to-Value and Qualifying Ratios

LTV = loan amount ÷ value (lower of price or appraisal).

Worked example: A home is priced at $250,000 and appraises at $240,000. The buyer wants an 80% loan. The lender uses the lower figure ($240,000). Loan = 0.80 × $240,000 = $192,000. Required cash = $250,000 − $192,000 = $58,000 (a larger down payment because the appraisal came in low).

Qualifying ratios (typical conventional guidance):

• Front-end (housing) ratio = PITI ÷ gross monthly income, often ≤ 28%.
• Back-end (total debt) ratio = (PITI + other debts) ÷ gross monthly income, often ≤ 36%.

Example: Gross monthly income $6,000. Max housing payment at 28% = 0.28 × $6,000 = $1,680. Max total debt at 36% = $2,160, so non-housing debt can be at most $480/month before the housing payment is squeezed.

Other Loan Structures

• Fixed-rate — rate and payment stay constant; fully amortized (principal + interest each payment).
• ARM (adjustable-rate) — rate adjusts to an index + margin; watch caps (periodic and lifetime).
• Balloon — small periodic payments, large final lump sum.
• Interest-only — no principal reduction during the I/O period.
• Term/straight loan — interest-only with full principal due at the end.
• Conforming loans meet limits set for purchase by the secondary market; jumbo loans exceed them.

The secondary mortgage market (Fannie Mae, Freddie Mac, Ginnie Mae) buys loans from lenders, replenishing funds to make new loans. Fannie/Freddie are GSEs; Ginnie Mae is a government agency backing FHA/VA pools.

Points, Buydowns, and the Cost of the Rate

A discount point equals 1% of the loan amount and is paid to lower the interest rate (a buydown). A rough rule tested on exams: one point typically lowers the rate by about 1/8%, though actual amounts vary by lender.

Worked example: On a $200,000 loan, 2 discount points cost 2 × 1% × $200,000 = $4,000. An origination fee (often expressed in points) covers the lender's processing cost and is separate from discount points.

• Permanent buydown — points reduce the rate for the full term.
• Temporary buydown (e.g., 2-1) — the rate is reduced 2% in year one and 1% in year two, then resets to the note rate.

Who pays points is negotiable; sellers sometimes pay buyer points as a concession, subject to loan-program seller-contribution limits.

Underwriting and the Four Cs

Underwriters approve loans by weighing the Four Cs of credit:

If the appraisal comes in low, the lender lends on the lower value, forcing more cash or renegotiation. Automated underwriting speeds approvals, but documentation of income, assets, and employment still drives the decision. Reserves (months of payments left after closing) strengthen marginal files. Remember: the exam treats capacity as ability and credit as willingness — they are not the same thing.

Government Loan Programs and PMI vs. MIP - Worked Numbers

PMI cancellation: On a conventional loan, a borrower can request PMI removal at 80% LTV and it must auto-terminate at 78% LTV (Homeowners Protection Act). FHA MIP often lasts the life of the loan when the down payment is under 10%.

Worked LTV problem: A home appraises at $300,000 and the buyer borrows $270,000. LTV = $270,000 / $300,000 = 90%. Because LTV exceeds 80%, the conventional lender requires PMI. To reach 80% LTV the buyer would need a $240,000 loan, i.e., a $60,000 (20%) down payment. The exam tests both directions: given LTV find the loan, or given the loan find the LTV. Always divide the loan by the lesser of price or appraised value.