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

Conventional vs. government-backed

Loans split into two big buckets.

• Conventional loans are not insured or guaranteed by the federal government. They may be conforming (meeting Fannie Mae / Freddie Mac limits) or non-conforming (e.g., jumbo loans above the limit).
• Government loans are backed by an agency: FHA-insured, VA-guaranteed, and USDA Rural Development.

The practical exam difference is the down payment and the insurance. Conventional loans with less than 20% down require private mortgage insurance (PMI). FHA loans require a mortgage insurance premium (MIP) regardless of down payment.

Government loan quick facts

Trap: FHA does not make loans; it insures approved lenders. VA does not insure, it guarantees a portion so the lender risks less. Students swap "insure" and "guarantee" on these two constantly.

PMI removal and the HPA

For borrower-paid PMI on conventional loans, the Homeowners Protection Act (HPA) sets the rules:

• A borrower can request cancellation when the balance reaches 80% of original value.
• The lender must automatically terminate PMI when the balance reaches 78% of original value (on schedule), if payments are current.

Worked example: original value $300,000. The 80% request point is a balance of $240,000; automatic termination occurs at a $234,000 balance (78%). Contrast with FHA MIP, which on most modern loans lasts the life of the loan unless 10%+ was put down.

Loan structures

• Fixed-rate: same rate and payment for the term; amortized so each payment covers interest then principal.
• Adjustable-rate (ARM): rate moves with an index plus a fixed margin; protected by caps (periodic and lifetime).
• Amortized vs. interest-only: a fully amortized loan pays off at term; interest-only defers principal.
• Balloon loan: low payments then one large final balloon payment.
• Buydown: points paid upfront lower the rate (temporarily or permanently).

Each discount point equals 1% of the loan amount and typically lowers the rate. On a $250,000 loan, 2 points cost $5,000.

Other structures the national exam names: a graduated payment mortgage starts with low payments that rise on a schedule; a reverse mortgage lets qualifying senior owners draw equity with no monthly payment until they move or die; and a package mortgage finances real property plus personal property (appliances, furniture) under one lien. A blanket mortgage covers multiple parcels with a partial release clause freeing lots as they sell, common in subdivision development.

Lender qualifying ratios and LTV

Lenders measure risk with two ratios:

• Front-end (housing) ratio = housing payment (PITI) / gross monthly income.
• Back-end (total debt) ratio = (PITI + all recurring debt) / gross monthly income.

Worked example: gross monthly income $6,000, target back-end ratio 43%. Maximum total debt payments = 0.43 x $6,000 = $2,580. If the borrower already owes $400/month in other debt, the maximum PITI is $2,180.

Loan-to-value (LTV) = loan amount / value (or price, whichever is lower). A $240,000 loan on a $300,000 home is an 80% LTV, the threshold at which PMI is usually avoided.

Secondary market and underwriting

Lenders rarely keep loans on their books. They sell them into the secondary market to free up capital to lend again.

• Fannie Mae and Freddie Mac are government-sponsored enterprises that buy conforming conventional loans and bundle them into mortgage-backed securities.
• Ginnie Mae guarantees securities backed by government loans (FHA, VA, USDA).
• Because these buyers set the conforming limit and documentation standards, the secondary market is why your local lender enforces nationwide rules.

Underwriting evaluates the three C's: capacity (income and ratios), credit (score and history), and collateral (the appraised property). A weak appraisal can sink a loan even when the borrower qualifies, because the lender caps the loan to the lower of price or appraised value. If a $300,000 contract appraises at $290,000, an 80% loan is computed on $290,000 ($232,000), and the buyer covers the gap or renegotiates.

Points, the loan estimate, and term math

Points come in two flavors that students confuse.

• Discount points lower the rate; each point is 1% of the loan amount and is a form of prepaid interest.
• Origination points (fees) compensate the lender for making the loan and do not reduce the rate.

Worked example: a $250,000 loan with 1 origination point and 2 discount points costs $2,500 + $5,000 = $7,500 in points at closing. Shortening the term raises the monthly payment but slashes total interest: a 15-year loan costs far less interest than a 30-year loan at the same rate, because principal is repaid faster. Conversely, an interest-only or balloon structure keeps early payments low but defers principal, leaving a large balance that must be refinanced or paid in a lump sum at the balloon date.

Usury, the Mortgage Players, and a Full Qualifying Walk-Through

The exam expects you to identify the parties in the lending chain and the consumer-protection limits that bound them.

Usury laws cap the maximum interest a lender may charge; a loan exceeding the legal rate is usurious and the lender faces penalties. An impound (escrow) account collects 1/12 of annual taxes and insurance with each payment so the servicer can pay those bills when due.

Worked full-qualification example

A buyer earns $7,200/month gross. The lender uses a 28% front-end and 36% back-end cap.

1. Front-end max housing (PITI) = 0.28 x $7,200 = $2,016.
2. Back-end max total debt = 0.36 x $7,200 = $2,592.
3. The buyer has $450/month in car and student-loan payments, so back-end allows $2,592 - $450 = $2,142 for housing.
4. The lender uses the lower ceiling: $2,016.

Now add the collateral test. The buyer offers $360,000 on a home that appraises at $350,000. The lender computes the 80% LTV loan on the lower $350,000, so the maximum 80% loan is $280,000 and the buyer must cover the $10,000 appraisal gap plus the down payment. If the buyer instead borrows 90% ($315,000 on $350,000), the loan exceeds 80% LTV, so PMI applies until the balance amortizes to 78% of original value under the Homeowners Protection Act — at which point the servicer must automatically terminate it.