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

Major Loan Programs

Conventional loans are made by private lenders without government insurance or guarantee. Government-backed loans reduce lender risk through federal programs.

Table: Loan Program Comparison

The FHA insures the lender; it does not lend money. The VA guarantees a portion of the loan. Both typically require owner occupancy.

Loan-to-Value (LTV)

LTV measures the loan against the property's worth: LTV = loan amount ÷ the lesser of sale price or appraised value. Higher LTV means more lender risk.

Worked Example

A buyer purchases a $300,000 home and borrows $270,000.

• LTV = $270,000 ÷ $300,000 = 0.90 = 90%
• Because LTV exceeds 80%, a conventional loan would require PMI.

If instead the buyer put 20% down ($60,000) and borrowed $240,000, LTV = $240,000 ÷ $300,000 = 80%, so no PMI is required.

Low Appraisal Trap

If the contract price is $300,000 but the appraisal is $290,000, LTV uses the lower $290,000. A 90% loan would be $261,000, and the buyer must cover the gap in cash.

Mortgage Insurance: PMI vs. MIP

Private mortgage insurance (PMI) applies to conventional loans with LTV above 80% and protects the lender, not the borrower, against default loss.

Under the federal Homeowners Protection Act (HPA):

• Borrowers may request PMI cancellation when the loan reaches 80% LTV of original value.
• PMI automatically terminates at 78% LTV based on the original amortization schedule, provided payments are current.

Mortgage insurance premium (MIP) is the FHA equivalent. FHA borrowers pay an upfront MIP plus an annual MIP, which often lasts the life of the loan when the down payment is small. Common trap: candidates assume MIP cancels at 80% like PMI, it usually does not for modern FHA loans.

The Four Cs of Underwriting

Underwriters evaluate four risk categories.

• Credit the borrower's score and repayment history.
• Capacity income and debt-to-income (DTI) ratio, the ability to repay.
• Capital the down payment, reserves, and cash to close.
• Collateral the property's appraised value and condition securing the loan.

DTI Example

Gross monthly income is $7,000 and total monthly debt payments (including the proposed PITI) are $2,800. DTI = $2,800 ÷ $7,000 = 40%. Many programs cap back-end DTI near 43%-50%, so this borrower likely qualifies on capacity.

Pre-Qualification vs. Pre-Approval

• Pre-qualification is an informal estimate based on stated, unverified figures.
• Pre-approval rests on verified documents and a credit pull; sellers treat it as far stronger.

PITI stands for Principal, Interest, Taxes, and Insurance, the components of a typical escrowed monthly payment.

Amortization and Loan Structures

Most residential loans are fully amortizing: each level payment covers all interest due plus enough principal to retire the debt by the final payment. Early in the term the payment is mostly interest; over time the principal share grows.

Table: Common Loan Structures

For an ARM, the rate equals an index (a published benchmark the lender does not control) plus a margin (the lender's fixed markup). Periodic and lifetime caps limit how much the rate can rise per adjustment and over the life of the loan.

Down Payments, Reserves, and Seller Concessions

The down payment is the buyer's cash equity at purchase; reserves are months of payments the lender wants left in the bank after closing. Seller concessions (seller-paid closing costs) are capped by program: conventional limits scale with the down payment, FHA caps concessions at 6%, and VA limits seller-paid costs to 4% of value for certain items.

Discount Points and the Funding Fee

Discount points are prepaid interest paid at closing to buy down the rate; one point equals 1% of the loan amount. A point typically lowers the rate by roughly one-eighth to one-quarter percent, though the exam usually tests the 1%-of-loan definition.

Worked Example: Points

A borrower takes a $240,000 loan and pays 2 discount points. Cost = 2% × $240,000 = $4,800 due at closing. Note that points apply to the loan amount, not the sale price, a frequent trap.

The VA funding fee and the FHA upfront MIP are usually expressed as a percentage of the loan and may be financed into the balance rather than paid in cash.

Conforming vs. Jumbo Loans

A conforming loan meets the size limits and underwriting standards set by Fannie Mae and Freddie Mac, so it can be sold on the secondary market. A loan above the conforming limit is a jumbo loan, which carries stricter credit and reserve requirements because it cannot be sold to the GSEs.

The Secondary Mortgage Market

Lenders sell closed loans to Fannie Mae and Freddie Mac (and to Ginnie Mae for FHA/VA pools) to replenish cash for new lending. The secondary market does not lend to consumers; it buys existing loans and sets the underwriting standards primary lenders follow.

Trap: candidates confuse conforming (a size/standards label) with conventional (a not-government-backed label). A loan can be conventional and jumbo at the same time.