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

Conventional, FHA, and VA Loans

The national exam expects you to compare the three main loan channels.

• Conventional loans are not government-backed. They follow Fannie Mae/Freddie Mac (conforming) guidelines or are non-conforming/jumbo. They typically require the strongest credit and down payment.
• FHA loans are insured by the Federal Housing Administration. They allow low down payments (as little as 3.5%) and looser credit, but require mortgage insurance premiums.
• VA loans are guaranteed by the Department of Veterans Affairs for eligible veterans. They allow 0% down, no monthly mortgage insurance, and use a one-time funding fee.

Key trap: FHA insures and VA guarantees — the government does not directly lend in either program; approved private lenders do.

Loan-to-Value (LTV) and PMI

The loan-to-value ratio = loan amount / lesser of price or appraised value.

Worked example: a home is purchased for $300,000 with a $60,000 down payment.

• Loan amount = $300,000 − $60,000 = $240,000
• LTV = $240,000 / $300,000 = 80%

On conventional loans, when LTV exceeds 80% (down payment under 20%), the lender requires Private Mortgage Insurance (PMI) to protect against borrower default. Under the Homeowners Protection Act, PMI automatically terminates at 78% LTV based on the original amortization schedule, and a borrower may request cancellation at 80%. PMI protects the lender, not the borrower.

Government Mortgage Insurance: MIP and the VA Funding Fee

Government programs use their own insurance instead of PMI.

FHA's MIP includes an upfront premium financed into the loan plus an annual premium. Because FHA MIP can last the life of the loan, borrowers often refinance to conventional once they reach 20% equity to drop it.

Qualifying the Borrower: Ratios

Lenders measure capacity to repay with two debt ratios.

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

PITI = Principal, Interest, Taxes, Insurance.

Worked example: gross monthly income $6,000; proposed PITI $1,500; car and card payments $600.

• Front-end = $1,500 / $6,000 = 25%
• Back-end = ($1,500 + $600) / $6,000 = $2,100 / $6,000 = 35%

Many conventional programs cap roughly 28% front / 36% back, so this borrower qualifies comfortably.

Points, Buydowns, and Interest

• Discount points lower the interest rate; one point = 1% of the loan amount, paid at closing. On a $240,000 loan, 2 points = $4,800.
• Origination fee compensates the lender for making the loan and is also quoted in points.
• A buydown prepays interest to reduce the rate temporarily (e.g., a 2-1 buydown) or permanently.
• Usury laws cap the maximum interest a lender may charge.

Distinguish fixed-rate loans (constant payment, predictable) from adjustable-rate mortgages (ARMs), which tie the rate to an index plus a margin and limit changes with periodic and lifetime caps.

Amortization and the Loan Lifecycle

Most residential loans are fully amortizing: each level payment covers interest first, then reduces principal, so the balance reaches zero at maturity. Early payments are mostly interest; later payments are mostly principal. Contrast this with:

• Interest-only loans — payments cover interest only for a period, then recast.
• Balloon loans — small payments leave a large lump sum due at the end.
• Term (straight) loans — interest-only with the full principal due at maturity.

Worked interest example: on a $200,000 loan at 6% annual interest, the first month's interest = $200,000 × 0.06 / 12 = $1,000. If the level payment is $1,199, then $199 reduces principal, leaving $199,801. Because the balance shrank, next month's interest is slightly lower and more goes to principal — the engine of amortization. Lenders also verify income, assets, and the appraisal; if the appraisal comes in below the contract price, the loan is sized off the lower value.

Special programs, ARM mechanics, and a worked PMI-cancellation case

Beyond the big three, the exam expects a handful of specialty programs. USDA Rural Development loans offer 0% down for eligible rural and suburban borrowers within income limits. Jumbo loans exceed the conforming loan limit and carry stricter underwriting. Construction loans are short-term, interest-only draws that convert to permanent financing. A reverse mortgage (HECM) lets a homeowner 62 or older convert equity to payments with no required monthly repayment until they sell, move, or die.

For adjustable-rate mortgages, know the moving parts: the index (a published benchmark such as SOFR) plus the lender's fixed margin equals the new rate at each adjustment. Caps protect the borrower — a periodic cap limits each adjustment, a lifetime cap limits total increase, and a payment cap limits the dollar payment change (which can cause negative amortization if interest outpaces the capped payment). A "2/2/6" ARM means a 2% first-adjustment cap, 2% per-period cap, and 6% lifetime cap.

Worked PMI-cancellation example: a borrower buys a $250,000 home with 10% down. Loan = $225,000; original LTV = 90%, so PMI is required. Under the Homeowners Protection Act, the borrower may request cancellation once the balance reaches 80% of the original value ($200,000), and the servicer must automatically terminate PMI at 78% of original value ($195,000) based on the amortization schedule, assuming payments are current.

Note this 78%/80% rule applies to conventional loans only — FHA's MIP follows separate FHA rules and often lasts the life of the loan, which is exactly why borrowers refinance FHA into conventional after building equity.