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

Conventional, FHA, and VA loans

The national portion expects you to distinguish the three big loan families.

Trap: FHA and VA loans are originated by private lenders. The government does not lend the money — FHA insures, VA guarantees. Confusing 'who lends' with 'who backs' is a classic miss.

Amortization, term, and rate structure

• Fully amortized loan: equal payments retire the loan exactly at maturity; the principal portion grows each period.
• Interest-only loan: payments cover only interest, leaving the principal due later.
• Balloon loan: small periodic payments end in one large lump-sum payoff.
• Adjustable-rate mortgage (ARM): the rate is tied to an index plus a margin and adjusts periodically; caps limit how far it can move.
• Fixed-rate mortgage: the rate never changes for the loan's life.

With an ARM, the margin is the lender's fixed add-on and the index is the moving benchmark. Rate = index + margin, subject to periodic and lifetime caps.

Lender qualifying ratios (worked)

Lenders use two debt ratios. The front-end (housing) ratio = PITI ÷ gross monthly income. The back-end (total debt) ratio = (PITI + other recurring debt) ÷ gross monthly income. PITI = principal, interest, taxes, and insurance.

Worked example. A buyer earns $6,000/month gross. PITI = $1,500; car and card payments = $400.

1. Front-end ratio = $1,500 ÷ $6,000 = 25%.
2. Back-end ratio = ($1,500 + $400) ÷ $6,000 = $1,900 ÷ $6,000 = 31.7%.

If a conventional program caps ratios at 28%/36%, this buyer qualifies on both. If PITI rose to $1,800, the front-end becomes 30% — over the 28% guideline — and the loan may be denied or require compensating factors.

PMI vs. MIP vs. VA funding fee

• PMI (private mortgage insurance): protects the lender on conventional loans when the borrower puts down less than 20%. Under the federal Homeowners Protection Act, PMI auto-terminates at 78% LTV based on the original schedule, and the borrower may request cancellation at 80% LTV.
• MIP (mortgage insurance premium): the FHA equivalent — an upfront premium plus an annual premium. On most FHA loans today, MIP lasts the life of the loan unless a large down payment was made.
• VA funding fee: a one-time fee in place of monthly mortgage insurance; it can be financed into the loan.

Trap: mortgage insurance protects the lender, not the borrower, even though the borrower pays for it. LTV (loan-to-value) = loan amount ÷ the lesser of price or appraised value.

Points, discount points, and the buydown

Lenders quote charges in points, where one point equals 1% of the loan amount. An origination point covers the lender's cost of making the loan. Discount points are prepaid interest the borrower pays to lower the note rate — buying down the rate.

Worked example. On a $250,000 loan, the lender charges 1 origination point plus 2 discount points.

1. Each point = $250,000 × 0.01 = $2,500.
2. Total points = 3 × $2,500 = $7,500 due at closing.

A common rule of thumb is that each discount point lowers the rate by roughly 0.25%, though the exam expects you to compute the dollar cost of points, not the rate change. Trap: points are calculated on the loan amount, not the sales price — if a question gives both, use the loan figure.

Conforming limits, usury, and the loan estimate

Conforming loans meet Fannie Mae/Freddie Mac size and underwriting limits; loans above the cap are jumbo and often carry higher rates. Usury laws cap the maximum interest a lender may legally charge; charging above the ceiling is illegal.

Underwriters weigh the borrower's credit score, debt ratios, employment stability, and the appraised value of the collateral. If the appraisal comes in below the contract price, the lender bases the LTV on the lower appraised value, which can force a larger down payment or a price renegotiation.

Trap: a 'pre-qualification' is an informal estimate, while a pre-approval involves verified documentation and carries far more weight with sellers — do not treat them as equivalent on the exam.

Assumability, Subordination, and a Worked LTV/PMI Problem

Loan type also controls assumability. Most conventional loans contain a due-on-sale (alienation) clause that blocks assumption, while FHA and VA loans are generally assumable by a qualified buyer (with lender/agency approval and, for VA, restoration-of-entitlement concerns). This matters in a rising-rate market where a buyer wants the seller's low rate.

Worked LTV/PMI example. A buyer purchases a $300,000 home with $30,000 down.

1. Loan = $300,000 − $30,000 = $270,000.
2. LTV = $270,000 ÷ $300,000 = 90% — above 80%, so PMI is required.
3. PMI auto-terminates at 78% LTV on the original schedule; the buyer may request cancellation at 80%.

To reach 80% LTV up front the buyer would need $60,000 down (loan $240,000). The exam expects you to compute LTV from the lesser of price or appraised value, then decide whether PMI attaches.