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

Conventional, FHA, and VA Loans

The exam classifies loans first by who backs them. Conventional loans are not insured or guaranteed by the government; many conform to Fannie Mae/Freddie Mac limits. FHA loans are insured by the Federal Housing Administration, allow lower down payments (as little as 3.5%), and have flexible credit standards. VA loans are guaranteed by the Department of Veterans Affairs for eligible veterans, often requiring no down payment. FHA and VA do not lend money themselves; they insure or guarantee loans made by approved private lenders.

Amortization and Loan Structures

A fully amortized loan has level payments that retire the principal entirely by maturity; early payments are mostly interest, later payments mostly principal. A straight (term) loan pays interest only with the full principal due at maturity as a balloon. An adjustable-rate mortgage (ARM) ties the rate to an index plus a margin and uses caps to limit increases. A balloon loan has a large final payment. A graduated payment mortgage starts low and rises on a schedule, sometimes causing negative amortization.

Mortgage Insurance: PMI vs. MIP

Lenders require insurance when the borrower's equity is thin. Private Mortgage Insurance (PMI) applies to conventional loans when the down payment is under 20% (loan-to-value above 80%). Under the federal Homeowners Protection Act, PMI must automatically terminate when the balance reaches 78% LTV of the original value, and a borrower may request cancellation at 80% LTV. FHA loans instead carry a Mortgage Insurance Premium (MIP) with both an upfront and an annual component; MIP rules are governed by FHA, not the HPA. VA loans use a one-time funding fee, not monthly insurance.

Quick comparison the exam loves to test:

Note: only conventional PMI follows the 78%/80% HPA cancellation rule. FHA MIP often lasts the life of the loan when the down payment is below 10%.

When mortgage insurance attaches and how it ends

Mortgage insurance protects the lender against default and is tied to the loan type and down payment.

Trap: PMI can be cancelled as the balance falls (Homeowners Protection Act: borrower request at 80% LTV; automatic termination at 78%). FHA MIP generally cannot be cancelled the same way when the down payment is small — it runs much longer. Confusing PMI cancellation rules with MIP is a classic miss.

Worked qualifying example (LTV + DTI)

A buyer earns $7,000/month gross. The lender caps the housing ratio at 28% and the total DTI at 36%.

• Max housing payment = $7,000 x 0.28 = $1,960.
• Max total debt = $7,000 x 0.36 = $2,520; if other monthly debts are $400, the housing payment is capped at $2,520 − $400 = $2,120, so the $1,960 housing cap controls (use the lower).

On LTV: a $300,000 purchase that appraises at $290,000 with an 80% cap yields a max loan of $290,000 x 0.80 = $232,000 — value, not price, drives LTV, so the buyer covers the gap.

Points and the secondary market

One discount point = 1% of the loan, paid to buy down the rate; points are computed on the loan, never the price. Lenders sell closed loans to the secondary market (Fannie Mae, Freddie Mac, Ginnie Mae), which is why loans must meet conforming underwriting standards — a borrower-facing reason the qualifying ratios above exist.

Lender Qualifying: LTV and Debt Ratios

Lenders evaluate two main numbers. Loan-to-value (LTV) = loan amount divided by the lesser of price or appraised value. A $300,000 home with a $240,000 loan has an LTV of 80% ($240,000 / $300,000), so no PMI is required. Debt-to-income (DTI) ratios cap how much income goes to debt. The front-end (housing) ratio covers PITI (principal, interest, taxes, insurance); the back-end ratio adds all recurring debt. Conventional benchmarks often run roughly 28% front-end and 36% back-end, though automated underwriting allows higher figures.

Worked DTI Example

A buyer earns $6,000 gross monthly income. Proposed PITI is $1,560 and other monthly debts (car, cards, student loan) total $540.

• Front-end ratio = $1,560 / $6,000 = 26%
• Back-end ratio = ($1,560 + $540) / $6,000 = $2,100 / $6,000 = 35%

Both fall under the 28%/36% conventional guideline, so the buyer qualifies. A common trap is forgetting to include taxes and insurance in PITI, or omitting a recurring debt from the back-end ratio, which understates the true burden.

Points, Buydowns, and the Secondary Market

Lenders price loans with discount points, where one point equals 1% of the loan amount paid upfront to lower the interest rate. On a $250,000 loan, two points cost $5,000. A buydown uses prepaid points to reduce the rate temporarily (a 2-1 buydown) or permanently. Separately, an origination fee compensates the lender for processing and is not the same as discount points. Loans are frequently sold after closing into the secondary market to Fannie Mae, Freddie Mac, or Ginnie Mae, which replenishes lender capital and is why conforming loan limits and underwriting standards matter so much.

The Promissory Note's Interest Mechanics

Understand how a loan's cost is computed. Interest may be fixed for the life of the loan or adjustable, where the rate equals an index (such as SOFR) plus a fixed margin. ARMs use periodic and lifetime caps to limit rate jumps. Watch for negative amortization, where a payment is too small to cover accruing interest, so the unpaid interest is added to principal and the balance grows. Usury laws cap the maximum legal interest rate a lender may charge. On the exam, distinguish the nominal (note) rate from the APR, which folds in points and certain fees to reflect the true annual cost.