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

Major loan categories

Key distinctions tested: FHA loans are insured, VA loans are guaranteed, and conventional loans are neither. "Conforming" conventional loans meet Fannie Mae/Freddie Mac limits; loans above the limit are jumbo loans.

Loan-to-value ratio (LTV)

LTV = loan amount ÷ (lesser of sale price or appraised value). Lenders always use the lower figure to protect themselves.

Worked example: A home sells for $300,000 but appraises at $290,000. The buyer wants a $261,000 loan.

• Use the lesser value: $290,000.
• LTV = $261,000 ÷ $290,000 = 90%.

Because 90% > 80%, this conventional loan requires PMI. If the buyer wanted to avoid PMI, the loan could not exceed 80% of $290,000 = $232,000, requiring a larger down payment.

Trap: When the appraisal comes in below sale price, the buyer must cover the gap in cash or renegotiate—the lender will not lend on the higher contract price.

Mortgage insurance: PMI vs. MIP vs. funding fee

• PMI (Private Mortgage Insurance) — conventional loans with LTV above 80%. Protects the lender if the borrower defaults. Paid monthly (or upfront).
• MIP (Mortgage Insurance Premium) — FHA loans. Includes an upfront premium (often financed) plus an annual premium. On many FHA loans MIP lasts the life of the loan.
• VA funding fee — a one-time fee, no monthly mortgage insurance. May be waived for veterans with service-connected disabilities.

When PMI must end

Under the Homeowners Protection Act (HPA):

Trap: PMI insures the lender, not the borrower—even though the borrower pays for it. MIP is FHA's version; do not call FHA insurance "PMI."

Qualifying the borrower

Lenders evaluate the classic factors—often summarized as the "Cs": capacity (income), credit, capital (reserves), collateral (the property), and character. Two ratios do most of the work:

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

Worked example: Gross monthly income $6,000. PITI is $1,560; car and student loans add $540.

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

If a lender caps front-end at 28% and back-end at 36%, this borrower qualifies on both. Push debt to $720 and back-end becomes $2,280 ÷ $6,000 = 38%, exceeding the 36% cap.

The primary vs. secondary mortgage market

Licensees lose points by confusing where loans originate with where they are sold. The primary market is where borrowers obtain loans directly — banks, credit unions, and mortgage bankers originate the note. The secondary market is where those loans are bought and sold so originators can replenish cash to lend again.

Trap: FHA and VA do not make loans. FHA insures and VA guarantees loans that approved private lenders fund. A question that says "the FHA lent the buyer money" is testing this point.

Fixed vs. adjustable and special structures

• Fixed-rate — rate and payment stay level for the term; predictable amortization.
• Adjustable-rate (ARM) — the rate moves with an index plus a margin, bounded by periodic and lifetime caps. The fully indexed rate = index + margin.
• Buydown — points paid up front lower the rate (a 2-1 buydown reduces the rate the first two years).
• Balloon — small payments then one large final payment of the remaining balance.
• Reverse mortgage (HECM) — equity is paid to a senior homeowner; the balance grows over time.

Worked ARM example: An ARM is tied to an index currently at 4.0% with a 2.5% margin and a 2% periodic cap. The fully indexed rate is 4.0% + 2.5% = 6.5%. If the index later jumps to 7.5%, the new fully indexed rate would be 10.0%, but the 2% periodic cap limits this adjustment to a 2-point rise from the prior 6.5%, so the rate can only reach 8.5% at the next adjustment. Caps protect the borrower from the full swing of the index.

Conforming limits, jumbo loans, and assumability

A conforming loan meets the size and underwriting limits set by Fannie Mae and Freddie Mac; a loan above the limit is a jumbo loan that the agencies will not buy, so it carries stricter underwriting. Government loans differ on assumption: many FHA and VA loans are assumable (with lender qualification of the new borrower), whereas conventional loans almost always contain a due-on-sale (alienation) clause that blocks assumption. A question pairing "assumable" with "conventional" is usually wrong; pair assumability with FHA/VA instead.

Trap: Do not confuse the VA funding fee (a one-time charge that can be financed and may be waived for disabled veterans) with FHA's MIP (upfront plus annual). Only conventional loans use the term PMI, and only PMI is subject to the Homeowners Protection Act's automatic 78% LTV termination.