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

The three loan families

National-exam financing questions cluster around three categories. Know who backs each and what insurance attaches.

Conventional loans are not government-backed. A conforming conventional loan meets Fannie Mae / Freddie Mac size limits and underwriting standards so it can be sold on the secondary market; a jumbo loan exceeds those limits.

FHA loans are insured by the Federal Housing Administration — the government does not lend the money; it protects the lender against loss. VA loans are guaranteed (not insured) for eligible service members and veterans, allowing 0% down.

Insured vs. guaranteed vs. conventional

The verbs matter on the exam. Insured (FHA) means a federal insurance fund reimburses the lender after a loss. Guaranteed (VA) means the agency promises to cover a portion of the lender's loss. Conventional loans have neither — risk is managed privately through PMI and underwriting standards. A common distractor swaps "insured" and "guaranteed" between FHA and VA; lock in FHA = insured, VA = guaranteed.

Mortgage insurance: PMI vs. MIP

This distinction is tested constantly.

• PMI (Private Mortgage Insurance) — required on conventional loans when the LTV exceeds 80% (down payment under 20%). It protects the lender, not the borrower.
• MIP (Mortgage Insurance Premium) — the FHA equivalent, paid in two pieces: an Up-Front MIP (UFMIP) that can be financed into the loan, plus an annual MIP collected monthly.
• VA charges a one-time funding fee instead of monthly insurance.

Homeowners Protection Act (PMI cancellation)

For conventional loans on a primary residence:

• The borrower may request PMI cancellation when the balance reaches 80% of the original value.
• PMI automatically terminates when the balance reaches 78% of the original value (with payments current).

Trap: FHA MIP cancellation rules differ from PMI — on many modern FHA loans MIP lasts the life of the loan if the down payment was under 10%. Do not apply the 78% PMI rule to FHA.

Amortization vs. interest-only and balloons

• Fully amortized loan — each level payment covers interest plus some principal, so the balance reaches zero at the end of the term. Early payments are mostly interest; later payments are mostly principal.
• Straight / term (interest-only) loan — the borrower pays only interest during the term, then repays the entire principal as a balloon payment at maturity.
• Partially amortized loan — amortizes for a period, then a balloon pays the remaining balance.

Worked interest math

Monthly interest = (balance × annual rate) ÷ 12.

Example: $200,000 balance at 6% interest. Annual interest = $200,000 × 0.06 = $12,000. Monthly interest portion = $12,000 ÷ 12 = $1,000. If the total payment is $1,199, then $1,000 is interest and $199 reduces principal in month one. Next month interest is computed on the slightly smaller balance, so the principal portion grows each month — that is amortization in action.

Qualifying the borrower: DTI ratios

Lenders apply two debt-to-income (DTI) ratios. (Exact limits vary by program; learn the concept and the typical conventional benchmarks.)

• Front-end (housing) ratio = total monthly housing payment (PITI: principal, interest, taxes, insurance) ÷ gross monthly income. Typical conventional guideline ≈ 28%.
• Back-end (total debt) ratio = all monthly debt (PITI + car, cards, student loans) ÷ gross monthly income. Typical guideline ≈ 36% (higher with compensating factors).

Worked ratio example

Gross monthly income = $6,000. Proposed PITI = $1,560.

Front-end ratio = $1,560 ÷ $6,000 = 26% → within a 28% guideline.

Add $600 of other monthly debts: total debt = $2,160. Back-end ratio = $2,160 ÷ $6,000 = 36% → at the guideline limit.

Trap: taxes and insurance count in PITI even though they are not loan interest — leaving them out understates the ratio and is a common exam error.

Lenders may stretch the back-end ratio above the benchmark when the borrower shows compensating factors — a large cash reserve, a strong credit score, a sizable down payment, or stable long-term employment. The ratios are guidelines, not hard caps, and government-backed programs (FHA, VA) often permit higher DTIs than conventional conforming loans. Expect a question that tests whether you know the ratio is a benchmark rather than an absolute legal limit.

Secondary Market, Loan Programs, and ARMs

Lenders rarely keep loans; understanding the secondary market and a few special programs completes the financing picture.

Primary vs. secondary market

The primary market is where borrowers obtain loans from lenders (banks, credit unions, mortgage bankers). The secondary market is where those loans are bought and sold as investments, replenishing lenders' cash to make new loans. The major players: Fannie Mae (FNMA) and Freddie Mac (FHLMC) buy conventional conforming loans, and Ginnie Mae (GNMA) guarantees securities backed by government (FHA/VA) loans. A conforming loan meets Fannie/Freddie size and underwriting limits so it can be sold; a non-conforming or jumbo loan cannot.

Adjustable-rate features

An adjustable-rate mortgage (ARM) ties the rate to an index (such as SOFR) plus a fixed margin; index + margin = the fully indexed rate. Caps limit increases - a periodic cap limits each adjustment, a lifetime cap limits the total rise. A low teaser rate may apply initially. Worked example: an ARM at index 4.5% plus a 2.5% margin carries a fully indexed rate of 7%; a 2% periodic cap means next year it cannot exceed 9%.

Specialty financing

A buydown pays points up front to lower the rate (a 3-2-1 buydown steps the rate down for the first three years). A package mortgage includes personal property (appliances, furniture). A blanket mortgage covers multiple parcels with a partial release clause freeing lots as they sell - common for developers. Matching the loan name to its feature is a quick source of exam points.