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

The three loan families

Key distinctions examiners test:

• Conventional loans are not government-backed. Conforming conventional loans meet Fannie Mae/Freddie Mac limits and can be sold to them.
• FHA loans are insured (the government reimburses the lender's loss). FHA charges MIP: an upfront premium (commonly financed into the loan) plus an annual premium paid monthly.
• VA loans are guaranteed (the VA backs a portion). There is no monthly mortgage insurance; instead a one-time funding fee applies (waived for certain disabled veterans).

A frequent trap: students say FHA "guarantees" and VA "insures." It is the reverse — FHA insures, VA guarantees.

LTV uses the lower number

LTV is calculated on the lower of the sale price or appraised value. If a home is under contract for $300,000 but appraises at $290,000, an 80% loan is 80% of $290,000 = $232,000, not of $300,000. The borrower covers the gap in cash or renegotiates.

PMI and the HPA cancellation rules

Private mortgage insurance (PMI) protects the lender (not the borrower) on conventional loans when the down payment is under 20% (LTV above 80%). Under the federal Homeowners Protection Act (HPA):

• Borrower-requested cancellation: allowed when the loan reaches 80% LTV of the original value (good payment history required).
• Automatic termination: the servicer must cancel PMI when the balance reaches 78% of the original value.
• Final termination: at the loan midpoint of the amortization schedule if still in force.

Worked numeric: when does PMI drop?

Original value/price $250,000, conventional loan $237,500 (95% LTV), so PMI applies.

• Borrower can request cancellation at 80% LTV: 0.80 × $250,000 = $200,000 balance.
• Automatic termination at 78%: 0.78 × $250,000 = $195,000 balance.

So as principal amortizes from $237,500 down, the borrower may ask at $200,000 and the servicer must drop it by $195,000. Note FHA MIP is not governed by HPA — on most modern FHA loans with low down payments MIP lasts the life of the loan, a classic distractor.

Underwriting ratios

Lenders qualify borrowers with two ratios:

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

Worked numeric: do they qualify?

Gross monthly income $7,000; proposed PITI $1,750; car + student loans $650/month. A lender caps front-end at 28% and back-end at 36%.

• Front-end = $1,750 ÷ $7,000 = 25.0% → within 28%. ✓
• Back-end = ($1,750 + $650) ÷ $7,000 = $2,400 ÷ $7,000 = 34.3% → within 36%. ✓

Both ratios pass, so the file qualifies on ratios. The exam often gives a borrower who passes front-end but fails back-end because of consumer debt — always test both.

Special Loan Structures and Discount Points

Beyond the three loan families, examiners test several structures and the cost of buying down a rate.

• Fixed-rate loans keep the same rate and payment; adjustable-rate mortgages (ARMs) adjust periodically using an index plus a margin, bounded by periodic and lifetime caps.
• Conforming conventional loans meet Fannie Mae/Freddie Mac limits; jumbo loans exceed them and carry stricter terms.
• A balloon loan has small or interest-only payments with a large final lump sum. A package loan includes personal property (appliances); a blanket loan covers multiple parcels with a partial release clause; a wraparound loan keeps an existing low-rate loan in place beneath a new larger one.

Discount points lower the borrower's interest rate. One point = 1% of the loan amount, paid up front. A common rule of thumb is that 1 point lowers the rate by about 0.25%, though actual buydowns vary.

Worked example: On a $280,000 loan the lender charges 2 discount points to reduce the rate.

• Cost of points = $280,000 x 0.02 = $5,600 paid at closing.
• If each point buys down 0.25%, 2 points lower the rate by about 0.50% (e.g., 7.0% to 6.5%).

The borrower weighs the $5,600 upfront against monthly savings to find the break-even period. Points are deductible mortgage interest in many cases, and the exam may ask you to compute the dollar cost of a given number of points — always take the percentage of the loan amount, never the purchase price.

Comparing FHA, VA, and Conventional in a Worked Decision

The exam often asks you to pick the right loan for a borrower profile, testing the distinctions in practice.

• A first-time buyer with a 600 credit score and 3.5% down is a classic FHA candidate: FHA allows lower scores and a 3.5% down payment but charges MIP (upfront plus annual), which on most modern low-down FHA loans lasts the life of the loan.
• An eligible veteran with little cash fits a VA loan: 0% down, no monthly mortgage insurance, just a one-time funding fee (waived for certain service-connected disabled veterans).
• A buyer with strong credit and 20%+ down chooses conventional: no government insurance, and with 20% down no PMI at all.

Worked numeric comparison on a $250,000 home:

• FHA at 3.5% down: down payment = $250,000 x 0.035 = $8,750; financed amount is higher and carries MIP.
• Conventional at 20% down: down payment = $250,000 x 0.20 = $50,000; no PMI because LTV is exactly 80%.
• Conventional at 10% down: down payment = $25,000, LTV 90%, so PMI applies until the balance reaches 80% (request) or 78% (automatic) of original value.

The trade-off the exam highlights: lower down payments (FHA, low-down conventional) increase mortgage-insurance cost and total interest, while VA uniquely combines low cash with no monthly insurance for those who qualify.

Special Loan Structures and Discount Points

Beyond the three loan families, examiners test several structures and the cost of buying down a rate.

• Fixed-rate loans keep the same rate and payment; adjustable-rate mortgages (ARMs) adjust periodically using an index plus a margin, bounded by periodic and lifetime caps.
• Conforming conventional loans meet Fannie Mae/Freddie Mac limits; jumbo loans exceed them and carry stricter terms.
• A balloon loan has small or interest-only payments with a large final lump sum. A package loan includes personal property (appliances); a blanket loan covers multiple parcels with a partial release clause; a wraparound loan keeps an existing low-rate loan in place beneath a new larger one.

Discount points lower the borrower's interest rate. One point = 1% of the loan amount, paid up front. A common rule of thumb is that 1 point lowers the rate by about 0.25%, though actual buydowns vary.

Worked example: On a $280,000 loan the lender charges 2 discount points to reduce the rate.

• Cost of points = $280,000 x 0.02 = $5,600 paid at closing.
• If each point buys down 0.25%, 2 points lower the rate by about 0.50% (e.g., 7.0% to 6.5%).

The borrower weighs the $5,600 upfront against monthly savings to find the break-even period. Points are deductible mortgage interest in many cases, and the exam may ask you to compute the dollar cost of a given number of points — always take the percentage of the loan amount, never the purchase price.