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

Loan Types, Lender Requirements, PMI, and Mortgage Insurance

The exam tests whether you can classify a loan, identify who backs it, and apply the lender's qualifying math. Loans split into conventional (not government-backed) and government (FHA-insured, VA-guaranteed, USDA).

Conventional loans

A conventional loan is made by a private lender with no government insurance or guarantee. The benchmark is 80% LTV (20% down). At higher LTV the lender requires private mortgage insurance (PMI) to cover its risk.

• Conforming loans meet Fannie Mae / Freddie Mac limits and underwriting; they sell easily on the secondary market.
• Nonconforming (jumbo) loans exceed those limits and carry stricter terms.

Government-backed loans

• FHA loans require a Mortgage Insurance Premium (MIP) regardless of down payment; it is not the same as conventional PMI and often cannot be canceled the same way.
• VA loans charge a one-time funding fee but carry no monthly mortgage insurance. A Certificate of Eligibility proves entitlement.

PMI cancellation (key dates)

Under the Homeowners Protection Act, on conventional loans PMI automatically terminates at 78% LTV of the original value (on schedule), and a borrower may request cancellation at 80% LTV. FHA MIP follows separate HUD rules and frequently lasts the life of the loan when the down payment is under 10%.

Loan-to-value and worked math

LTV = loan amount / value (or price, whichever is lower).

Example: Price $300,000, appraisal $290,000, loan $232,000. Use the lower figure (appraisal). LTV = $232,000 / $290,000 = 80%. Because LTV is exactly 80%, no PMI is required; the buyer must cover the $10,000 gap between price and appraisal in cash.

Down-payment example: Buyer puts 10% down on a $250,000 conventional purchase. Loan = $225,000, LTV = 90%, so PMI applies until the balance reaches 80% ($200,000) on request, or 78% ($195,000) automatically.

Qualifying ratios

Lenders apply two debt ratios:

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

Conventional guidance often allows roughly 28% front-end / 36% back-end. Example: Gross monthly income $6,000. Max housing at 28% = $1,680. With $500 in other monthly debt, back-end at 36% = $2,160, leaving $1,660 for housing - so the back-end ratio is the binding limit here.

Points and the secondary market

• One discount point = 1% of the loan amount, paid to buy down the rate.
• On a $200,000 loan, 2 points = $4,000.
• An origination fee compensates the lender for processing; it is also quoted in points.
• The primary market originates loans; the secondary market (Fannie Mae, Freddie Mac, Ginnie Mae) buys them, restoring lender liquidity.

The secondary market matters because it standardizes underwriting. Lenders write to Fannie/Freddie guidelines so the loans can be sold and the cash recycled into new originations. Ginnie Mae guarantees pools of government (FHA/VA/USDA) loans.

Common loan structures

An ARM's rate equals index + margin, capped by periodic and lifetime rate caps. A 5/1 ARM is fixed for 5 years, then adjusts annually. These features are heavily tested because they change the borrower's risk and qualifying payment.

Worked ARM example: An index sits at 3.25% with a 2.5% margin. The fully indexed rate = 3.25% + 2.5% = 5.75%. A 2% annual cap means a single adjustment cannot raise the rate above the prior rate plus 2 points, even if the index moves more. Candidates who add only the index, or ignore the cap, choose the wrong payment.

Usury and predatory lending

State usury laws cap the maximum interest a lender may charge; federal rules curb predatory features like steering, equity stripping, and loan flipping. On the national portion, recognize that excessive fees, undisclosed balloon payments, or pressuring a borrower into a worse loan are red flags, even when the headline rate looks legal.

Underwriting the borrower

Lenders evaluate the four Cs: capacity (income/ratios), credit (history/score), capital (reserves and down payment), and collateral (the appraised property). A weak appraisal can kill an otherwise approvable loan because the collateral no longer supports the loan amount.

Trap: Candidates assume FHA MIP equals conventional PMI. They differ in structure, duration, and cancellation. Another trap: computing LTV from the sale price when the appraisal is lower - always use the lower of price or appraised value. A third: forgetting an ARM's rate is index plus margin, not the index alone.