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

The Four Major Loan Programs

Lenders package loans into recognizable programs. The exam tests which one fits a given borrower and what insurance each carries.

Key distinctions to memorize: FHA = MIP always; VA = funding fee, no monthly PMI; USDA = rural + income limits; conventional = PMI only above 80% LTV.

Loan-to-Value (LTV)

LTV = loan amount / value, where value is the lesser of the sale price or appraised value. LTV measures lender risk: the higher the LTV, the less borrower equity cushions a default.

Worked example: A home sells for $300,000 and appraises at $300,000. The buyer borrows $270,000.

• LTV = $270,000 / $300,000 = 0.90 = 90% LTV
• Down payment = $30,000 = 10%

Because 90% exceeds 80%, a conventional loan here requires PMI. Trap: if the appraisal had come in at $290,000, value drops to the lesser figure ($290,000), so LTV rises to $270,000 / $290,000 ≈ 93.1% and the buyer must add cash.

Equity, Buydowns, and Seller Concessions

Equity is the difference between market value and the loan balance. It grows two ways: as the borrower pays down principal, and as the property appreciates. A buyer who puts 20% down starts with 20% equity, which is exactly why that level avoids PMI.

A buydown uses points to lower the rate, sometimes temporarily (for example, a 2-1 buydown that cuts the rate 2% in year one and 1% in year two before settling at the note rate). Seller concessions let the seller pay a capped portion of the buyer's closing costs, but program limits apply, and an inflated price to fund concessions can fail the appraisal. Trap: concessions reduce the buyer's cash to close but do not lower the actual loan rate the way points do.

PMI vs. MIP

Private Mortgage Insurance (PMI) is for conventional loans and protects the lender (never the borrower) when LTV is above 80%. Under federal rules, a borrower may request PMI cancellation at 80% LTV, and the lender must automatically terminate it at 78% LTV (based on the original amortization schedule), assuming payments are current.

Mortgage Insurance Premium (MIP) is the FHA equivalent. FHA charges an upfront premium plus an annual premium, and on most modern FHA loans MIP lasts the life of the loan rather than canceling at 78% LTV. Trap: candidates assume MIP cancels like PMI — it usually does not.

The Four Cs of Underwriting

Underwriters approve or deny based on four risk pillars:

• Credit — score and repayment history.
• Capacity — income relative to debt; measured by DTI ratios.
• Capital — down payment, reserves, and the source of those funds.
• Collateral — the property itself, confirmed by the appraisal.

If an exam stem describes a borrower's income and monthly debts, it is testing capacity. If it describes savings and down payment, it is testing capital.

Debt-to-Income (DTI)

DTI = total monthly debt / gross monthly income. Lower is safer.

Worked example: Gross monthly income $6,000; total monthly debt (proposed housing payment plus car, cards, student loans) $2,100.

• DTI = $2,100 / $6,000 = 0.35 = 35%

Many programs cap total DTI in the low-to-mid 40s, though automated underwriting and compensating factors (strong reserves, high credit) can stretch it. A second example: income $8,000, debts $3,600 → DTI = 45%, which is near or above common limits and may require those compensating factors.

Points and Pre-Approval

Discount points are prepaid interest: one point = 1% of the loan amount, paid at closing to lower the interest rate. On a $270,000 loan, two points cost $5,400. Points can be paid by buyer or seller.

Pre-qualification is an informal estimate from stated (unverified) figures. Pre-approval rests on verified income, assets, and credit, so sellers treat it as far stronger. Trap: a pre-qualification letter is not a financing commitment.

Fixed vs. Adjustable and Amortization

A fixed-rate loan keeps the same rate and payment for the full term, so the borrower trades a potentially higher starting rate for certainty. An adjustable-rate mortgage (ARM) starts lower but resets after an introductory period using an index plus a margin, subject to caps that limit each adjustment and the lifetime increase. The risk is payment shock when the rate jumps.

Most residential loans are fully amortized: each level payment covers the period's interest first, then reduces principal. Early payments are mostly interest; later payments are mostly principal, which is why equity builds slowly at first. A balloon loan, by contrast, leaves a large lump sum due at the end.

Conforming Loans and the Secondary Market

Conventional loans that meet Fannie Mae and Freddie Mac guidelines (including the annual conforming loan limit) are conforming and easy to sell on the secondary market; loans above the limit are jumbo and carry stricter terms. Selling loans to these government-sponsored enterprises replenishes lender capital so they can originate more loans.

Trap distinction: the primary market is where lenders originate loans to borrowers; the secondary market is where those closed loans are bought and sold by investors. A borrower never deals with the secondary market directly, even though it shapes the rates they are offered.