Real Estate Exam: Real Estate Financing, Mortgage Types, FHA, VA, Conventional

A mortgage involves two parties: the borrower, called the mortgagor, and the lender, called the mortgagee. The borrower pledges the property as collateral and retains title. A deed of trust involves three parties: the borrower or trustor, the lender or beneficiary, and a neutral trustee who holds bare legal title until the loan is paid. The key practical difference is foreclosure method: mortgage states require judicial foreclosure through the courts, while deed of trust states allow faster non-judicial foreclosure through a power of sale clause.

A conventional loan is a mortgage not insured or guaranteed by a government agency. It is originated and funded by private lenders like banks and credit unions and follows guidelines set by Fannie Mae and Freddie Mac for conforming loans. Government-backed loans include Federal Housing Administration, or FHA, loans insured by HUD, Veterans Affairs, or VA, loans guaranteed by the VA, and United States Department of Agriculture, or USDA, loans for rural areas.

A Federal Housing Administration, or FHA, loan is a government-insured mortgage designed for borrowers with lower credit scores and smaller down payments. FHA loans require a minimum down payment of 3.5 percent for borrowers with credit scores of 580 or higher, and 10 percent for scores between 500 and 579. Borrowers pay an upfront mortgage insurance premium plus an annual premium for the life of the loan in most cases. FHA loans are popular with first-time homebuyers because of the lower qualification requirements.

A Veterans Affairs, or VA, loan is a mortgage guaranteed by the Department of Veterans Affairs for eligible veterans, active-duty service members, and surviving spouses. VA loans offer several advantages: no down payment required, no private mortgage insurance, competitive interest rates, and limits on closing costs. The VA does not lend money directly but guarantees a portion of the loan, reducing risk for lenders. Borrowers need a Certificate of Eligibility and must meet income and credit requirements.

Private mortgage insurance, or PMI, is insurance that protects the lender if the borrower defaults on a conventional loan. It is required when the borrower's down payment is less than 20 percent of the purchase price, resulting in a loan-to-value ratio above 80 percent. PMI is paid monthly by the borrower and can be canceled once equity reaches 20 percent of the original value through payments, and must be automatically terminated at 22 percent equity. PMI is different from FHA mortgage insurance, which applies to government-insured loans and has different cancellation rules.

A fixed-rate mortgage maintains the same interest rate and monthly principal and interest payment throughout the entire loan term, providing predictable costs for the borrower. An adjustable-rate mortgage, or ARM, has an interest rate that changes periodically based on a market index plus a margin set by the lender. ARMs typically start with a lower rate than fixed-rate loans during an initial fixed period, then adjust annually. Most ARMs have rate caps limiting how much the rate can increase per adjustment period and over the life of the loan.

The loan-to-value ratio, or LTV, is calculated by dividing the loan amount by the appraised value or purchase price of the property, whichever is lower. For example, a 180,000 dollar loan on a 200,000 dollar property equals a 90 percent LTV. LTV matters because higher ratios represent greater risk for lenders: borrowers with less equity are more likely to default, so lenders charge higher rates or require mortgage insurance. Conventional loans above 80 percent LTV require private mortgage insurance. FHA loans allow up to 96.5 percent LTV. Lower LTV ratios qualify borrowers for better terms.

The Real Estate Settlement Procedures Act, or RESPA, is a federal law that requires lenders to provide borrowers with disclosures about settlement costs, prohibits kickbacks and referral fees between settlement service providers, and limits escrow account deposits. RESPA requires a Loan Estimate within three business days of loan application and a Closing Disclosure at least three business days before closing. The Consumer Financial Protection Bureau enforces RESPA.

The Truth in Lending Act, or TILA, is a federal law that requires lenders to disclose the true cost of credit to borrowers, including the annual percentage rate, or APR, total interest cost, payment schedule, and total amount financed. TILA gives borrowers the right to cancel certain mortgage transactions within three business days, known as the right of rescission, which applies to refinances and home equity loans but not to purchase mortgages on a primary residence.

An amortization schedule is a table showing each monthly payment on a loan broken down into the portions applied to principal and interest over the entire loan term. In the early years of a fully amortized loan, most of each payment goes toward interest, with a small portion reducing the principal balance. As the loan matures, the interest portion decreases and the principal portion increases. By the final payment, the loan is paid in full. A 30-year fixed mortgage at six percent interest will pay roughly 54 percent of total payments in interest over the life of the loan.

A balloon mortgage requires the borrower to make regular monthly payments for a set period, typically five to seven years, and then pay the entire remaining balance in one large lump sum called a balloon payment. Monthly payments during the initial period may be calculated as if the loan is amortized over 30 years, making them low and affordable. The risk is that the borrower must either refinance, sell the property, or pay the full remaining balance when the balloon comes due. If property values drop or the borrower cannot qualify to refinance, they may face default and foreclosure.

Prequalification is an informal estimate of how much a borrower might be able to borrow, based on self-reported income, assets, and debts without verification. It provides a rough budget range but carries no commitment from the lender. Preapproval is a formal process where the lender verifies the borrower's credit, income, employment, and assets, then issues a conditional commitment to lend a specific amount. Preapproval carries much more weight with sellers because it demonstrates the buyer has been vetted financially. ---